How do your different portfolios correlate?

Trend Following & Momentum Strategy

My trend following and my momentum strategy really are extremely highly correlated. They’re both momentum based strategies, i.e. buying breakouts. They both trade the same part of the market –so in effect I shouldn’t be doing both of them. The reason why I do stay with one of them is because I like for my clients to see that I’ve got skin in the game. They can see that we’re taking the same signals with our money. As a result, I don’t get people ringing me up saying, “I’ve lost 5% this month”, or whatever. They can see that I’m doing the same thing. There’s no point in ringing me up to say that because I know. I’m losing 5% as well! The smart thing would be to stop trading that shorter term momentum strategy because it is highly correlated with my longer term trend following model.

U.S Strategy

The U.S. strategy that we use, I don’t know the exact correlation, but it’s a completely different strategy. The trend following model, average hold period, six to eight months –you can hold trades for over a year, it’s a breakout strategy, trades the Australian market, and does about fifty trades a year. You switch that across to the U.S. strategy, average hold period would be three days, it’s a mean reversion strategy; we’re buying the dip, not a breakout. This one does about seven hundred trades a year. Completely different in every aspect, completely opposite. In terms of correlation, it’s probably higher from a purely philosophical basis because we’re trading long only equities, and generally equity markets are moving together. The trend following strategy was spinning its wheels for a few years, as the Australian market went sideways –but the U.S. strategies were going well. One of them is up 38% this year to date. We’ve got another high frequency one that’s up about 23%.

Now, let me just clarify that high frequency one. The broader market’s up 22%. Case in point, if someone rang me up and said, “Well I might as well just buy the S&P 500 as a buy and hold.”. The problem with that is my 22% or 23% return has come from only allocating 10% of my assets to that strategy. It is replicating the market return, but I’m only using 10%, so my exposure is dramatically lower. I think my average exposure over the long term is only 13%. You’re making a lot more bang for your buck. The great thing with that strategy is that it will switch itself off, so when the broader market S&P 500 starts to trend down, we’ll be sitting in cash.

2008

That’s why we did so well in 2008 –we sat in cash. I think we were in cash by June or July 2008. We just sat back and let the whole world go down the toilet. It’s not a painless exercise, don’t get me wrong because we lost 13% in 2008. Considering most fund managers went through a 40% to 50% draw down during that period of time, there are different degrees of pain.

The important thing is obviously financially you’re a lot better off, but you can also recover your draw down a lot quicker. A lot of fund managers, especially here in Australia, still have not recovered to post out pre 2007 highs. The other thing is psychologically you’re a lot better off. You haven’t been slapped that hard that you can’t get up again and put the trade on. Even today I come across people who lost so much money back in 08’ that they can’t get involved in the market again.

I think the big reason is they don’t have an exit strategy, so they are scared that it’s going to happen again. As soon as you understand how you’re going to protect your capital, the game becomes a lot easier. Until you get to that point, things are very difficult.

If you are interested in testing and validating your own strategies using the same software we use, have a look at our Beginner’s Guide to Building Trading Systems course.