Basics of Portfolio Construction For Price Followers – Introduction Part 7 – The Entry
Let’s drill down into another common statement made by the Trend Follower. Many boldly declare that the entries do not matter as it is the exit condition where they place their focused attention. Myth or Fact?
Let’s look at a nice long term graph of 40 of the top Fund Managers who practice the arcane shady art of diversified trend following across global asset classes. Over the entire 20 year performance period, look at the index result. What do you see? Look closely.
Can you see it yet?
Let’s place a regression line on the index result and see if you can now see it.
What about now?
Let’s spell it out. Can you see how the overall performance volatility between 1/1/2000 to the GFC in 2008 has now changed post GFC?
Note how the trajectory closely followed the line of regression. The growth rate was far more continuous in nature up to 2008 with less volatility.
Now look at the period post GFC to current day. Can you see the increased volatility in overall performance with long periods of building drawdowns versus strong corrective periods of boom?….but also notice a strange thing……the overall trajectory of the regression line has still maintained it’s overall growth slope.
So we now ask why?
Here are some possible factors that we feel may answer this riddle.
- Market conditions across diversified sectors have substantively changed in nature post GFC but FM returns still intrinsically bear the overall same growth trajectory….many possible reasons for this;
- One reason that comes to mind is that diversification benefits of reduced volatility has reduced post GFC where markets have become more correlated in nature;
- The style drift associated with these 40 FM’s has increased from a desire to address building drawdowns post 2008; and/or
- The progressively increased volatility is a signature of building leverage being applied within these 40 FM systems which have exacerbated overall volatility around their index average growth rate.
While the latter may have some minor role to play where FM’s have been chasing returns during difficult periods, we are of the opinion that it is the former 3 possible factors that hold most weight. In particular the first broad assumption. Markets have simply changed their behaviour.
Something has changed in overall participant behaviour over this timeframe. So now let’s be bold with a hypothesis. What really has changed?……well that is an easy one. QE intervention post 2008 and the rise and rise of the algos.
So let’s surmise that it is more likely to be a symptom of QE intervention given its gargantuan impact on the world economy that has attempted to regulate overall market volatility. We further surmise that during this overall intervention, occasionally there is a ‘snap’ where the market attempt to return to normal transition which catches the central banks off guard and ensure they continue to roll out a program of QE whether by printing money or lowering interest rates to negative yields.
This impact is of market suppression by regulatory intervention which is magnified by a new swarm of predictive participant (aka the algo’s) that sing to the tune of this regulated mean reversion to capture a share of this predictable oscillation.
According to this rationale….we are now returning to a new normal state of the market, as central bankers are now starting to take their fingers off the dopamine injections, and the equity and bond markets wobble as these drug addicted asset classes just don’t know which way to go. The market appears to be magically healing itself.
So let’s get back to the story of the traditional trend following FM’s who are represented in this example. Since post 2008 the market has separated into a protracted phase of mean reversion which has periodically and unpredictably been separated by periods of strong divergence (the snaps).
The rationale provided above provides a narrative of either fact or fiction to help at least understand why the FM’s have suffered building drawdowns during this period, but on average are still over the long term performing faithfully as always. We all like a good story….even us price followers.
No matter what the reasons, the period post GFC however has been extremely tough on the patience of the diversified systematic trend follower however and more importantly it’s devoted league of loyal supporters who invest in these juggernauts of the industry.
So now let’s get back to the original point of this post in relation to the question….do entries matter in the new context that we now find ourselves in?. Never mind the story. Just accept the impact of the trillions of $ released into the systems that needs to sit somewhere. We must admit that conditions are not the same post GFC than they were before GFC.
However it is not surprising at all. Common to all complex systems is that they evolve and adapt in their emergent expressions. Change is a factor we must deal with whether we simply follow Price or not. The index performance results are simply a symptom arising from a different market expression.
You may be familiar with famous trend following experiments such as ‘The Turtles Experiment’ or Tom Basso’s random entry experiment that were undertaken well before GFC. Well, to not bore you with the details, these experiments and many of the simplified assumptions that related to a different market context no longer apply today. FM’s have had to adapt or perish in response to these new market conditions.
A simple random entry using a simple trend following model of Tom Basso’s proves to be a dud these days in most instances when testing these assumptions over an extended time interval that includes today’s modern markets. What still works however is a random entry after you have applied a filter to extract you from the noise of the current market condition.
Similarly the same ‘Turtle soup’ recipe applied today, unless revamped to reflect current market conditions, would share a similar fate as the naive application of the Tom Basso experiment. Now the interesting thing to note is that the Turtle soup recipe was actually very specific to the ‘when of an entry condition‘. The Donchian channel look-back dictated when to enter the trend following trade.
So perhaps we need to now admit that our statement about ‘entries don’t matter’ ……..might be a legacy of the past market condition. To not consider the importance of your entry is probably an unwise move in today’s different market climate.
Now another factor to consider is that a large majority of those firms that you see represented in that equity curve above have had to adapt their recipes to be alive and well today. There has been style drift from their traditional form. Many of them have stepped out towards the longer timeframe to achieve this, where noise and the tendency of mean reversion is less prevalent.
This move out to the longer timeframe is actually an acceptance that entries actually do matter…..so don’t subscribe to the hype of the mantra. Investigate all mantras.
Furthermore, we also note that many of these FM’s wait for a breakout to enter their trend following positions. The nuance of the breakout is that by definition it is fundamentally linked to the method of entry deployed by these guys.
Bottom line is that entries do matter these days….maybe not as much as exits….but they are now critical in these altered market regimes where noise and mean reversion have a more significant and enduring propensity to have the ultimate say in the matter.
So in our philosophical approach of trading the outlier, by entering a trade within the anomalous zone, embedded in this principle is that it is the market context that is important as opposed to the specific nature of the entry itself.
We only enter our trades when conditions are ‘abnormal’. There is a zone outside the normal day to day machinations of the market where we apply our entries. We can however be anywhere in that zone….but it is being in that zone of market context that matters….not the specificity of the actual type of entry itself.
Once that trade is entered using a variety of different configured traps that have a singular origin at that entry point. We ride every possible favourable price move that emanates from that singularity in a very diversified systematic way. We hit the entry with a machine gun array of positive trajectory options….where a few of them may take a very long favourable journey, some of them will have a short hiatus….but all of them can only suffer a very small adverse price move along the way.
The traditional trend follower would say, add to winning trades….while we say “hit the entry with a machine gun and see which bullets cut through”. In the Law of Large Numbers the big numbers win at the the end of the day.
But you might of guessed by now that we do not classify ourselves as trend followers. We subtly differ and represent a different species of predator that devour predictors. We call ourselves the Diversified Systematic Price Follower and we have a different set of teeth that can be seen in the diagram below. We are a new breed of price follower that has emerged from the dark abyss in response to altered market conditions post GFC. We have a similar approach to the traditional trend following predator….but in this space, the size of your scales and the shape of your teeth actually matters. Nuance now counts for something.
The entry condition that we provide by restricting our entries to the anomaly zone and the types of trap we deploy allows for a broader range of options that capitalise on short term momentum surges and long term trending condition. The average trade holding period can range from a few hours…to a few years. Why so large a variation?…… ’cause we are hunting the outliers chaps and these big boys can take a variety of different forms from small to large. We are just not excited by the limited bounty that ‘the normal zone’ can deliver from time to time.
Trade well and prosper
Thee ATS mob
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