Observations on the death of trend following

"Trend" is a relative term and trend-followers must be watched closely in today's markets.

Scott Stenger of Stenger Capital Mgmt., noted that “I have seen situations where algorithms work until they don't and then they blow up. From my perspective, algorithms can't always adapt to new conditions as one can't conduct a back test with similar conditions. Furthermore, algos have to keep trading.”

Such constraints on back testing and the inability to go to cash are common criticisms of quantitatively driven strategies. Some of the largest quant firms readily admit that they don't have an objective means by which to determine if their strategy is no longer profitable. Simply stated, it's probably best to avoid most pure quant approaches in difficult environments unless you can pinpoint the fail safes.

Investor drill down

Next, the composition of price movements has altered during the past four to five years. Number of trending days, basically the number of days price is moving in the same direction on average across a set of markets, is a powerful tool when comparing the large changes in performance from pre 2009 to date. In short, 2009 had very few trending days. As a daily observer of the specific positions of several managers, Greg Taunt of IASG, commented that ”when I see the big reversals that whipsaw managers forcing them to get out at the worst time before moving the other way the next day or, even the same day, you can see why there are struggles. We certainly haven't had any clear direction since the end of 2008 as we lurch from crisis to crisis with the occasional bout of positive economic news.”

Even more confusing is a few very long-term managers, who take a lot to stop out, as well as some shorter term managers, who very actively trade out of bad positions, are doing well. For example, one New York-based CTA with a long track record found that their intermediate term trend following system was the best performer during 2012. But their short and long-term trend following programs lost money as did mean reversion and volatility breakout.

Such general comments emphasize that investors have to drill down. Quite unlike the early trend followers, not all current trend following programs are similar in composition. Various components or “overlays” of the core program make them unique. An investor really has to understand a manager's strategy and its limitations. Perhaps most importantly, they need to determine what performance results can occur by chance alone in the shorter run, without their being an underlying longer term problem.

Also, two factors shed light on the “new” markets. First, as Taunt observed, when the past few years' volatility of commodities common to most managed futures strategies is summed up, the size of daily and weekly moves has increased about 10%, compared to quarterly and annual moves, and second, monthly and quarterly moves also have increased in relation to annual moves. As the frequency of short term moves have increased more than long term moves, the added “noise” has created more stop outs for trend followers such as the hypothetical manager cited above, thus increasing short term losses considerably.

In its report, "Why have managed futures strategies underperformed recently?,” MA Capital concludes that decreased performance of long term trend followers is “probably better explained by a relative pick up in short-term volatility as compared to the [changes in] long-term moves in markets.” This is certainly part of the picture. However, it is not quite as simple as looking at buy, sell and stop strategies – because shorter trend following and pattern recognition programs also are suffering, as are some reversion programs of the same periodicity. While you would think that increased shorter-term volatility would be good for active traders, certain markets continue to whipsaw and in some instances also can move rapidly for no apparent reason, like the rapid collapse of crude that occurred during Q3 2012 or the two-week collapse of the S&P 500 in August 2011.

Another good example is found in the currency markets. “The FX sector struggled in the shorter term timeframes in 2012. Due to the global central banks' pivotal role, the FX markets remain the most susceptible to interventions and exhibit an extreme mean reverting character. This characteristic is self-reinforcing as it is supported by market participants trying to gain an edge, which means that it is likely to continue for the foreseeable future,” noted a Quest Partners quarterly report.

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