Trend following and VCs

There’s a trend with burgers. Go into some burger joints, and they’ll be offering a “wagyu” burger. This is generally code for charging you more for a burger. Wagyu steak tends to be prohibitively expensive. The difficulty with a burger, is that the meat gets minced, so even if what you are getting served really was super expensive wagyu steak, once it has been minced (which seems doubtful), the texture of it would be difficult to discern. For restaurants jumping on the trend, why not though! If some folks are willing to pay a few bucks more a “wagyu” burger, give them what they want.


Trends are not just a burger thing! Financial markets are subject to trend following behaviour. Why do trends start in financial markets? There are many explanations. There include crowding from investors, and the whole fear of missing out factor (FOMO) which can drive asset prices, and often at odds with fundamentals. More broadly, you could also argue that long term trends exist because of the business cycle, and the reactions of central banks to it.


Trend following as a strategy has been popular for many decades, in particular across the main futures contracts. There are many CTAs which are predominantly trend followers, although admittedly these days many “trend followers” have diversified into other systematic strategies. One of the “easiest” ways to improve trend following returns is to have a bigger universe of assets, both in terms of increasing asset classes and the number of assets you trade in those asset classes. So rather than purely trading the liquid futures contracts that exist, you can add stuff that might be OTC, and more exotic. For many of these more unusual assets, it might be more tricky to source liquidity. The more assets in a trend followers universe, the more likely they’ll be trends in at least one of these assets at any point in time.


That being said, there will still likely be periods where trend following may not perform. There can also be periods where the macro environment, means where trend following performs exceptionally well across many markets.


What has this trend following stuff got to do with investing in VCs who invest in startups rather than in futures contracts or other instruments in financial markets? Implicitly, you could argue that the approach is actually related to trend following, where it is also regime dependent. VC investing is not done in a vacuum. It is impacted by the macro environment. In a rate hiking environment, where capital is expensive, funding markets become less forgiving. By contrast when rates are low, valuations can be driven higher – compare the present environment to 2021! 


Also trend following can be a feature of VC investing. Sometimes one specific sector is seen as hot: just think of Generative AI right now, and how startups are trying to hurtle to this space for opportunities. Just like with trend following in liquid financial markets, VCs will try to spread these risk across a large number of names. If just one investment “trends” it will be enough wipe away smaller losses in many others.


Of course there are many other divergences between VCs and trend followers. For one, VCs have a much more discretionary approach, whereas trend following funds typically use systematic trading rules. The assets which trend followers trade are much more liquid, and they can also be shorted. The assets that VCs invest in, are more illiquid, and there are a huge number of them, which requires a lot of deep research to understand. At heart though, despite the obvious differences, there are still some surprising similarities between systematic trend followers and VCs.