Trend Following. Ritholtz Barry

be a benefit. At least you can survive. At the very least, you will survive over the long-term. But if you don’t have a valid basic philosophy, you won’t be successful because change will eventually kill you. I knew I could not predict anything, and that is why we decided to follow trends, and that is why we’ve been so successful. We simply follow trends. No matter how ridiculous those trends appear to be at the beginning, and no matter how extended or how irrational they seem at the end, we follow trends.48

      A valid basic philosophy means a trading strategy that can be defined, quantified, written down, and measured in terms of numbers. Trend following does not guess at buys and sells. It knows what to do because valid basic philosophy is codified into a specific plan for all contingencies.

      The Man Group, one of the largest trend following traders, describes the source behind their profits:

      …trends as a persistent price phenomenon that stems from changes in risk premiums – the amount of return investors demand to compensate the risks they are taking. Risk premiums vary massively over time in response to new market information, changes in economic environment, or even intangible factors such as shifts in investor sentiment. When risk premiums decrease or increase, underlying assets have to be priced again. Because investors typically have different expectations, large shifts in markets result over several months or even years as expectations are gradually adjusted. As long as there is uncertainty about the future, there will be trends for trend followers to capture.

      Change Is Life

      Patrick Welton saw no evidence trend following has devolved. He constructed 120 trend following models. Some were reversal based, and some not. Some were breakout-style trading systems based on price action, and others relied on volatility and band-style breakouts. The average holding periods ranged from two weeks to one year. The results gave almost identical performance characteristics.

      Welton addressed head on the misconception that the sources of return for trend following had changed. He pointed out starting from first principles, it was a fact the source of return for trend following resulted from sustained market price movements. Human reaction to such events (read: Daniel Kahneman), and the stream of information describing them, takes time and runs its course unpredictably. The resulting magnitude and rate of price change could not be reliably forecast. This is the precise reason why trend following works.49

      One fund consultant confronted trend trading skeptics decades before trend following’s huge October 2008 positive returns:

      [In the 1980s] on a tour of Germany sponsored by the Deutsche Terminborse, several advisors and pool operators were making a presentation to a group of German institutional investors. Among them were two trend-based traders, Campbell and John W. Henry. During the question-and-answer period, one man stood and proclaimed: “But isn’t it true that Trend Following is dead?” At this point, the moderator asked that slides displaying the performance histories for Campbell and Henry be displayed again. The moderator marched through the declines, saying, “Here’s the first obituary for trend-based trading. Here’s the next one.. and the next but these traders today are at new highs, and they consistently decline to honor the tombstones that skeptics keep erecting every time there’s a losing period.” Campbell and Henry have made their investors hundreds of millions of dollars since that time. It might, therefore, be a mistake to write yet another series of obituaries.50

      Like sunrise, sunset you can always expect a new trend following obituary, oblivious to the data, and rooted in purposeful ignorance, will be written every few years by an agenda-driven press, EMT defenders, and player haters despite the incredible amounts of money made by trend following practitioners.

      Perplexed at Wall Street’s lack of acceptance, one trend follower sees the danger in trying to be right: “How can someone buy high and short low and be successful for two decades unless the underlying nature of markets is to trend? On the other hand, I’ve seen year-after-year, brilliant men buying low and selling high for a while successfully and then going broke because they thought they understood why a certain investment instrument had to perform in accordance with their personal logic.”51

      Trend following trader Paul Mulvaney made the point: “One thing to bear in mind is that we have made no changes to our trend following strategy since 2005. So in a way we take the ancient Spartan view that everything that needed to be said about long-term trend following has already been said.” He continued: “In recent years our research has focused on execution algorithms – but those are of minor importance versus the strategic trend following philosophy.”

      Here is Mulvaney’s philosophy in performance data format:

      Mark Spitznagel, a trader focused on tails and a close associate of Nassim Taleb, would characterize Mulvaney’s returns as “lumpy” with “extreme asymmetric payoffs” – exactly how he would refer to his trading world. And whether using Spitznagel’s strategy, or Mulvaney’s go-for-the-gusto high-octane strategy, an opportunistic plan of attack knows you aim to lose battles, but win the war.

      Let me be clear, though: Mulvaney’s track record is but one example for industrious types to go reverse-engineer, to learn step by step how those volatile but overall up numbers came to be. His performance table is an initial shot across the bow to bring you into the trend following, month-to-month mindset of no benchmarks. But trend following is much more than one trend following track record alone – this strategy has performed consistently for more than a century across an untold number of traders. And the reasons to explain why markets have tended to trend more often than not include investors’ behavioral biases, market frictions, hedging demands, and never-ending market interventions launched by central banks and governments.52

      Follow the Trend to the End When It Bends

      In an increasingly uncertain and downright unfriendly world, it is extremely efficient and effective to base decision making on the single, simple, reliable truth of price. The 24/7 never-ending fundamental data barrage, such as price-earnings ratios, crop reports, and economic studies, plays right into the tendency to make trading more complicated than it need be. Yet by factoring in every possible fundamental piece of data, which is impossible, you still would not know how much and when to buy, or how much and when to sell. The truth of price always wins if the debate is grounded in reason. Price is the only fact.

      That said, even if you digest price as the key trading variable, it is not unusual for traders to focus on only one market – usually individual stocks in their home country to the exclusion of all other global opportunities. Seeking a maximum degree of comfort, many follow their one familiar market’s movements faithfully every day. They never dream of branching out into currencies or futures or coffee or gold. The idea you could know enough about Tesla and soybeans to trade them the same might be unfathomable, but think about what cotton, crude oil, Cisco, GE, the U.S. dollar, the Australian dollar, wheat, Apple, Google, and Berkshire Hathaway all have in common: price action.

      Market prices, traded prices, are the unequivocal objective data reflecting the sum total of all views. Accepting that truth allows you to compare and study prices, measuring their movements, even if you don’t know a damn thing about fundamentals. You could absolutely look at individual price histories or charts, without knowing which market is which, and trade them successfully. That is not what they teach at Harvard or Wharton, but it is the foundation of making millions as a trend following trader.

      Further, don’t try to guess how far a trend will extend. You can’t. You will never know how high or how low any market might go. Peter Borish, former second-in-command with Paul Tudor Jones, lays bare the trader’s only concern: “Price makes news, not the other way around. A market is going to go where a market is going to go.”53

      The concept of price as the paramount trading signal is too simple for Wall Street to accept. This

48

John W. Henry (presentation, Geneva, Switzerland, September 15, 1998).

49

Patrick Welton, “Has Trend Following Changed,” AIMA Newsletter (June 2001).

50

Guest Article, Managed Account Reports 249 (November 1999), 9.

51

John W. Henry (presentation given to financial consultants, November 17, 2000).

52

Brian Hurst, Yao Hua Ooi, and Lasse H. Pedersen, “A Century of Evidence on Trend-Following Investing,” AQR Capital Management (Fall 2014).

53

Peter Borish, “Upstairs/Downstairs Seminar with Tom Baldwin,” Futures Industry Association (1994).