Podcast Summary
Trend following strategies perform well in unprecedented market conditions: Despite not having seen anything like it before, trend following strategies delivered returns between flat to up 10% for larger trend followers during the pandemic year, showcasing their robustness in various market environments.
Trend following strategies, which are based on historical data, can still perform well even in unprecedented market conditions, such as the one we experienced in 2020. Niels Costa Blaarsson, a veteran of the finance industry and a trend following investor, shared his experience of how their models at Dun performed during the pandemic year. Despite not having seen anything like it before in their 46-year-long dataset, the models were able to deliver returns between flat to up 10% for larger trend followers. This signifies the robustness of the strategy, which can deal with various market environments. The models follow their investment plan without hesitation or second-guessing, and when long equity positions were triggered to exit in February, there were no hesitations. The reduction of long exposure and going short oil allowed for a strong return during March when clients needed it the most. However, as a medium to long-term trend follower, having frequent changes in the direction of trends is not ideal. But, the challenge for these strategies is when the market makes a U-turn, and robust risk management systems are essential to keep out of trouble. Furthermore, unexpected events like the pandemic provide new research opportunities for trend following strategies, as the models can now be updated with new data. Consistent and incremental improvements to trading models have kept Dun going for over 4 decades.
Impact of 2020 events on trend following strategies varies: The success of trend following strategies in 2020 depended on specific asset positions during the crisis and central bank interventions.
The inclusion of the unique events of 2020 in financial models depends on the specific lookback period and data restrictions used by the model designers. While 2020's volatility and central bank interventions may seem ideal for certain strategies like trend following, the actual impact on these models depends on what assets were in the portfolio during the crisis. For instance, trend following strategies that were short stocks, long bonds, and short some commodities (except for gold and silver) would have performed well had the central banks not intervened. However, it's important to note that not all trend following strategies were successful in 2020, and some shorter-term managers faced liquidity concerns. Additionally, it's crucial to remember that trend following strategies, like stock investing, involve a diverse range of positions and strategies, and not all trend followers experienced the same results in 2020.
Understanding the differences in trend following strategies: Diversification across various trend following strategies, including those with different market compositions and design elements, can help mitigate risk and maximize returns.
A portfolio of trend following strategies is not a one-size-fits-all investment. While trend following strategies may seem similar due to their correlation, the differences between managers can lead to significantly different returns. These differences can be attributed to what is traded and how it is traded. The composition of a portfolio, including which markets are included and the risk allocation, can make a big difference in performance. Additionally, the design of a trend following system, such as entry methods, position sizing, exit strategies, and how markets are mixed, can also impact returns. For example, short-term managers may perform well in the initial stages of a crisis but may underperform in the long term, while longer-term managers may lag initially but catch up later. Therefore, it's essential to have diversification across different types of trend followers to mitigate risk and maximize returns. Ultimately, the success of a trend following strategy depends on the overall trend environment, making it crucial to have a well-thought-out design and a clear understanding of trend strength. However, quantifying and visualizing trend strength can be challenging.
Half of markets in a diversified portfolio should be trending for trend following to perform best: Trend following, a strategy that performs best when around half of markets in a portfolio are trending, had positive results in 2020 with six or more months of strong trending markets, despite limited number of strong months in recent years.
Trend following, a type of systematic investment strategy, performs best when around half of the markets in a diversified portfolio are trending. According to Nils Jansons, founder of a CTA firm, weak trending conditions for more than nine months in a year usually result in negative performance for trend followers. Conversely, a year with six or more months of strong trending markets tends to yield positive results. However, the number of strong months in recent years has been limited. Despite this, December 2020 provided a strong reading, and the trend barometer indicated six readings at or above 50% for the entire year, suggesting a positive performance for trend follows in 2020. Trend following can be compared to momentum investing, but while momentum focuses on an asset with strong recent price performance, trend following looks for trends that last longer.
Identifying and profiting from market trends with trend following strategies: Trend following strategies involve using systematic rules to enter and exit positions based on market trends. These strategies can be applied to various financial instruments and timeframes, but require quick reactions to market reversals and a focus on exit rules to maximize profits.
Trend following is a strategy that involves identifying and profiting from trends in financial markets. This can be done through various methods, such as breakouts of moving averages or volatility bands, or time series momentum. While entry rules are important for getting into positions, exit rules are more challenging as they need to allow for quick reactions to market reversals while avoiding premature exits during normal corrections. Trade frequency can also vary greatly among trend following managers, with some preferring a long-term approach and others making more frequent adjustments. At Don Capital, they use a long-term trend following approach with a focus on exchange-traded futures contracts due to their liquidity and performance during crisis periods. Overall, trend following requires a systematic and rules-based approach to identifying and capitalizing on market trends.
Benefits of Trend Following Strategies: Cost Effective, Eliminate Counterparty Risk: Trend following strategies involve trading futures contracts across multiple markets, offering cost effectiveness and eliminating counterparty risk with exchanges. Strategists aim for equal exposure in each market, focusing on managing portfolio risk and constructing a diversified portfolio.
Trend following strategies, which involve trading futures contracts across multiple markets, offer several benefits including cost effectiveness and eliminating counterparty risk with the exchanges. Nils Jansson, a trend follower, explained that they have active bets in all markets, but the number and size of positions can change daily based on their read of the trend strength and risk management. They treat all markets equally and aim to have the same exposure in each market, recognizing that a few strong-trending markets can generate significant returns. The low-interest-rate environment has impacted returns for some sectors, particularly commodities, currencies, and equities, but it's not the sole factor. Trend followers, as risk managers, focus on managing portfolio risk and constructing a diversified portfolio across markets. Despite the challenges, they have not seen significant degradation in returns since 2006.
Central bank interventions lead to economic stability, but investors face potential market shifts: Trend following strategy, with low correlation to stocks, offers diversification, lower volatility, and potentially higher returns to mitigate bond risks in uncertain economic times
Central bank interventions have led to less economic volatility, but this stability may leave investors with large bond holdings vulnerable to potential market shifts. Trend following, a strategy that profits from market trends regardless of direction, can help mitigate this risk by providing diversification and potentially higher returns with lower volatility and drawdowns. The evidence supporting this strategy is compelling, as trend following has historically shown low correlation with stocks. By combining these non-correlated assets, investors can enhance portfolio performance and reduce overall risk. The importance of this strategy is highlighted as investors seek to navigate an increasingly uncertain economic landscape.
Adding trend following strategies to global equity portfolios: Incorporating trend following strategies can enhance returns and reduce risk in global equity portfolios, improving risk-adjusted performance metrics like the Sharpe ratio, but it's important to consider the limitations of these metrics.
Adding trend following strategies to a global equity portfolio, such as the MSCI, can lead to higher returns with lower risk. This is due to the zero correlation between stocks and trend following strategies, resulting in a reduction of drawdowns and an increase in the Sharpe ratio. However, it's important to note that the Sharpe ratio, which measures risk-adjusted returns, has limitations. One of its flaws is that it treats upside and downside volatility equally, penalizing investments for their upside volatility. A better alternative is the Sortino ratio, which focuses only on the downside volatility. However, even the Sortino ratio has its limitations, as it doesn't take into account the order of returns. Despite these challenges, understanding the limitations of popular risk metrics like the Sharpe ratio is crucial for investors to make informed decisions.
Measuring Investment Risk Beyond Sharpe Ratio: Consider measures like the ulcer index, UPI, conditional drawdown at risk, pitfall indicator, and serenity ratio to gain a more complete understanding of an investment's true riskiness beyond the Sharpe ratio's expected return per unit of risk.
While traditional risk measures like the Sharpe ratio provide valuable information about the expected return per unit of risk, they don't fully capture the gut-wrenching experience of investment drawdowns. To get a better sense of an investment's true riskiness, it's important to consider measures like the ulcer index, which takes into account both the depth and duration of drawdowns, and the ulcer performance index (UPI), which adjusts the return for the ulcer index. However, the ulcer index only represents an average risk and doesn't account for extreme negative surprises or hidden risks. To address this, it's important to look at conditional drawdown at risk, which measures the average drawdowns that fall below a certain confidence level. The pitfall indicator, which is the conditional drawdown at risk divided by annualized volatility, helps identify any unexpected extreme drawdowns not accounted for by the strategy's volatility. Finally, the serenity ratio, which uses a penalized risk measure that combines the average risk from the ulcer index and the extreme risk from the pitfall indicator, provides a more complete picture of a strategy's riskiness by considering both average and extreme drawdowns.
Evaluating Investment Strategies with the Serenity Ratio: The Serenity Ratio, a new metric, measures the balance between returns and emotional impact of drawdowns, favoring strategies like global macro and trend following for their transparency and serene investment experience. Diversification across various assets is necessary for success.
The Serenity Ratio, a new metric for evaluating investment strategies, provides a more comprehensive view of risk by considering the emotional impact of drawdowns on investors. This ratio, similar to the Sharpe Ratio, measures the balance between returns and risk. Strategies with higher serenity ratios, such as global macro and trend following, offer greater transparency about risk and provide a more serene investment experience. However, not all markets trend equally, and applying a trend following strategy across a diverse range of assets, including stocks, bonds, currencies, and commodities, especially commodities, is crucial for its success. While the strategy may only make money on about 40% of trades, its long-term evidence and uncorrelated returns make it an essential component of any equity portfolio.
Mixed results for trend following strategies in 2020, volatility strategies showed opposite performance patterns: Trend following strategies had strong returns during market crises and optimism, while volatility strategies faced opposite performance patterns. Our approach uses changes in the forward curve of the VIX complex to identify patterns and generate returns with no correlation to stocks, bonds, or other strategies.
Trend following strategies had mixed results in 2020, with strong returns during the March crisis and December optimism, while volatility strategies showed opposite performance patterns. Volatility, as a strategy, requires different methods to trade effectively due to the VIX's non-trending nature. Short volatility managers make consistent returns during calm markets but can face significant losses during crises, while long volatility managers thrive in crisis situations but slowly lose money otherwise. Our approach, which includes a small allocation to volatility in our trend following strategy and now offers a standalone fund, uses changes in the forward curve of the VIX complex to identify patterns and generate returns with no correlation to stocks, bonds, or other strategies. We employ a fully systematic process without relying on market headlines or anticipation.
Identifying market trends and utilizing diversification strategies: Investing objectively by focusing on market patterns and employing diversification through trend following and volatility strategies can help investors avoid emotional attachments and make informed decisions.
Understanding market patterns and utilizing diversification through different investment strategies, such as trend following and volatility strategies, can help investors make objective decisions and avoid getting emotionally attached to specific markets or stocks. The financial markets in 2020, with examples like Tesla and Bitcoin, demonstrated the danger of becoming too opinionated and emotionally invested. Trend following strategies capitalize on market emotions by identifying and profiting from trends, regardless of personal opinions. Rules-based investors focus solely on market data and objective rules, acting as their guardian angels, while the trend remains their friend. To learn more about Steve and his trend following insights, listeners can tune into his podcasts or explore Done Capital.
Exploring Don Capital and Their Educational Resources: Don Capital offers open educational content on their website and podcasts, allowing access to valuable insights from top traders and financial experts. To access more detailed information, users can accredit themselves.
If you're interested in learning more about Don Capital and accessing their educational content, the best place to start is by visiting their website, doncapital.com. There, you can find open educational content and accredit yourself to gain access to more detailed information. Additionally, you can listen to podcast series on toptraderspodcast.com, featuring weekly conversations on market events and answers to community questions, as well as 1 on 1 conversations with top hedge fund managers and investment managers, and group conversations with financial thought leaders. Be sure to tune in next week for another episode of The Investor's Podcast, and for more information, visit theinvestorspodcast.com. Remember, this podcast is for entertainment purposes only and before making any investment decisions, consult a professional.
