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Trend Following Is Dead…Opps…Alive Again

From “Hedge fund nightmare turns into a dream” by Miles Johnson:

Do computers that trade financial markets ever have nightmares about losing money? It is a question investors have asked in recent years of the hedge funds that use automated algorithms and models to buy and sell billions of dollars of assets. Having almost consistently made money in the decade leading up to the financial crisis, these so-called trend following hedge funds appeared to have been scrambled by the high correlation across markets caused by ultra-low interest rates and central bank intervention. While the money being lost was just another data entry for the computers buying and selling assets ranging from pork belly futures to Japanese government bonds, their creators faced the very human stress of investors losing faith in their investment strategy. As the funds came under huge pressure to remodel their apparently malfunctioning computer programs, some investors even began to argue that trend following systems were permanently broken – that the mathematicians and scientists should close down their spread sheets for good. “No matter how much we have a statistical, disciplined and scientific approach to investing, that doesn’t mean that as a human you don’t watch your returns going down in periods of poorer performance and experience all the negative emotions that losses entail,” says Ewan Kirk, chief investment officer of UK-based hedge fund manager Cantab. But the managers, who go as far as sending researchers to the British National Archives to extract grain prices from the Domesday Book to construct trend following models, remained convinced the strategy would recover. “When people doubted trend following, it reminded me of people giving up on value investing before the technology bubble burst, at exactly the wrong time,” says Sandy Rattray, chief executive of Man Group’s AHL, one of the largest and oldest of this type of hedge fund. “Studies have shown that momentum has worked well over long periods. It was a brave person who said that momentum was permanently broken, but many did at the beginning of 2014.” Having begun the year as the most hated hedge fund strategy, many of these trend following funds have emerged as the best performing funds of 2014, outpacing their stock picking rivals who rely on mere human intuition to make money. Helped by large moves in commodities, energy prices and interest rates, as well as the ongoing devaluation of the Japanese yen, funds like AHL, as well as rivals such as Cantab, and Isam, have all reported double digit returns for their investors this year. In contrast, many well known funds following other strategies, most notably global macro traders, have lost money this year. Their managers argue it was their ability to withstand the short-term pressure of radically overhauling their core principles that meant they were ready to profit when the right market conditions returned. “Have we changed things on the basis of what happened? The answer is no. We did not lose the faith. We are always grounded in research, and coming up with new ideas,” says Mr Kirk of Cantab, which has $3.2bn under management. “If a model is losing money, but is within the statistical expectation, you can’t just chop and change everything because you have a period of poorer performance.” Investors in these funds, who were beginning to lose patience, now appear to be back on side. “They really needed this,” says an executive from a multibillion-dollar hedge fund investor. “If they had suffered another year of bad performance it was possible some of the smaller ones could have gone out of business entirely.” Part of the problem for trend following funds has been their perceived complexity, with terms such as “black box” frequently used to describe an investment strategy that many hedge fund investors find difficult to analyse compared with more traditional stock picking techniques. Mr Rattray argues that in fact the machines, which are constantly monitored by humans to check for abnormal market moves, are far more transparent than traditional fund managers. “If you tell me what Japanese government bonds will do tomorrow I can tell you exactly what we will do in response,” he says. He believes people will gradually get more comfortable with computers making decisions about investing their money. “Sometimes people can be suspicious of the idea of using models or computers to make decisions. It reminds me of Nissan at first finding people didn’t want to buy the cars they built using robots in factories. It took time for consumers to trust cars that were not put together by humans on an assembly line”.

Trend following is dead…is dead.

Trend Following and The Financial Times

Consider the helter skelter world of The Financial Times:

September 7, 2014 7:02 am
Trend-following hedge funds’ future in doubt

By Madison Marriage

September 16, 2014 7:37 pm
‘Trend-following’ algo funds back in fashion

By Miles Johnson

Perhaps, FT has other value, but reporting accurately on trend following is not part of their skill set.


Rational Logic Means Nothing in the Markets

Greenspan speaks to how irrational markets can be:

Michael, Thanks for making all of your podcasts available to the public. Please keep up the good work. I thought you might find the quote below from Alan Greenspan of interest. It’s from a 10/26/13 interview with the FT entitled “Crash Course”:

“…He [Greenspan] admits that he first saw how irrational finance could become as long ago as the 1950s and 1960s when he briefly tried, as a young New York economist, to trade commodity markets. Back then he thought he could predict cotton values ‘from the outside, looking at supply-demand forces’. But when he actually ‘bought a seat in the market and did a lot of trading’, he discovered that rational logic did not always rule. ‘There were a couple of guys in the exchange who couldn’t tell a hide from copper sheeting but they made a lot of money. Why? They weren’t trading a commodity but human nature…and there is something about human nature which is not rational‘…”


Trend following foundational point #1,232,980.

I Never Promise Secrets: Trend Following is Hard Work

Pauline Skypala writes in “Secrets of winning systems remain hidden”:

Homespun investment wisdom does not come much cheesier than the Whipsaw Song, available on YouTube. Sung to a bluegrass tune, it imparts the trading philosophy of Ed Seykota, who is regularly described as a legendary trend-following trader. His advice is simple: ride your winners, cut your losses, manage your risk, use stops, stick to the system, file (ie, ignore) the news.

The same list could also be used to summarise the lessons Michael Covel seeks to teach in The Little Book of Trading: Trend Following Strategy for Big Winnings (John Wiley & Sons, 2011). But there is a caveat; it is not as easy as it might sound. In fact, the main insight Mr. Covel provides is that successful trading is hard won, and requires an entrepreneurial mindset, a fascination with numbers and charts, and discipline. A helping hand from a mentor such as Mr Seykota does not go amiss either.

Mr. Covel’s profiles of big name trend followers are more likely to persuade readers to hand over their money to these people than to attempt to emulate them. Retail investors “tend to blow up”, he says, because they lack the discipline to “stick with their system”. The most common mistake is a failure to cut losses–to let emotion interfere.

Clearly, traders need to believe in whatever system they devise so they can trust it sufficiently to leave it alone. Mr. Covel does not give anything away about the workings of the systems of the successful traders he writes about, such as Larry Hite, David Harding and Michael Clarke. He does not “reveal the secrets of trend following insiders” as is promised on the cover blurb.

Such information would doubtless be worth far more than the price of the book, but some of the reviewers on Amazon obviously felt short-changed by the lack of any discussion of trading strategies.

The book merely contains advice such as this: “Certain types of systems do perform better than others, and selecting certain clusters of variables within a system will affect system performance.” Then repetition of the point already made, that once established, a system must be followed religiously. Further, a system must work across all futures markets, over many types of market conditions and over many timeframes.

Such a system could take some time to perfect, but Mr. Covel reassures readers that they can operate it out of their bedroom. There is no need for a big office and an army of PhDs (unless you want to do very short term trading or “sophisticated PhD stuff”, which he does not define).

He advises that market selection is a crucial element in success. Any system would have made money in cotton, but none would have done so in cocoa, for example. “There’s a pervasive mindset that every market should be weighted equally. That’s not true,” he writes in the chapter on David Druz, who apparently learned this from Mr Seykota.

However, in a later chapter, Mr. Covel says one of the key realisations was “that risk management centered on trading markets equally, from a risk perspective, was mission critical. You just can’t favour one market over another.”

The first point is about portfolio selection, the second about risk management, so they are not as contradictory as they first appear. Presumably they are both factors that need to be built into a system.

But the rambling and repetitive nature of the book is unhelpful in tying such points together.

Mr. Covel is an evangelist for the trend following style of investment. He decries traditional investment approaches that rely on fundamental analysis, and says buy and hold investing via mutual funds will never make anyone rich. Selling trend-following courses is his business, so this is no surprise.

The apparent ability of trend following commodity trading advisers to make money when all others are losing it, as in 2008, has made investors sit up and take notice of this corner of the investment world. Mr. Covel’s book is timely in that respect.

But the idea that anyone with some skill in maths and computer programming can achieve similar results is fanciful. They may get lucky, but are more likely to get wiped out.

My first thought is courtesy of Seth Godin:

Stand out or fit in. Not all the time, and never at the same time, but it’s always a choice. Those that choose to fit in should expect to avoid criticism (and be ignored). Those that stand out should expect neither.

Thanks for paying attention. Now a dialogue can unfurl. You can find a little snippet of a response on today’s podcast too (first few minutes).

Note: I never promise secrets in my books, film or training. Trend following for those not yet familiar with it is all about gaining knowledge you might not have yet. Perhaps, that can be characterized as secrets by some, but it really comes down to hard work–why people pay me.

Recommended Reading and Listening

Entrepreneurship and Asymmetric Information

Possible Better Processes

Alexander Elder Podcast Interview

Podcast with Harry Silverglate

Interview with Art Collins

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