Trend following?
Some quant models do work. Good hedge fund + bad quarter = buying opportunity. As I expected most quality hedge funds have performed very well so far in 2009. It is no surprise that market dislocations, misvaluations and panic-selling hysteria created fantastic opportunities for skilled managers. Inevitably performance was bound to be strong when so many "experts" even recommended to avoid hedge funds! Redemptions by those that didn't understand TRUE diversification have benefited investors who REDUCED risk by having lots of good hedge funds in their portfolios.
Even more impressive are the hedge funds that made money in both 2008 and 2009. Market timing is difficult but some have the talent. A way to evaluate any investment strategy is its return on risk. Even with the recent stock and credit market rally, the return on risk of long only funds has been very low. Is the equity risk premium zero or negative? I don't know but unhedged stock market exposure is too unreliable for investors wishing to grow and preserve their capital. Invest in managers with the skills to MAKE MONEY when things go pear-shaped - ie markets or economies go bad.
All trends end. Inconsistent how those who argue trend following hedge funds have no value yet conversely advocate long only equity funds because of an upward trend that can supposedly be extrapolated far into the future. Their insouciant belief in past being prologue is dangerous for investors. The volatility of recent years has shown pear-shaped times provide the best risk management stress test. As we saw with stock, credit and commodity markets recently, the more long lasting the trend, the more violent the end. The trend is your friend until it ends.
The potential return from stocks fails to compensate for their notorious risk. Most economists and "passive" index fund groupies sell a rosy view of a future that we can apparently all look forward to...eventually. I hope they are right but CONSISTENT CAPITAL GROWTH requires mitigating the downside. Few investors can afford to ignore drawdowns or volatility. Follow the trend? Into the abyss? Many equities drop to zero but NONE has ever gone to infinity. Portfolios need to be structured for ANY possibility including a dystopian long term.
Unfortunately the crowd STILL uses normal assumptions which is fine UNTIL things cease to be normal. Pear-shaped situations require pear-shaped analysis. I've always preferred non-linear pear-shaped equations since they capture the initial quasi-linear uptrend and then model the volatile end game. WE DON'T KNOW THE FUTURE but we do know that there are always securities to short sell and others to buy.
Linear math is easy which is why most financial "professionals" rely on it to their CLIENTS heavy cost. But since most phenomena are non-linear it stands to reason that linear equations are of limited use. The simplest pear-shaped formula is y^2=x^3-x^4 which only has solutions in the real world for the infinity of inputs between 0 and 1. We can define the beginning of anything at zero and ending at one to transform any process into that range. Identifying and jumping onto a trend is relatively easy. Lots of people make money in bull markets. Knowing when to get out or reverse into a short position is what separates the alpha players from the beta repackagers.
Many things exhibit pear-shaped characteristics. The universe is pear-shaped. Time is certainly pear-shaped. Just ask Professor Stephen Hawking. Atoms are too. If the largest and smallest physical systems are pear-shaped, it would seem possible that financial processes could also exhibit a similar form. Bonds and loans are great assets till the borrower defaults. Mortgage backed securities are fine unless real estate goes pear-shaped. Bull markets last longer and have low volatility while bear markets (pear markets?) are quicker but often eviscerate years of growth from the prior bull market.
Recently I reread some books on the economic shape of the world. One was The
World is Flat by Thomas Friedman. While interesting, the premise is incomplete. The world is actually pear-shaped and only gives the illusion of flatness during easy times. Protectionism may be ending the globalization trend. While David Smick's book The
World is Curved is more insightful, we need techniques to prepare for the different scenarios beyond the curve. Perhaps I should write a book called The World is Pear-Shaped.
Invention eliminates the obsolete. The life-cycle for businesses shortens all the time. Corporate and even country hegemony is not as long term as it used to be. Typewriters, slide rules and vinyl records all had rising sales for decades but have not had much "growth" recently. Innovative investment strategies that seep into the public domain and crowded trades are prone to end with a meltdown. Bubbles take a long time to form but a short time to end. The best alpha generators are those managers equipped to navigate difficult markets. Successful trend following requires good entries AND exits.
Some absolute return strategies went pear-shaped in 2008 like CB arbitrage and long biased equity. The returns have stormed back this year by those managers with the skills to achieve them. Meanwhile good managed futures CTAs and short biased funds continue to deliver ESSENTIAL negative correlation to their clients. Fiduciary duty REQUIRES portfolio construction for optimistic AND pessimistic scenarios. Bear markets or bull markets are irrelevant in a robust strategy allocation.
Even more impressive are the hedge funds that made money in both 2008 and 2009. Market timing is difficult but some have the talent. A way to evaluate any investment strategy is its return on risk. Even with the recent stock and credit market rally, the return on risk of long only funds has been very low. Is the equity risk premium zero or negative? I don't know but unhedged stock market exposure is too unreliable for investors wishing to grow and preserve their capital. Invest in managers with the skills to MAKE MONEY when things go pear-shaped - ie markets or economies go bad.
All trends end. Inconsistent how those who argue trend following hedge funds have no value yet conversely advocate long only equity funds because of an upward trend that can supposedly be extrapolated far into the future. Their insouciant belief in past being prologue is dangerous for investors. The volatility of recent years has shown pear-shaped times provide the best risk management stress test. As we saw with stock, credit and commodity markets recently, the more long lasting the trend, the more violent the end. The trend is your friend until it ends.
The potential return from stocks fails to compensate for their notorious risk. Most economists and "passive" index fund groupies sell a rosy view of a future that we can apparently all look forward to...eventually. I hope they are right but CONSISTENT CAPITAL GROWTH requires mitigating the downside. Few investors can afford to ignore drawdowns or volatility. Follow the trend? Into the abyss? Many equities drop to zero but NONE has ever gone to infinity. Portfolios need to be structured for ANY possibility including a dystopian long term.
Unfortunately the crowd STILL uses normal assumptions which is fine UNTIL things cease to be normal. Pear-shaped situations require pear-shaped analysis. I've always preferred non-linear pear-shaped equations since they capture the initial quasi-linear uptrend and then model the volatile end game. WE DON'T KNOW THE FUTURE but we do know that there are always securities to short sell and others to buy.
Linear math is easy which is why most financial "professionals" rely on it to their CLIENTS heavy cost. But since most phenomena are non-linear it stands to reason that linear equations are of limited use. The simplest pear-shaped formula is y^2=x^3-x^4 which only has solutions in the real world for the infinity of inputs between 0 and 1. We can define the beginning of anything at zero and ending at one to transform any process into that range. Identifying and jumping onto a trend is relatively easy. Lots of people make money in bull markets. Knowing when to get out or reverse into a short position is what separates the alpha players from the beta repackagers.
Many things exhibit pear-shaped characteristics. The universe is pear-shaped. Time is certainly pear-shaped. Just ask Professor Stephen Hawking. Atoms are too. If the largest and smallest physical systems are pear-shaped, it would seem possible that financial processes could also exhibit a similar form. Bonds and loans are great assets till the borrower defaults. Mortgage backed securities are fine unless real estate goes pear-shaped. Bull markets last longer and have low volatility while bear markets (pear markets?) are quicker but often eviscerate years of growth from the prior bull market.
Recently I reread some books on the economic shape of the world. One was The
World is Flat by Thomas Friedman. While interesting, the premise is incomplete. The world is actually pear-shaped and only gives the illusion of flatness during easy times. Protectionism may be ending the globalization trend. While David Smick's book The
World is Curved is more insightful, we need techniques to prepare for the different scenarios beyond the curve. Perhaps I should write a book called The World is Pear-Shaped.
Invention eliminates the obsolete. The life-cycle for businesses shortens all the time. Corporate and even country hegemony is not as long term as it used to be. Typewriters, slide rules and vinyl records all had rising sales for decades but have not had much "growth" recently. Innovative investment strategies that seep into the public domain and crowded trades are prone to end with a meltdown. Bubbles take a long time to form but a short time to end. The best alpha generators are those managers equipped to navigate difficult markets. Successful trend following requires good entries AND exits.
Some absolute return strategies went pear-shaped in 2008 like CB arbitrage and long biased equity. The returns have stormed back this year by those managers with the skills to achieve them. Meanwhile good managed futures CTAs and short biased funds continue to deliver ESSENTIAL negative correlation to their clients. Fiduciary duty REQUIRES portfolio construction for optimistic AND pessimistic scenarios. Bear markets or bull markets are irrelevant in a robust strategy allocation.
© posted by Veryan Allen on 23.8.09
by Veryan Allen 
<< Home