By Predicting Future Outcomes you May Find that you Miss the Greatest Trends
A lot of our time as Trend Followers is spent explaining why we ‘cut losses short’ but this particular ‘half of our full mantra’ is simply an explanation for how we manage to survive the turmoil of financial market uncertainty. What we need to stress is the importance of the latter part of our mantra, namely ‘letting our profits run’, as this is the actual basis for understanding the long term performance returns of the diversified systematic trend follower.
Unlike convergent trading methods whose performance returns are dictated by price movements which are predictable in nature, and are associated with a notion of directional price oscillations about an historic equilibrium, divergent methods base their performance returns on directional price movement arising from unpredictable market transitions which are a feature of the directional evolution of a complex adaptive system.
The difference in directional price extension between convergent and divergent conditions is subtle but important for wealth ambitions. Convergent methods base their profitable outcomes on the non linearity associated with negative feedback impacts arising from market participation. This non linearity is bounded in extent and is associated with the Law of Diminishing returns that surrounds market equilibrium. Divergent methods on the other hand base their profitable outcomes on the non linearity associated with positive feedback impacts arising during market transitions. This non linearity is unbounded in extent and is associated with the Law of Increasing Returns that is found at the boundary between certainty and uncertainty.
There are arbitrage opportunities arising from both convergent and divergent approaches to speculation in a liquid financial market which can be clearly demonstrated in any long term data sample of daily market returns (Figure 1), however it is critical that we understand the differences between the methods applied to each form of extracting an enduring edge from the financial market, and do not conflate the two. The methods adopted to extract an edge from convergence versus divergence are the antithesis of each other and there is not a ‘one size fits’ all solution for both methods.
Figure 1: Distribution of Daily Returns for 6 Liquid Markets
Now while there is no dispute that opportunities for arbitrage lie in both convergent and divergent methodologies, one of the enigmas of the Fund Management Performance record is that there is a significantly greater representation of divergent FM’s who have stood the test of time than their convergent cousins. There is a relative absence of convergent FM’s in track records that extend beyond the 20 year horizon, whilst there are a plethora of divergent FM’s that do.
The possible reasons for this representational disparity in the performance record can be the subject of a future discussion, however a clue to this riddle lies in the ‘unbounded’ versus the ‘bounded’ profitability that lies in these differing regions of the market distribution of returns. This difference relates to the magnitude of the impact expressed by the outliers, that are present in the long term track record of divergent methods.
This post is going to focus on the reason for the outstanding performance track record of the divergent Fund Managers and demonstrate that while ‘Cutting losses short’ is a necessary condition to ensure survival under uncertainty, it is not a sufficient condition to explain the reason for the outstanding track record of the FM’s that apply this mantra. The raison d’etre for the performance record is actually the second half of this mantra, where under divergent market conditions, you simply ‘let profits run’.
Now to be clear, when we say that we ‘let profits run’ we need to take this seriously. What this means is that we simply do not interfere with a trade event at any time between the entry and the exit of that trade. Any form of interference potentially disrupts the ability to capture an outlier event.
Many would declare that taking profits off the table, volatility adjusting, moving trailing stops and methods to pyramid into trends are wise moves, when it comes to ‘profiting’ in this trading game….however I would suggest that ALL forms of post trade entry interference actually disrupt the potential to capture outlier trade events.
An outlier by definition cannot be predicted in advance, so any method of ‘supposed wise interference’ is based on a predictive conclusion associated with the notion that ‘all trends must end’. An outlier begs to differ with this conclusion. An outlier is of such magnitude that the predictive trader is left scratching their heads in hind-site wondering …..”if only I had traded that beast…it would have set me up for life”.
If you interview the best traders in the world and ask them what were the major contributors of their success, they will announce proudly that it was a handful of signature trades over their lifetime. In fact when you closely look at the performance track record, this is spelled out in black and white. However none of the most successful traders in the world would be able to assign ‘precognition’ as the reason for their selection of these outlier trades. It actually turns out to be their process that simply allowed them to ‘let profits run’. It was the fat tailed nature of the behaviour of the market itself that delivered the fortunes to these traders…..not their powers of prediction.
Let’s have a look at the long term performance track record of a divergent trading system and then the best divergent FM’s in the world to observe the impact of the outlier and how it is by far the dominant contributor to long term performance.
Figure 2: Trend Following Model applied to Real Market Data versus Random Market Data
Figure 2 above displays a divergent trend following system when applied to real market data (top most equity curve) versus random market data (lower array of the balance of equity curves). The reason why I have displayed the result of a trend following system being applied to real market data versus random market data is to highlight the fact that it is the market that dictates a trend followers fortunes….and not the system itself. The system is simply a method to capture the edge that resides in a trending market data series.
The edge associated with the Trend Following system lies in it’s simplicity and its ability to capture an array of different ways a trending market can express itself. Complex systems provide increased constraints within which market data is allowed to move, and therefore restricts your ability to capture the many possible forms that an outlier can take.
Notice that already we can see the need for a simple system design where less is more…when it comes to trend following. This should give us an idea that complex methods used to constrain the markets tendency to trend….such as vol targets and other predictive conclusions that interfere with the markets desire to transition, actually reduces our ability to capture the fruits of the unpredictable outlier event.
Now let us have a look at the histogram of trade results arising from this Trend Following system.
Figure 3: Histogram of Trade Results of a simple Trend Following System
Despite the nice-looking equity curve of the Trend following system described in Figure 2, when you examine the trade histogram in Figure 3 above, you see that total positive performance can be attributed to 5.3% of all trades taken during the 50 year test. What this means is that if I exclude the top 5.3% of all trades in the test, I am left with a system that has simply achieved a break-even result over the entire test period. This is a hell of a conclusion to make…so take the time to read it again.
This feature that is common to all divergent methods over the long term track record, is symptomatic of the fact that it is the ‘outlier’ which actually is responsible over the long term for ALL the positive performance of the Trend Following system.
Now comes the question why? You see it really comes back to Ed Seykota’s “Whipsaw Song” where we wheel our partners round to the lyrics of “one good trend pays for em’ all”.
It is the non-relative extreme magnitude of these outlier events when compared to the normal trade event, that turn our trend following game from one of perhaps breakeven, (if we cut our losses short at all times), to one of hedonistic bliss if we are fortunate enough to capture an outlier.
So given that we cannot predict when or where these outlier events will happen in the future, how do we increase our chances as trend followers to participate in them? The answer to that riddle relates to diversification as a means to search far and wide for ‘outlier events’, the need to preserve our capital at all times so we can always participate, and the need to be fully systematic so we are always ready for the unpredictable event 24/5.
Now just to demonstrate that this Outlier impact is not simply restricted to this particular trend following model, let’s have a look at the performance track record of the best Diversified Systematic Trend Followers in the world that offer a long term track record.
Let’s eliminate the top 10% of months in the BTOP 50 Index. The impact of excluding outlier impact months on the performance results is about as material as it gets. It reduces a profitable long term Index into a less than breakeven proposition.
Figure 4: Removing the Top 10% of Monthly Performance Returns from the BTOP 50 Index
Now let’s look at this impact by viewing a comparison of monthly returns. The yellow months are the excluded ‘outlier months’.
Table 1: Monthly Performance Results of the BTOP 50 with the top 10% of results removed
But now lets focus on the other 90%. Look how they range in value from +ve to -ve. Not a result symptomatic of Performance Dispersion…but simply a result that could be attributed to the variation that exists within a Normal Distribution (aka a symptom of Randomness.). In other words, all the Funds that were represented in the BTOP50 Index managed risk well in that there were no adverse left tailed events in the performance record and that the returns outside of ‘outlier’ periods were a result of ‘the luck of the draw’ for a particular month.
Lets now have a look at the spectacular performance returns of the short term record of some of the younger breed of Trend Following firms. We might assume that the short term performance returns are symptomatic of more consistent performance attributed to some novel new technique or method applied to trend following ….however that is actually not the case at all.
Have a look at these stunning results of Purple Valley Capital.
From the results above you might be tempted to conclude that this ‘relative’ new kid on the block has something different up their sleeve. The performance record of 17.73% CAGR sits above the more benign results of the BTOP 50 or the long term Trend Following FM’s that make up this record, however when you drill down into the record itself, you can see it is simply another story of capturing a significant ‘single’ outlier event in the latter half of 2020.
You see, while the Trend Follower can always preserve their capital, the ability to capture an outlier is really out of their hands and is a result that can only be delivered by the market itself. The only way a Trend Follower can improve their chances of participating in these events is to diversify widely and be in the right place at the right time.
What this Blog post clearly demonstrates is that the real drivers of ‘total return performance’ are outlier events of which none of us can predict in advance.
What we can clearly demonstrate is that if we elect to tamper with any of the results of this small handful of outlier trades through methods that constrain our ability to achieve ‘infinite yield’ then we totally compromise our wealth ambitions if we are to take outliers seriously.
Of course the temptation is there to take profits off the table when we are trading on the right hand side of the chart….but it is the ‘extreme’ event of unknown magnitude where our riches actually lie….so don’t compromise your ability to obtain that wealth arising from uncertainty.
Trade well and prosper
The ATS mob