I don’t know what’s going on and why it’s happening. I’m following the market’s movement
Creation and deployment of a trend-following investment system follows these principles – it opens many small positions in many different markets and systematically cut losses as soon as the trend moves against open positions. This means that the system generates more losses than profits, but profits prevails over losses in the long run.
Typically, the system’s success rate is lower than fifty per cent. The system stands on two pillars: position sizing, i.e. proper capital allocation among individual markets, and trend signals (for example, crossing of moving averages or a typical breakout signals where we speculate on breaking of a certain price level, such as a long-term high or low). It should be added that trend-following strategies aren’t discretionary, they can’t be “manually managed”, they are completely systematized and algorithmized because they fill trade orders in many markets. A trend-following strategy doesn’t rely on any fundamental model, it doesn’t focus on a specific asset class, and they are typically based on the long-short model (we open both long and short positions). This strategy is also “agnostic” as to the reasons of market behavior – the system only follows market trends. Therefore, it has nothing to do with fundamental analysis.
Diversify, diversify, diversify!
Trend following is a relatively young investment approach, it’s creation was allowed by the development of information technologies and automated trading systems. However, it’s not too young and we are able to evaluate the real trading results. The results of many hedge funds which have been using trend-following strategies over the last thirty years correspond to theoretical assumptions: trend following as an asset shows a positive slope of the yield curve, plus the potential to bring profits even in times of market slump. Drawdowns of trend-following systems are generally shorter and up to one-third lower than drawdowns of buy-and-hold strategies. Drawdowns often appear when the market offers no opportunities and has no clear trend. Most profits are generally generated during periods of unexpected market events and large movements. And then there’s one big plus: the trend-following strategy does not behave like any investment asset, i.e. there is no correlation. This makes it a useful tool for portfolio diversification.
Most investment strategies are based on the convergent risk principle, which means that they can generate devastating losses during unexpected market events.
Trend-following and similar strategies use the divergent approach to risk and are therefore immune to market drops during crises. This system basically calculates with volatile growth and it is able to generate big profits under extreme market conditions. The following table demonstrates the results of the trend-following system.
Source: Trend Following with Managed Futures (2014), Alex Greyserman and Katharyn M. Kaminski
Over the last twenty years, the trend-following strategy has closely beaten the S&P500 index. However, what is more interesting, the divergent trend-following tracking system combined 50/50 with a convergent style of equity investment gives even better results and increases the Sharpe ratio by 50% with the acceptable maximum drawdown of 22% (which is much lower than the drawdown of long-term investing in shares). The benefits are obvious: by incorporating the trend-following strategy into the classic equity investment approach we can achieve a higher level of portfolio diversification. Most experienced hedge fund managers combine several strategies in order to bring the distribution of returns as close as possible to the normal random distribution and thus achieve the highest average yield. Through this approach, portfolio managers gain better control over yield variability – in other words, they seek to achieve more stable returns, even at the cost of higher potential profits. They emphasize risk control – the standard deviation is significantly lower. However, individual investors aren’t fund managers. And such a trading system isn’t cheap – don’t try to build it at home, unless you have at least a million dollars to play with. You can entrust yourselves to a fund manager using such a strategy. This could definitely be a great way to diversify your portfolio.
Previous chapter: 2/3 Which Alternatives Do We Have to Long-term Equity Investments?
Petr Tmej
(c) AOStrading.cz
