How Much Diversification in Trend Following Programs? – Let’s Go to Infinity and Beyond with a Fund of Fund!
How Important is Track Record?
Now you probably realise by now that I am a trend following groupie. I can’t help myself. For those of us with skin in the game who have gone through the school of hard knocks over a long history of market participation…..you quickly realise that the edge in trading is actually very slight and that to actually win in these markets over the long term….you need a robust risk adjusted method that allows you to survive long enough to then take advantage of the miracles of compounding.
In my opinion, for the skilled trader out there who is seeking to participate in the markets over the long term,….there is simply no better approach than the humble process of diversified systematic trend following. It is such a robust method that is capable of surviving across a broad class of different market conditions and yet still capable of delivering a weak edge that can then be magnified by compounding.
In my jaded viewpoint, I am less concerned with ‘current performance’ and more concerned with ‘long term performance’ as there is significant future risk that must be attached to that ‘current performance’, namely the risk of ‘what if the current market conditions change’.
For example, I could adopt a ‘Martingale no loss winning strategy’ that could survive the last decade with some caveats and punch out stellar returns that would make a Fund Manager blush…..but only I would know that warehoused risk lurked in this model and that in those different market conditions pre GFC, the Martingale model would have suffered risk of ruin. You see I could deliver a stunning 10 year track record and deceive many investors and make them think that I actually possessed a trading skill using a simple money management trick that applies to some but not all conditions.
So in a nutshell we can all talk about the 10 year track records of some great discretionary traders out there….and even write books about them….however when we talk in terms of those traders who have gone on to deliver 20-30 year track records…..we can only hear the sound of crickets. Why is that?
Well call me cynical….but even the 10 year track record is a short track record if you consider that Central Bank intervention has been a major feature of the markets post 2008 GFC. Who knows…perhaps those very successful traders with a 10 year track record have simply been buying the dips and selling the tips of this market intervention over this period?
You see a trader adopting a simple mean reverting system over say the last 10 years is likely to have literally ‘cleaned up’ with a performance track record boasting an elegant Sharpe ratio over this period. Is this ‘skillful’ or is this simply luck applied to the adoption of a particular system that exploits a repeatable condition? In my opinion a problem arises when you assess ‘skill in terms of trade sample size’.
For example, if the trade sample size is large, yet across a narrow range of market conditions, then this is not a sign of skill at all. It is simply a sign that a trader adopting a simple strategy that caters for a narrow range of market condition has been able to exploit this opportunity and it is just that the market has delivered this opportunity for an extended period of time. Furthermore a sample size of 30,000 trades may be a blip in the ocean for a High Frequency trader and extend across a single market condition only.
So sample size should not be the ‘go to’ measure in terms of a proxy for an edge, when the number of different market conditions to which a strategy has been exposed is few. The real test of an ‘edge’ is the number and extent of different market conditions that a strategy has been exposed to.
So back to the ‘why question’ above. The reason for the significant decline in the number of successful traders with a long term track record of > 20-30 years is that the range of different market conditions over this longer term horizon really sorts out the wheat from the chaff in terms of trading skill. The real crucible for a Managers ‘skill’ should relate to how well they have fared across a diverse array of different market conditions, many of which have been unfavourable to the strategy deployed. In other words the result you get when the entire kitchen sink has been thrown at you by the market. Those that have been left standing (aka the survivors) are where the ‘real skill resides’. It is only the long term survivors that can take full advantage of the compounding effect. There is no recovery from risk of ruin.
….and what do we find in this longer term horizon. Well in a nutshell apart from the Jim Simons of Renaissance Capital and perhaps the likes of a Warren Buffett or two, this long term track record space is dominated by the systematic diversified global multi strategy players of which a large component comprise the trend following/ momentum mob. For example in my recent Fund Management Performance Report for 31 October 2020….. we had a total of 52 Systematic CTA’s with a track record exceeding 20 years of which 49 were systematic with only 9 being discretionary. Of this listing 34 were systematic trend following globally diversified funds.
This just demonstrates the power of globally diversified trend following funds in delivering long term wealth building returns and their ability to navigate a vast array of different market conditions.
…..and here are the long term results of these different classifications over the last 20 years. You can see that both Indexes outperform the S&P500TR Index over this period with far lower adverse drawdowns.
Who to Choose?
So let’s say I have convinced you about the power of these diversified systematic trend following methods over the very long term track record….and you are now eager to participate in a wealth building process that possibly sets you up in 20-30 years for a happy retirement, then what are the paths you could take:
- Path 1 – The Do It Yourself Approach
- Path 2 – The Invest with the Best Approach
Now for the purposes of this Blog post I will assume that (unlike myself and a few others) you don’t have the desire to invest many years of your life with your head immersed in the nuances of this game, I mean…some of us have other ambitions in life…..so I will assume that most of us sane folk would want to follow Path 2. How could we go about this exercise?
Well here lies our problem as unfortunately if you elect to follow this path, you already need significant capital at your disposal. Many of the funds in this listing have very high minimum investment requirements. This therefore significantly limits your ability to invest in this technique. Furthermore, this minimum investment criterion (without the aid of hind-site bias), means that you have to be lucky in choosing the right fund that in 20-30 years can deliver that future track record.
For example, let’s say that Bill Eckhardt’s Evolution Strategy Program floats your boat and you would like to allocate to this Fund. Not all of us mere mortals have $20M available as a minimum investment…*snickers*
So herein lies the problem for those that want to participate in this long term wealth building bonanza but lack the available capital.
A Solution to the Problem using a Fund of Funds Model
Now as far as I am aware, there are only a small handful of players who offer Fund of Fund models that specialise in diversified systematic CTA models……but none of which simply specialise in those Programs with a long track record in the Globally Diversified Systematic Trend Following space.
So this is what this Blog Post is going to explore. I am going to do a quick and nasty assessment of two possible Fund of Funds (FOF) structures whose investment mandates are restricted to the following scenarios:
- CAGR FOF – Only Invest in Globally Diversified Systematic Trend Following Programs with at least a 20 year track record: Only 5 Funds are selected each year using the Compound Annual Growth Rate (CAGR) over the entire track record. Re-balancing by equal $ weighting occurs each year for the 5 selected Funds for the ensuing 12 month performance period.
- MAR FOF – Only Invest in Globally Diversified Systematic Trend Following Programs with at least a 20 year track record: Only 5 Funds are selected each year using the CAGR/Max Drawdown ratio = MAR over the entire track record. Re-balancing by equal $ weighting occurs each year for the 5 selected Funds for the ensuing 12 month performance period.
For the purposes of this assessment we adopt a 1% management fee to cover all fund expenses of this arrangement and also understand that there are no re-balancing costs incurred through annual fund rotation.
Fund Selection Universe
For this assessment I used Nilsson Hedge as a data source (Nilsson Hedge: https://nilssonhedge.com) which ensures that we select from the available Fund offerings at the time of re-balancing. This therefore eliminates the possibility of selection bias influencing the result of this assessment. The number of eligible funds have significantly increased over the 20 year test horizon…… from about 20 Programs in 2000 to well over 350 Programs by 2020. This just demonstrates the strong growth in Trend Following Programs arising from the growing popularity of this well worn approach to trading.
The Funds that achieved selection criteria for each FOF category are detailed below.
You will notice that the performance result was fairly consistent each year with little alteration in Fund composition throughout the 20 year history.
FOF Performance Results
Below are the performance results based on Net Asset Value (NAV) for each FOF model.
Now whatever way you cut it, the examples above demonstrate how diversified compilations of these Trend Following FM’s with a long term track record produce stellar performance results. There is ample alpha available in these examples to support FOF structures and still deliver exceptional risk adjusted performance returns for clients.
Indeed, the possibility exists to develop FOF structures using this class of investment technique that would have strong appeal to pension plans and the superannuation fund industry in Australia and overseas and provide an opportunity for Retail investor exposure.
But let’s lever up the MAR FOF example as it wouldn’t be too difficult to finance such sustainable diversified assets using Margin structured arrangements. So let’s gear up the MAR FOF example with a 50% Equity and 50% Debt arrangement and apply conservative funding rates to this solution over the period.
We can clearly see how there is more than enough capacity within these FOF models to support additional leverage.
So now let us compare and contrast all three options.
So there you have it. Three fine examples of wealth building structure for different risk appetites that can be achieved with a bit of innovative FOF modelling within this single class of Fund style. There is no guesswork here in the selection process. We are simply letting the track records of these FM juggernauts speak for themselves and then compiling the result.
So if you are scratching your head wondering how to tackle this question of “where I should be allocating my hard earned investment capital?” you really do not need to step outside this well tested domain of diversified systematic trend following methodology.
You can achieve that wealth building ambition of yours within this investment class itself. There is no need to compromise that ambition by allocating towards less robust convergent methodologies that may have negative skew. Stick with the FMs with a proven track record of 20 years plus. Let the experience of a validated track record speak for itself…..after all anything else is just assumption and you know how us trend followers hate any form of predictive assumption.
While this post posits the possibility of developing powerful FOF’s within this investment class…. it should not come as any surprise. After all each Fund we have used in this exercise are globally diversified….so in essence we are just taking diversification to the next level towards “Infinity and Beyond“.
Trade well and prosper
The ATS mob