Trend Following and Crisis Alpha

We have to be careful in our assumptions that Trend Following is a panacea for those looking to protect themselves from market downturns. The bottom line is that diversified trend following strategies have low correlation between the traditional buy and hold portfolio heavily invested in equities and bonds.

That is about as far as we can draw our conclusions about the relationships between these forms of investment style and there is no need to assign mystical associations to these qualities. Of course, having low correlation over a very long term data set does allow for the possibility that at times when the equity or bond markets are tanking that the diversified systematic trend following camp as a broad class may be achieving hedonistic bliss, but there are no guarantees particularly with a low correlated relationship.

For example, correlation itself is no guaranteed measure of any causal relationship existing between a data series. The statement ‘correlation does not equal causation’ needs to be kept front of mind. It is a symptom of causation but there are many correlated data samples that have no such causal connection.

Furthermore, if we found that diversified systematic trend following techniques as a broad class were negatively correlated with buy and hold equity/bond portfolios and still offered the same long term risk adjusted returns as they have done over the last 30 years or so, then this would be a preferred relationship to provide wealth protection during market downturns….still with no guarantees about any causal relationship.

One of the problems with broad statements such as these is that you have to unpack them as they are bandied about the investment space as a ‘truism’ but are littered with broad qualifiers with which you need to drill into to appreciate them. I must admit that I get a bit fed up with the ‘mantras’ you might hear from those that know better. Those in the know have a responsibility to be more fully transparent in their dealings with the investment community so you don’t need to be a translator of hieroglyphics or a Buddhist monk to understand them.

There seems to be a penchant in this game for the ‘mystical mantra statement’ which is uttered on the pulpit to a bedazzled flock of followers….which might mean well in broad intent…but does nothing to help the cause of attracting AUM. Bottom line is that investors are a curious bunch who like to find out how their BMW’s work and deserve the context as opposed to the one-lined mystical puzzle from a mountain somewhere in Nepal.

The low correlation that exists between diversified systematic trend/momentum styles of strategy (let’s call them camp 1) and traditional 60:40 buy and hold portfolios in equities and bonds (let’s call them camp 2) stems from the following factors:

Their portfolios trade different assets.

Camp 1 tend to be heavily diversified across and/or within asset classes, timeframes and systems leading to superior risk-adjusted returns over the long term.

Camp 2 on the other hand are focused on a narrow range of asset classes, but can do very well when those particular asset classes are performing…but of course don’t do well when they don’t. This less diversified stance in their portfolios leads to a more volatile signature over the long term.

Their trading styles are vastly different

Camp 1 tend to ‘cut losses short and let profits run’.

Camp 2 ‘buys and holds’ for the longer term.

Camp 1 (as a broad class) are ambivalent towards the market direction and are trend/momentum chasers in the long or short direction. Their trading strategies are couched in non-predictive terms and they ‘follow price’ in preference to predicting it, but get out quickly when price turns against them. They do well when persistent momentum or trend exist and suffer losses when they don’t. This leads to many small losses and the occasional large but unpredictable wins that creates positive skewed returns over the long term. The need to cut losses short and let profits run require that the managers are ‘active managers’ which requires decision making to enter the fray and encourages human intervention, so recognising the possible issues associated with human bias, Camp 1 counters this issue by placing an emphasis on systematic application to remove active management biases. A systematic application also allows them to manage a huge array of diversified trading systems collectively which cannot be achieved by the human mind.

Camp 2 as a broad class are long only in nature with the understanding that the future is more certain and that over the long term prices will rise. Given the fact that Camp 2 holds these investments over a long period of time with less active management intervention, they don’t need to be so systematic but their return streams are subject to high volatility at times. Their equity curves tend to approximate the overall market returns and any difference between the market returns and the portfolio returns stems from original asset selection or impacts of occasional re-balancing.

The philosophies regarding the future market condition are vastly different

Camp 1 view the markets as unpredictable adaptive moving feasts where behavioural biases and uncertainty itself are major players in the game. They don’t like predictable stationery markets as these regimes tend to lead to periods of building drawdown however given their non-predictive stance they can’t afford not to trade them as they never know when the markets will change their nature. They believe that history may rhyme but it doesn’t repeat and rely on this principle for their bread and butter.

Camp 2 rely on the underlying track record of investment returns of the past or view assets in the context of being either overvalued or undervalued in relation to an expected value and project this into the future. The buy and hold approach therefore tend to adopt market timing principles in selecting assets with the under the assumption that history repeats and prices will always rise over the long term. My advice to these practitioners is to treat history with respect and recognise that financial markets can have very long protracted periods of bull and bear phases. Don’t be sucked in by recent history, closely examine all available history. You might be surprised.

The different philosophies shape the method of trading style and opinion from these two camps.

So in a nutshell they are uncorrelated because they are different. There is no deeper mystical connection between these styles to guarantee protection from ‘Crisis Alpha’, but as you dig down into their modus operandi, you could possibly see why there may be certain conditions during market crisis where the diversified systematic trend following camp shines.

I must admit I am not partially invested in the Trend Following space but rather “Fully invested”. So you probably see a bit of bias itself arising in some of the comments made in this article…..however if I hear another “where is crisis alpha” from a naysayer or a “follow the sun for tomorrow the rain may come” from a guru…I am going to lose the plot and start deploying legions of drones to mercilessly hunt the astral travelers that float around in cyberspace.

For those interested in digging into the ‘Crisis Alpha’ statement, then you need to fully understand the context and for that I recommend you listen to or read the works of Kathryn Kaminski or Alex Greyserman. These authors of ‘crisis alpha’ must be rolling around in their beds at the moment (as they fortunately are with us today) when seeing how the context has been abused by the ‘one liner’.

Those with the penchant for the use of the one liner to inspire, frequently forget that it was the context that led them to their ahaa moment. They would be doing a service to the community if they could provide that context for these one liners to allow others to jump on their same wave.

More from Kathryn Kaminski and Alex Greyserman here.