Trend Following ETFs: How the Rule Works and Where It Breaks

A trend following ETF buys markets whose prices are rising. It exits or shorts markets whose prices are falling. A rule on price makes every decision, and the fund holds Treasury bills as collateral.

That's the whole idea. No forecast, no analyst call, no view on what the Fed does next.

What is a trend following ETF?

It's an exchange-traded fund that applies one price rule across dozens of futures markets. Stock index futures, government bonds, currencies, crude oil, copper, grains. The fund goes long what's been rising and short what's been falling.

Most of these funds sit inside the managed futures category. The risk-transfer logic underneath them is covered in our piece on managed futures ETFs. Read that first if you want to know why the return should exist at all.

The wrapper is the new part. Advisors used to reach this strategy through a limited partnership with a lockup and a K-1. Now it trades intraday and issues a 1099.

How does the trend signal actually work?

1. Pick the market set. Usually 40 to 100 liquid futures contracts across equities, rates, currencies and commodities.
2. Measure the trend. A moving-average crossover, a channel breakout, or plain price change over three to twelve months.
3. Set the direction. Above the threshold, go long. Below it, go short or go flat.
4. Size by volatility. A calm market gets a bigger position than a violent one. Each market then contributes similar risk.
5. Rebalance on a schedule. Daily or weekly. The rule runs whether or not the last trade worked.

Notice what's absent. Nobody asks whether oil belongs at $60 or $90. The rule only asks which way it's been going.

What does a trend following ETF actually hold?

Open the holdings file and you'll find mostly Treasury bills. That cash is collateral. A futures contract requires margin, not full payment. So the fund controls far more exposure than the money it posts.

Two structural details matter for advisors. Many of these funds route commodity exposure through a Cayman subsidiary. That's because a regulated investment company faces limits on direct commodity income.

The second is tax. Most futures positions are Section 1256 contracts. They get 60/40 long-term and short-term treatment, and they're marked to market at year end. The reporting is simple. The timing isn't always what a client expects.

Worked example: what trend following did in 2022

2022 is the cleanest case on record. Stocks and bonds fell together.

The S&P 500 fell 19.4% on price for the calendar year. The Bloomberg US Aggregate Bond Index fell roughly 13%, its worst calendar year on record. A traditional 60/40 portfolio had nothing to hide behind.

Trend following spent that year on the other side of those moves. The 2-year Treasury yield started 2022 near 0.73% and finished above 4.3%. Bond prices fell for twelve straight months, so the rule held a short. WTI crude opened the year near $76 and traded above $120 in March, so the rule held a long.

Trend following made money in 2022 while both traditional asset classes lost. That's the case the category is sold on. It's also a single year.

When does trend following stop working?

It fails on reversals. March 2023 shows how fast.

On March 8, 2023, the 2-year Treasury yield sat near 5.05%. That was the highest reading since 2007. Silicon Valley Bank failed on March 10. By March 13 the same yield was under 4.00%. That three-day collapse was the sharpest since 1987.

Trend followers were short bonds going into that week. Bonds had fallen for fourteen months, so the rule was positioned for more of the same. A year of gains came apart in days.

That's a whipsaw, and it isn't a defect. It's the price of the method. A rule that follows price is always wrong at the turn. The turn is the one thing price can't tell you in advance.

The second failure mode is slower and harder on clients. 2011, 2012 and 2013 were three straight losing years for the trend category. US stocks climbed through most of it. Nothing was broken. Markets chopped sideways, and no trend lasted long enough to pay for the false starts.

The third problem is dispersion. Two funds both labelled trend following can run different lookbacks and different market sets. In a given month they can sit on opposite sides of the same trade. The label tells you less than advisors assume.

How should an advisor size a trend following ETF?

Treat it as a diversifier, not a core holding. Its correlation to equities is close to zero over long periods. That's the entire reason to own it. It's also why the fund will look wrong for years at a stretch.

Most allocations land between 5% and 10% of a portfolio. Below that it can't move the result. Above that the tracking error against a client benchmark gets hard to defend in a good equity year.

The real risk is behavioral. Clients fire the diversifier in the year it lags. That's usually the year before it earns its keep. Set the expectation in writing at purchase, not in the review meeting afterward.

Is a trend following ETF the same as a risk-managed equity strategy?

No. The distinction matters when you're filling a slot.

A trend following fund trades futures across asset classes and can be short. A rules-based equity strategy stays in equities. It steps toward cash when its own signals break down. The first diversifies away from stocks. The second changes how much stock risk you carry.

THOR builds the second kind. THOR Index Rotation applies price signals to equity exposure. It seeks to reduce participation in extended declines. It isn't a managed futures product and it doesn't replace one. Advisors who use both are solving two different problems. More on that split in our guide to tactical asset allocation.

Definitions

• Trend following: A systematic method that goes long rising markets and short falling ones, on price alone.
• Managed futures: The broader fund category holding futures positions. Trend following is its largest style.
• Time-series momentum: Comparing a market to its own past price rather than to other markets.
• Whipsaw: A loss taken when a trend reverses right after the rule commits to it.
• Notional exposure: The full contract value the fund controls, which exceeds the cash it posts.
• Volatility targeting: Sizing each position so calm and violent markets contribute similar risk.
• Section 1256 contract: A futures contract taxed 60% long-term and 40% short-term, marked to market at year end.

One practical check before you buy any of these funds. Read the lookback window in the prospectus. A three-month rule and a twelve-month rule build different portfolios in the same market. That single number explains most of the gap between two funds carrying the same label.

Disclosure: This material is for informational purposes only and is not investment advice. Past performance is not indicative of future results. Investing involves risk, including possible loss of principal. THOR Financial Technologies is an SEC-registered investment adviser. Registration does not imply a certain level of skill or training.