The Trouble with Trend-Following: Why You Should Trade
Dr. Smart’s Intensity Trading System
Many trend-following systems have suffered poor performance in the last three years. Some, including many mechanical trading system vendors, argue that this is part of the normal ebb and flow of the markets and that the decline in performance is temporary and will soon return to the halcyon days of yore. This might be defensible if the commodity markets were not in the biggest bull market seen since the 1970s. In the last few years, oil, natural gas, and copper have reached new all-time highs, and many other markets, including every major sector of the petroleum, precious metals, base and industrial metals and some agricultural commodities, such as sugar, have reached multi-year and multi-decade highs. A trader who took a passive buy-and-hold strategy to simply buy a basket of commodities would have outperformed many traditional trend-following strategies in the last few years. The figure below contains a comparison of many popular trend-following systems with two index funds, the Rogers Raw Materials Fund and the Berkshire Raw Materials Fund.
The trend-following systems were tested with fixed-fractional money management applied to a wide variety of commodity and currency futures, including British pound, coffee, cotton, crude oil, U.S. dollar index, euro currency, heating oil, Japanese yen, lumber, natural gas, Nikkei index, orange juice, palladium, soybeans, sugar, ten-year notes, unleaded gasoline, and U.S. bonds. Note that the trend-following system results are negative to break-even over this period, while the index funds are up over 40% during this period. No one who invests in the stock market would keep their money with a fund manager who had so badly underperformed the S&P 500 by such a large amount over a three-year period.
The cause of the problem is that too many speculators and investors are following similar strategies, and even many hedge funds use mechanical trend-following systems. Over $1 trillion is now invested with hedge funds, so competition for performance is extremely high. Michael Steinhardt, a legendary fund manager profiled in Market Wizards, recently wrote in an editorial in The Wall Street Journal (April 14, 2006) that "hedge funds are now are industry. They have become an asset class, marketed by investment companies and financial advisers to the masses. Today, there are simply too many funds being marketed to too many investors." The approach taken by many discretionary hedge funds is necessarily short-to-intermediate term because they must report results on a monthly and quarterly basis, and investors have little patience to stick with a fund that lags even for short periods. This has led to a chase for short-term results, leading to a lemming-like behavior among hedge funds, with many buying and selling at or near the same time, resulting in higher short-term volatility in many markets. It has also been rumored that some of the largest hedge funds even manipulate some markets, creating brief intense upturns, and then quickly locking in these gains as others enter, including mechanical trend-followers..
The recent change in market dynamics necessitates a change in approach. Legendary commodities trader Richard Dennis advised in Market Wizards to “be a short term or as long term as you can stand… the best strategy is to avoid the middle like the plague.” Richard Dennis spoke these words in the late 1980s. As more individual and fund traders have adopted mechanical trend-following approaches, the “middle” has expanded to encompass so-called “long-term trend following.” One of the problems, I believe, lies with the exit methodology. Many commercially available trading systems employ a trailing stop. One sophisticated and popular trailing stop is the chandelier exit. The chandelier exit involves setting a trailing stop based on the highest high (for long trades) or the lowest low (for short trades) attained during the trade. A public domain trading system was developed several years ago that used this exit approach as a reversal system, with long exits signaling short entries and short exits signaling long entries. This system worked well through 2001, when performance became extremely choppy, and on net basically choppy and flat from the end of 2001 to the present. Also, in each year since 2001 maximum annual draw downs have been higher than the maximum draw down experienced during the preceding period. The maximum draw down for 1979-2001 period was less than 25%, and a new maximum drawdown of approximately 45% was set in 2005. See the figures below for the equity and drawdown curves for this approach.
This means a mechanical systems trader should either take a longer-term approach or a shorter-term approach than many commercially available systems. The problem with taking a longer-term approach is that it either requires a high tolerance for risk or a large amount of money to invest, since diversification on a long-term time frame is harder to achieve. I believe a shorter-term approach is better for most investors. The new Intensity commodity trading is such an approach. Intensity delivers better absolute and risk-adjusted performance than longer-term approaches, and unlike the trend-following approaches, outperforms the indices. See the graphs below for a comparison of Intensity with these approaches.
From these graphs you can see that Intensity outperforms traditional trend-following systems in hypothetical testing both in the recent past and over the last twenty years. Intensity is a trend-following system, but its advantage lies in taking profits earlier than traditional approaches, leading to higher win percentages than most trend-following systems. Intensity is un-optimized - rules are the same for all markets. Intensity is also robust – the rules are simple and are based on traditional indicators. And best of all, Intensity is available for purchase. Purchasers of Intensity receive a 100-page manual explaining the rules and logic – Intensity is not a black-box system. Purchasers of the system also receive Tradestation code and an implementation of the system in Excel. Click here to purchase now.