From the March 2014 issue of Futures Magazine • Subscribe!

Trend following dead again: Watch out

One of the questions I often get from readers is how do select I the traders we profile in our “Top Traders of the Year” annual feature. Much like the successful trades we profile, it is often a combination of quantitative and qualitative elements. At times it can be systematic but it is never completely mechanical. 

I always like to talk to traders and try to capture a clear understanding of where they get their edge.  When doing due diligence on a manager I want to know what they are doing, how they are doing it and why they are doing it. It is always a red flag for me to come out of a half-hour conversation with a trader without a clear understanding of what he or she is doing or where they get their edge. 

Readers often ask, “Is it just based on performance?” 

Well no, it is not just based on performance but performance is pretty high up on my list. One of my pet peeves is when analysts like to say ‘performance results aren’t that important.’ Nonsense. Of course they are. Performance, in fact, is the first thing I look it. After all, we are profiling absolute return vehicles so performance is the number one criterion. Of course, we take a nuanced look at performance and measure it on a risk-adjusted basis. 

What those analysts really mean to say is that you have to look at performance based on the risk taken to gain that performance, as well as other factors such as correlation to existing investments.

Take our current crop of Top Traders. Their returns where: 26.42%, 10.52%, 10.4% and 10.71% respectively. There were many managers who did better than them on a raw percentage basis but not necessarily on a risk-adjusted basis.

Many years ago Sol Waksman, president of BarclayHedge, taught me how to use some of the unique tools that are part of his database. One enables you to normalize the standard deviation (STD) of a group of managers, which allows you to measure them on an apples-to-apples basis. Or at least closer to an apples-to-apples basis. 

This year’s Top Traders: Diamond Capital Management, Four Seasons Commodities Corp., Tlaloc Capital (see “Finding winners in a risk on/risk off world,”) and Esulep LLC (see “Esulep: A strange place to find non-correlation,”) all exhibited solid performance. 

After normalizing the STD of these managers with others managers with strong absolute performance, all four showed a higher risk-adjusted-return than most managers earning much higher returns on a raw percentage basis — some several multiples higher. 

Of course STD is not a perfect measure of risk as many critics of the Sharpe ratio attest. I also like to look at the upside vs. downside STD. A manager should not be punished for a high STD when most of it is coming from higher upside returns. 

While we are basing this designation on the previous year’s performance, I probably won’t select a manager coming off of a huge down year. I did profile a manager who once had a 90% drawdown but only after his fourth-in-a-row double digit positive year and with a clear understanding of what caused the drawdown. 

I do not look at managers who take on greater risk with suspicion — in fact I like looking at managers who venture beyond the current low-risk metric — as long as they are completely upfront with the risk taken to achieve those returns. 

In this year’s article I spoke to Marty Bergin, president of Dunn Capital Management. I always admired Bill Dunn’s aggressive approach and the upfront way in which he describes the risk inherent in his approach. 

I was very concerned with the reputation of the managed futures space after reading what I viewed as a very slanted article by Bloomberg earlier this year, where it tarred the entire managed futures space based on the fee structure of certain retail products. Perhaps most disturbing is it came when the industry was down. And even worse for investors, could discourage them from seeking investments that are non-correlated to traditional portfolios just as equities wrap-up an historic five-year bull move (see “Can equities stand on their own in 2014?”). In the story, Frank Cholly points out that bull equity markets often get tired after five-year runs. 

It has always been a bone of contention that alternatives in general, managed futures in particular, were viewed as high risk investments only appropriate for institutional investors. While the appropriate retail structure and customer protections are necessary for any investment, it doesn’t seem right that only high-net-worth individuals should be able to gain access to alternatives. 

The fact that retail investors can be invested in the stock market but not managed futures has less to do with the suitability of the vehicles than the entities who are selling it. If it is a matter of structure, then the appropriate structures must and are being built. 

What will the folks at Bloomberg say if we have another year like 2008 when managed futures was virtually the only asset class that earned positive returns and they helped to keep a generation of investors locked into long-only stock and bond portfolios? 

And I must comment on the hand wringing over whether trend following is dead. I started at Futures in 2001 during another tough period for trend-followers when many so called experts declared the strategy dead. The current difficulty is the  third go around of “Is trend following dead” stories and I am sure there will be more because I am sure the strategy will once again produce strong returns. 

While there is risk in all investments, Modern Portfolio Theory teaches us of the benefits of allocating to multiple non-correlated strategies.

 

  

E-mail me at dcollins@futuresmag.com

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