The Power of Trend Following with Sean O'Hara of Pacer ETFs (EP228)
Updated: Oct 21, 2022
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Sean O'Hara comes on the Resilient Advisor Show to discuss the Pacer Trendpilot US Large Cap ETF (PTLC). This is part of the ETF Stories series on the show.
Learn more about the PTLC ETF: https://www.paceretfs.com
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Jay Coulter 0:18
Thanks for tuning in to this episode of ETF Stories. My name is Jay Coulter and my guest for this episode is Sean O'Hara of Pacer ETFs. They have a full suite of ETFs that covers a gamut of investment possibilities. But today, we're going to focus on trend following. Sean, thanks for coming on the show.
Sean O'hara 0:38
Oh, Jay, thanks for having me. Really appreciate it.
Jay Coulter 0:40
All right. So let's start at kind of a trend following one on one level. And let me tell you why I'd like to do that. In my experience, a lot of financial advisors when they hear trend following, they think about those expensive packaged products where you would use manage futures to capture trend falling results. And they were... they were paying, you know, 5%, 6%, 7% percent commissions and we're just not optimal for a client portfolio. Because of the ETF structure, you guys have been able to change that. So I'm hoping this can be an education session on trend following and then your suite of ETFs. So the first question, Sean is, you know, what is trend following?
Sean O'hara 1:18
Well, for us trend following Jay is using a 200 day, simple moving average as a barometer to determine whether we're going to own an equity index, or whether we're going to have half the portfolio in that equity index, or have 100% of the money in T-Bills. So the product you're focusing on today, PTLC, for example, uses the S&P 500. So when the S&P 500 index is above its 200 day moving average, we believe that that means it's in a positive trend. And so will all of the portfolio assets will be invested in the S&P 500. If that index falls below its 200 day moving average for five consecutive days, we believe that's the first sign that there's not a positive trend anymore, and so half the portfolio will go to T-Bill, so you'll have half S&P, and half T-Bills. And then from there, what we watch this the 200 day moving average itself, and if it starts to turn negative, it sort of rolls over, if you will, then the portfolio will go to 100% T-Bills. And then from there, we watch the index versus its moving average again. And when it goes back above for five straight days, we go back into the S&P 500. So trend following for us is using the 200 day moving average to determine whether we want exposure to an equity index, or whether we want an exposure to T-Bills or half and half with the entire mind of managing the downside risk by owning equities. And so you know, we're not traditional buy and hold investors in terms of this particular product, we use this methodology to try to move away from those significant down moves in the market.
Jay Coulter 2:48
If you're interested in learning about the philosophy behind how they're managing the trendpilot series, visit PacerETFs.com. There's a lot of great research out there. Sean, I'd like to go just a little bit deeper on that 200 day, simple moving average. You know, there's a thought out there that the exponential moving average, which is a slight deviation from the simple moving average could provide a little quicker turn back into getting either out of the market or into the market. What was the thought process at... at Pacer behind using the simple moving average?
Sean O'hara 3:20
Such a great question, you know, the research that we've done indicates that the fewer moves you make, the better your long term experiences. And so if you use a shorter term moving average, for example, you might get out quicker, or back in sooner. But what we've learned is if you run those scenarios over time, the longer moving average makes fewer decisions and fewer decisions benefits the shareholder. Same thing would be true with the exponential moving average, it is a little bit more twitchy if you will, perhaps than the simple moving average. But the net result of that is that it winds up making more decisions. And so it seems sort of counterintuitive, if you will, if you're putting it together an ETF strategy that's designed to manage downside risk, that you don't necessarily want to go out as fast as possible. But the research that we've done over time indicates that the fewer decisions that you make in a strategy like this, the better off you are over time.
Jay Coulter 4:20
Yeah, so longtime viewers of this show know it, I'm a big fan of the simple moving average, not just because we like to keep things simple, but as exactly what you just described, if you over engineer your strategy, it just it might look good in a back test over a particular time period. But it when it comes to actually executing the strategy and getting results for your clients. It doesn't necessarily do it.
Sean O'hara 4:41
Yeah. Can I make one more point on that, by the way that you know, the way it works for us is... I mentioned that five day period we that index has to go below its moving average for five consecutive business days. If you just use below one day as your option again, you make far more decisions, you might get out a little quicker on some scenarios. But if you take the totality of all of those scenarios, and you run a five day versus a one day trigger, again, the five day makes fewer decisions, and actually overtime provides a better investment result for the... the end client.
Jay Coulter 5:14
Excellent. So let's get back to the basics again. And explain to viewers why trend following is important, especially in today's markets.
Sean O'hara 5:25
Well, you know, we've been through several bear market cycles in the last 15 or so years, but one was really an uncharacteristic bear market, that would be the pandemic where, you know, the market fell like 32% in 45 days, and then it recovered very quickly because of, you know, an unparalleled fed intervention. But in a normal bear market cycle, if you can exit before the market bottoms out and then reenter before, it's come all the way back up, you can actually produce higher returns, we think over time, on the slide that you're looking at, this is just an indication of just using a simple moving average and a one day trigger, what would happen in the last several bear market cycles that we've been through, so you can see the red line is the what would be called the peak to trough decline in the S&P 500. And the yellow line would be how much your portfolio value would have gone down. If you just relied on the 200 day moving average is your trading opportunity, or is your opportunity to exit. And in all cases, it's less far, some cases far more, or far less buttons, and others not quite as much. But if you're looking as an investor, and you know, most investors today, the vast majority of money is controlled by baby boomers or people are near in retirement. And they just feel like they can't afford to do what they did in 2008, or 2000 to 2002, again, where you have this long, protracted two to three year decline, and then another two to three year climb off the bottom. And this is a tool that investors who are worried about that can utilize to minimize some of the downside exposure, and hopefully opportunistically provide a little excess return over time.
Jay Coulter 7:00
And that chart can be found in some of the research that you can find on PacerETFs.com. Alright, Sean, let's pivot for just a minute. And I'm gonna give you it's, it's a softball, but it actually is gonna be interesting to see how you choose to, to answer this. How do you identify a trend?
Sean O'hara 7:19
Well, again, what we... what we look at as moving averages are sort of, you know, I don't want to get overly technical, but they are technical indicators that investors have used for decade after decade after decade. And there's different variations of these, but we just simply utilize, the way we determine what a trend is, is what the underlying asset, the index, for example, the S&P 500, its relationship to its 200 day moving average. And there's a little bit of physics involved, if you will, you know, like a body in motion tends to stay in motion kind of thing. And so when that index is above, it's moving average, as I said earlier, we believe that's a positive trend. And when it falls below, for a period of time, we believe that creates a negative trend. And we would rather invest in those positive trends and belong in the S&P 500, for example, and not invest during those periods where things are negative, even though we might be wrong. And you know, that once the index goes below, it starts that, quote, unquote, downward trend, it may not last forever, it could be just a correction. But the whole goal of the trendpilot series and in particular PTLC, was not to time the market, it was to mitigate these catastrophic, big declines that happened in normal bear market cycles, so that the investor doesn't have to watch that part of their portfolio, ride prices all the way to the bottom, and then go back... back up. It's like, you know, when you think about that peak to valley thing, you know, the mountain, you don't have to go all the way down into one mountain, and then all the way back up the other side, if you sort of say, I'm just gonna cut out right here, and let the market go down, if it's a normal bear market period, where you have several years between that peak to trough, the 200, day moving average will come back down, and you'll get a much lower re entry point.
Jay Coulter 9:03
And Sean, I mean, it's safe to say that if you're using the 200 day, Simple Moving Average, and you have a hard set of rules, like you have with your products, it takes all the emotion out of it.
Sean O'hara 9:12
It does and that's what, you know, emotion is probably the worst thing investors can deal with. Because, you know, I often say, you know, if I if I was dealing with an individual client today, and I took a risk tolerance questionnaire, and I did it today versus say two years ago, I would argue that most of their answers would be far different today than they were two years ago. And not just because they've gotten older, but they're really more experiential. In the midst of a bull market, everybody is very bullish. And in the midst of a decline, everybody turns bearish. And so eliminating those those emotions can be a really critical part of putting a long term plan together, they can help people achieve their goals. And then one last thing, if you will, if you'll allow me with regard to the ETF, there's probably some folks out there saying, "Well, if you're selling what do you do with capital gains?" and so forth. And the ETF wrapper is really an excellent vehicle to implement a strategy like this, because there's tax efficiency in an ETF that doesn't exist in a traditional mutual fund. And so we actually can exit equities and buy treasuries for a while, and then reenter equities. And if we've had a nice run up before we've actually, we have the ability to, because it's an ETF shelter those potential gains. So you're not sort of lowering your overall basis, you're just keeping all the money in one place and compounding over a bigger sum over time.
Jay Coulter 10:35
Excellent. So Sean, we've already touched on a lot of the components of PTLC, the Pacer Trendpilot US Large Cap ETF, but I want to break it down again. So for somebody who's new to the space, they're starting to do their due diligence on PTLC, what is the investment process for this ETF?
Sean O'hara 10:54
It's very simple. I mean, there's really only two investment choices within the ETF, the S&P 500 or T-Bills. And we have a very specific set of rules that we utilize, we use the 200 day moving average, the simple two moving average versus the S&P 500 Total Return Index. And so we... the rules are simple when the index is above its 200 day moving average for five consecutive days, we're going to own the S&P 500 in its entirety, then that's where 100% of the portfolio will be. If the S&P 500 Total Return Index falls below its 200 day simple moving average for five consecutive days, we view that as a sign that maybe we should start to become a little more defensive. So half the portfolio will then go into T bills, and then we'll sit there and wait. We think about it Jay like and there's a client video on our website that explains this, but we think of it like a traffic light green, yellow and red, right? Green means go, that's when the index is above it's moving average, yellow means slow down, that's when it's fallen, fallen below for five straight days and half the portfolio will go to T-Bills. And then red means stop. That's when the portfolio will be 100% in T bills. And that only happens after the first signal hits index goes below its moving average. And then the moving average itself starts to roll over and turn negative.
Jay Coulter 12:07
So Sean, when you look at PTLC, where do you feel it fits in a portfolio?
Sean O'hara 12:12
Great question. So, you know, I think where we see the vast majority of investors utilizing this as as a complement to their traditional long only equity portfolio. So if I own let's say, for example, I own another ETF that tracks the S&P 500, like SPY or IVV as if either one of those two big issues need any advertising help from me, but if I did on one of those in a portfolio, I could pair that with PTLC. And essentially, I'm having the same exposure on the equity side. But I'm not exposed to the big declines, because the trendpilot methodology, in a downward trend will move me away from equities and protect my capital by investing it into T-Bills.
Jay Coulter 12:55
Excellent. So I'd like to wrap up with a chart. And this chart is from some of the research that you guys produce. And it shows the hypothetical growth of $100, which is common and marketing materials from ETF firms and mutual fund shops. But in this particular chart, you're breaking out the bull and bear markets, and it gives you what the hypothetical experience would be using some simple moving average trend following. Could you please walk people through this?
Sean O'hara 13:23
Yeah, I mean, I... my eyes are bad. So I'm gonna have to lean into the screen a little bit to see it. But like you have that... on the far left hand side, you've got the red bear markets, you know, that's the tech bubble busting. And so you can see the peak to trough decline on equities on the S&P 500 was 47% during that period, by using just simply using the 200 day moving average, you would have limited that declined to about 11%. And so you don't have to ride the market all the way to the bottom, in the middle of the chart is the financial crisis. And so you'll see that's when you know, we had all these levered loans and people had 16 mortgages on their house, and almost every bank in the country went broke. And again, you can see that peak to trough decline, there is about 55% Which by the way, you know, like that's hard for people to deal with, especially if you're retired, it's very, very difficult to hang in there, if you will, and just buy and hold in those scenarios. That's when your emotions really hurt you hurt you the most that we just said like just get me out. Well, again, using the simple 200 day moving average, your decline would have been limited to about 7% during that period. And then the far right hand side, that little sliver, which technically Jay would be labeled as a bear market, because the market went down percentage wise as much as it needed to more than 20% for it to be labeled a bear market. And that scenario, that trendpilot methodology are using a 200 day moving average, I should say, would eliminate your loss to around 11% as opposed to going down 32% I think is what it says there 33%. I like this chart as a setup for why you might want to start thinking about utilizing something like a trendpilot in your portfolio, I don't count COVID as a bear market, it just, there was nothing like it in history, it was a temporary thing that we unplugged the global economy, the markets, sort of reacted violently. And then there was this flood of cash that limited the timeframe. And so you don't, in order for a trend following strategy, like, like PTLC to work, you need that long, methodical decline in the market. And then that climb back up, which we saw post tech bubble busting and post financial crisis, that particular experience there is not ideal. But I will just note that if you said it, like if you gave me this as the part as it as like, as a fact, that that really wasn't a bear market, like in a traditional bear market, I would say, looking at this chart, there's an awful lot of long term green gains in there. And bear markets tend to come around when nobody suspects they're gonna come around. We all know after they happen, why they happened. But it's been a while since we've had a real traditional bear market scenario, with interest rates rising, inflation rising, this geopolitical crisis, and overall repricing of P/Es on the market that has almost always happens when you have rising rates and rising inflation, this might not be a bad time to use a little bit of a trend following strategy like PTLC in your portfolio, just to manage your downside risk a little bit.
Jay Coulter 16:18
Yeah, Sean, you know, so on this show, we don't do any predicting. We just look at the math and what has happened, which is why we're big fans of trend following. When you look at that chart, and I agree with you that it wasn't really a bear market, back in 2020. We haven't had one in almost a decade and a half. And what that means is there is a generation of advisors out there that have never sat across the kitchen table from a client who's seen their portfolios collapsed by 50% and believe that they're going to fail retirement and have those protracted conversations for two or three years, like we did after the tech wreck, like we did after '08 and trend following strategies are a great way to help potentially mitigate some of those conversations in the future.
Sean O'hara 17:03
And what was constant during that 15 year period, Jay was low interest rates and an accommodative fed and no inflation. And that's all looks like it's going to change. We know inflation is a problem anybody has been to the gas pump or the grocery store knows it's a problem. And the grocery store probably will get worse than the gas pump. And we have a Fed now who is trying to stop inflation by raising rates and reducing their balance sheet. So that 15 year period was allowed during a very accommodative Fed policy period, and a very low inflationary environment. And that's reversing itself. And so again, you know, if you're thinking ahead, not making any prediction, because I don't know, just as you don't know whether, you know, we're going to have another bear market this month, or next month or next year. But from an investor's perspective, if you could take a little piece of your portfolio and put it in something that uses trend following to manage your downside risk, if there's not a bear market, it'll keep going up. But if there is, you'll have at least that piece of your portfolio that I'll move to the sidelines of B and T bills, without you having to do anything.
Jay Coulter 18:05
Sean I appreciate you coming on ETF Stories to discuss PTLC. There is a whole suite of trendpilot ETFs that use different indices and implement the same strategy. To learn more, please visit PacerETFs.com That's PacerETFs.com. Sean, thanks for coming on.
Sean O'hara 18:25
Thanks so much for having me, Jay. I appreciate it.