So you have a nice backtest result that you feel demonstrates an edge….so it is onto the next question. How do I leverage this edge? Do I aggressively compound or not?
Now the central fact that you need to keep in your head with this decision is that compounding accentuates volatility inherent in the return streams. Too much compounding introduces speed wobbles into your system where you are trying to extract too much from the slim edge the system generates.
Here is an example. The two charts below represent the same portfolio with no monthly compounding or with applied monthly compounding. Notice how the compounded example is extremely volatile. If you like striking for filthy returns and can stomach the pogo stick ride…then ok….but I tend to stay on the conservative path and avoid compounding like the plague.
At ATS, we are simple conservative folk (a bit like Hobbits) who simply compound at six monthly or annual intervals during re-balancing efforts but may need to more periodically rebalance if we find the pogo stick arising.
The problem with compounding is that it applies a slight bias to the return stream. In the first few years you will not notice it but as time elapses and the curve builds, then the volatility accentuates. This is not a problem of the actual system….but a problem faced by leverage from compounding. Compounding can lead to risk of ruin without actually having a bad underling portfolio of systems.
Here is an FM who applies more aggressive compounding. Look at the wibble wobble it is going through now at the tail end of the equity curve. I have blanked out the FM name…but the illustration gives you an idea what to look for.
Here is an FM who is less aggressive in their method of accelerating returns through compounding.
As conservative Hobbits…… guess which one we prefer.
You need to be able to ‘look through’ the equity curve to interpret what is going on with the FM. A persistent edge reveals itself through the trajectory of the portfolio. The better managers with significant diversification can smooth the curve at the overall portfolio level and maintain a fairly consistent growth profile while mitigating drawdowns with well worn portfolio management techniques. When you start to see the wibble wobble occurring, then you can guesstimate how much leverage is being applied by the FM. We have already discussed how to evaluate visually whether the manager is ‘warehousing risk’ or ‘releasing risk’ prudently but keep your eye on the wibbles and wobbles like the Wombles of Wimbledon 🙂
The benefit of not compounding is that the tough years are in the beginning but as the pie grows without compounding, your drawdown actually lowers over time as your equity builds. You can then manage this at periodic intervals to occasionally lift return by an appropriate lift of positon sizing across the portfolio….but as a general principle make this a discretionary decision as opposed to a systematic feature of the portfolio that is appropriate for you or your clients risk appetite….otherwise you will “wibble wobble” yourself to death over the long haul.
Trade well and prosper
The ATS mob