Why Is Trend Following Not Beat?

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I heard Michael Covel’s excellent interview on Jim Puplava’s radio program. I have also read TurtleTrader and Trend Following books. I am very interested in Trend Following but I have a question that has been nagging me. My question is how do trend following traders gain an edge against the large trading houses with black boxes, proprietary trading, and an army of really technical quants? If trend following is a set of rules and discipline to follow those rules, would not the big trading houses have similar rules and discipline and thus beat the TurtleTrader at the game? Thanks, Lance

Most technical traders at big investment banks do not practice trend following. They practice very short term high frequency trading. Most of those houses are still centered around the concept of arbitrage and or long only fundamental investing. Those are some massive reasons why they don’t beat trend followers. Further, trend following is not something that is “beat” since the real competitors are mutual funds. As long as the vast majority of investors sit like sedated sheep in a Fidelity mutual fund with no plan to make money except in up markets — trend followers will ALWAYS make money. And lastly, human nature is human nature. It creates bubbles, and more bubbles, and then sees those bubbles popped — year after year — decade after decade. If what I mention ever stops — then maybe trend following stops.

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11 thoughts on “Why Is Trend Following Not Beat?

  1. Hello again Michael. 🙂

    Do you think bubbles are a result of people assuming that a rising price means that the market knows that the equity in question is great value (or vice versa), causing them to act accordingly and further move the price in that direction?

    Jeff

  2. Actually, I have been relatively successful applying trend following strategies to mutual funds also. While buy and hold is dead and some would think that mutual funds are also dead, there is nothing that says that you can not buy and sell mutual funds. While not wildly exciting, trend following strategies workm here also.

  3. Trend following realizes profits through the ACCEPTANCE and MANAGEMENT of RISK. When you accept risk that someone else doesn’t want, you will be rewarded for it in the long run.

    “Large trading houses” usually are not looking to accept risk.

  4. The “large trading houses” are in the business of hedging their perceived risk and earning profits as market makers. When they are occasionally mistaken as to the measurement of their actual risk (including counterparty risk), they can lose massively, especially when their normally liquid positions cannot find someone to take the other side of the trade at virtually any price.

  5. Large trading houses have to answer to investors and owners. This leads to a lot of stupid moves. For example, to maximize their bonuses and make the financials look good, they will liquidate positive positions for no other reason than it’s the end of a quarter.

    Furthermore, a lot of their hires are young aggressive Type A personalities…the exact personality that I drool over at the poker table because I know his need to “make something happen” will override the patience needed to succeed.

    Third, most of the hires are still MBA’s, despite what we hear about the math PhD quants. This means they’ve been educated with the same drivel that’s filled business schools for the past 30 years…efficient markets, fundamental analysis with blinders, and a large ego that makes a twenty-something honestly think he’s George Soros and can understand the 1000 variables that go into determining pricing at any given moment.

    If we can’t beat these clowns it’s time to throw in the towel.

    Cheers

  6. How much do large “trading houses” actually “trade”?

    Some simply buy at the bid and sell at the ask over and over. There is nothing wrong with this activity, known as “market making”, but is it really accurate to call the market makers “traders” and lump their activity in with trading profits?

    Some trade foreign exchange. Sometimes they get an order for 1MM USD worth of GBP. They buy this on the interbank market for credit to the house account then sell from inventory in the house account to the customer at a worse rate. They don’t charge commission but they treat the deal with the customer as a trade and book the markup as trading profit. The other FX trick for guaranteed profit is they get a big order for 25MM USD of GBP. They buy 27MM and then sell 2MM. The first 2MM at the best price goes in the house account. The 25MM of customer business spikes the market for a few minutes and then the house sell hits while the market is still high. Is this really trading? It’s called front-running and it’s illegal in stocks but is standard practice in FX.

    Some people take a position knowing that their research department is going to make a change in rating and that will briefly move the market. This will be booked as trading profits.

    Some places will take a bond trade that has gone bad and transfer it from the trading account to the dealing account. They book this as a trading profit. Then the sales force goes to work to unload the bonds from the dealing account on a customer. An example of this is documented in Michael Lewis’ book Liar’s Poker. It happens all the time in various forms. Nobody would buy bonds if they knew how often they are bailing out the house trading desk.

    Did you ever wonder how brokers can make money charging [famous mutual fund firm] next to nothing for stock trades? The answer is they don’t. But they get to show the deal flow to their proprietary trading team who trades alongside the customer which is technically not front-running but the effect is almost the same.

    As we sit here, the new financial services bill proposes to outlaw some of these practices. This has been tried before. My bet is that the firms will modify their practices a little to comply but nothing significant will change. The firms make too much money from this pseudo-trading.

  7. Let’s also not forget that all the big banks and “trading houses” are currently in the business of borrowing money from the government (the Fed) at 0.25% and then loaning that money back to the government (the Treasury) at 3%. Repeat this billions and billions of times.

    If I could get in on that racket, you certainly wouldn’t find me banging around a trend following web site. Ah well, I guess SOME of us have to earn an honest living.

  8. For some traders the quality of life that a particular trading style affords matters much more than how much money we end up making. A life spent trying to get ahead of the next guy is not my idea of a great life. To some of us life style matters much more than how much money we ultimately make.

  9. “If what I mention ever stops — then maybe trend following stops.”

    I would say this line might be more accurate:

    “If what I mention ever stops – then maybe the markets stop.”

  10. I am a CTA starting to trade systematic mechanical approach in 2008. I make a study, analyzing trading style of CTA’s from well known web site where these managers post results every month. I wonder how many are trend followers and how much money is being controlled by trend followers. It shows that in Jun 2010, 76% of all listed CTA’s uses trend following strategy in one way or another. 51.6% of all CTA’s uses 80% or more systematic trend following approach and only 35.3% uses 98% or more systematic trend-following approach. Now that would seem like good news if we consider that trading in futures is a zero sum game and assume that systematic trend following has the edge. 64.7% of all CTA’s are still choosing to make discretionary decisions thus are subject of making fatal errors from which trend followers may profit. Once we look at Assets under management (AUM) we get completely different picture as managers who use at least 80% systematic Trend-following approach control 89.4% and managers with 98% and more systematic trend following approach control 77.7% of all assets under management.
    What does it mean for trend following and how these numbers changed over the years I do not know. It is interesting that almost 80% of all AUM in offered CTA programs listed on this web site is as of June 2010 in hands of fully (or almost fully) systematic trend followers.
    Any thoughts?

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