Thus, what may be a difficult time period to trade in one market may not be so in another market; we cannot generalize on the duration of time periods that may or may not be problematic. Investors must question which markets a particular manager is focused on, with which strategies, and then review the respective behavior of such markets. Obviously, without such probing we can't develop a more comprehensive picture of the range of risks inherent to specific strategies. Again, any strategy's composition and limitations must be understood though the use of a comprehensive due diligence questionnaire and intense follow-up.
Digging even deeper
Richard Dennis (and William Eckhardt) is famous for teaching trend following strategies to a group that became known as the “Turtles.” Throughout the 1980s and to this day, several in this group became and still are the kings of trend following. After returning many multiples of their investor's original capital, for the most part since mid-2008, the performance of the remaining traders is essentially flat to negative. Additional factors that such trend followers are dealing with are:
- Increased volatility that has caused more stop outs for trend followers near the end range of reverting price moves. And just as punishing, they also enter longs closer to the highs and shorts closer to the lows.
- Markets are not just noisier from volatility, but also more erratic, in so far as they unpredictably deviate from patterns we have previously seen. One example is the stock market mini-crash of 2011. Prior to the move, tests by developers of hedge overlay strategies did not reveal the potential for a multi-day straight line dive in the indexes. They were crushed when weekly volatility far exceeded daily volatility. In the “this time it's different camp” it is likely that the majority of managers do not control for the role that new and unpredictable price patterns play in markets.
- Inter-market correlations have increased considerably and inconsistently. Correlations are now higher during large moves as a larger group (by numbers and assets under management) of technical and fundamental traders get on board. Further, a move that starts in one grain market leads to the others, as wannabes jump on board. The risk-on risk-off concern we have been facing more recently also has increased the herd behavior of what becomes an often large group. It is likely that similar influences are at play in equity markets.
The respective contributions of the above variables are not always simply an additive value. As there are several variables at play, different ones interact at different times in different markets to contribute to losses. We can't simply sum the individual components and derive a risk number. It's a large storm that's hitting. For example, correlations between markets have been high but also are very unstable. As such, measuring correlations may not help assess risk – they could last weeks or months; it's impossible to tell, so how can a CTA change its trading based on this observation?
Long vs. short positions
Another interesting observation noted by Quest Partners and others is the asymmetry between profitable long and short trades. Over the last 25 years, particularly for the managers with larger assets under management, long trades have been more profitable than short trades. Therefore, an investor needs to inquire whether a given manager can perform both longs and shorts.
Quest concluded at the end of 2012 “we enter 2013 expecting much of the same from the world's central banks and fiscal authorities as they continue their efforts to stimulate with ever lower rates the moribund U.S. and Japanese economies and, to shore up the European monetary union. We expect programs will continue to perform in 2013 much as they did in 2012 until volatility suppression efforts are ineffective or abandoned and markets return again to a more free flowing natural state when systematic managed futures programs will again shine and demonstrate their value in a diversified portfolio.”
Stanley Drunkemiller observed the same effects on equity markets from such sustained intervention. In a somewhat contrary stance, while the efforts of world-wide central banks and financial authorities push markets around, many years ago Robert Drach (and Robert Jr.) characterized the stages that stock markets go through during a recovery. This corrective process has not changed according to Drach Market Research. We are into a combined monetary infusion cycle, created by massive Federal Reserve and legislated stimulus actions. The central element of infusion cycles is additional money supply that eventually divides between increased productivity (public and private companies) and inflation.
Invariably, since creation of the current Fed, these cycles have resulted in significantly higher prices for productive assets, including common stock as the additional money works its way into the economy and stock market. Since the infusion cycle low (March 9, 2009), the S&P 500 has advanced about 130%.