Trading a Strategy over the Long Term
One of the keys for trend following is to apply the approach over a long period of time. The strategy we currently use is the one I built back in the 90’s. It’s almost exactly the same. The parameters are the same; except we’re trading stocks now rather than futures contracts. We’ve probably made two small adjustments to that strategy since we released it to the public back in 2006. In 2008 when the strategy was switch off during the bear market –which is one of its defensive mechanisms, we used to have a fundamental overlay. My theory, as wrong as it was, was that if you have stocks with the high broker consensus, fundamentally high broker consensus opinion, then fundamentally those stocks are probably quite good and they would therefore perform better. We removed that in 2008 because we started to realise that brokers at the end of the day, their opinion just follows the share price.
A classic example was Iluka (ILU). A few years ago when it was trading around three dollars fifty to four dollars, some of the brokers had sell recommendations, some of the brokers had hold, the valuation was about four dollars and twenty cents. That stock went one way to eighteen dollars, without the slightest pullback. Now during that whole one and a half year trend from four dollars to eighteen dollars, all the brokers slowly upgraded their valuations, after prices had already moved. Once price got to eighteen dollars, all the brokers had a valuation of twenty-one to twenty-two dollars, and of course the stock tanked and went straight down to twelve. So what we found is that broker consensus opinion tends to be a lagging indicator, and tends to follow price. So, we just removed it completely.
The other adjustment we made wasn’t so long ago. What we started to see was that we were being put into trends. This is specifically with higher volatility stocks, specifically resource sector stocks. We found that we were entering the stocks based on expansion of volatility, rather than the start of a new trend. By removing that expansion of volatility entry mechanism, we got a drastically better risk adjusted return. This was only possible because of technology. Up until a few years ago we were unable to do that because the technology wasn’t available, specifically being able to strip out certain kinds of stocks and certain kinds of sectors of stocks.
So basically what we do now is we define stocks very broadly, as in industrial stocks or resource stocks. Resource stocks tend to be extremely volatile and more driven by sentiment very quickly one way or the other rather than the steady trends that you tend to get with industrial stocks.
Bottom line is the key strategy remains the same as what it did back in the 90’s, but we’ve made a couple of small adjustments. That happens across the board and one of the greatest examples of that is DUNN Capital. Between about 2003 and about 2010, DUNN Capital went into a 60% draw down. That’s a significant draw down for a trend following strategy, managing hundreds of millions of dollars. They had their PhD’s all working on this problem, and they have just exploded to new equity highs since hitting that 60% draw down point. They just made some slight adjustments to the allocations. They basically said that they have an algorithm there that tends to say, “Well the market’s in a very trendy condition, so we’ll allocate more risk to that particular trade.”, or it’s “The market’s not so much in a trendy position, we’ll allocate less risk to that trade.”. Obviously they don’t give away exactly what they’re doing, but that seems to be what they’re doing.
So strategies if they’re robust, don’t tend to need to be adjusted but small adjustments along the way are pretty usual.
