Balancing Portfolios with Trend Following

---

This summary is written by Rich based on a conversation in our CTA series, between Russell Korgaonkar, the Chief Investment Officer at Man-AHL hosted by Niels and Alan. Key takeaways include:

• Opportunities and inefficiencies exist across markets, and in order to capture them, one needs to be able to move positions around to trade efficiently. Knowing what not to trade is as important as knowing what to trade.
• Russell emphasized the importance of modeling whole portfolios and thinking about tail scenarios as well as averages. He elaborated that by adjusting position sizes, traders can stay in the game during stressful markets and maximize their chances of optimizing returns.

About Man-AHL

Man-AHL is based in London, UK, and is a division of Man Group, a global investment management firm with offices in various countries around the world. Man’s Programs are split between systematic and discretionary, with AHL falling into the systematic category. The firm has a long history in the managed futures space, and its flagship AHL Diversified program has been running since 1987. 

• Man AHL has a wide range of trading strategies, which allows them to capture returns from a variety of market conditions. They use a systematic approach to investing, which means their investment decisions are based on computer models and data analysis rather than intuition or human judgment.
• Man AHL invests across multiple asset classes, including equities, bonds, commodities, and currencies. They use a variety of data sources to inform their investment decisions, including economic indicators, news events, and social media sentiment.
• Man AHL has a culture of innovation and collaboration, which helps them stay at the forefront of the industry. They invest heavily in technology and have a team of researchers and developers working to improve their trading algorithms and models.

Man AHL's investment philosophy is based on the idea that markets are inherently unpredictable and that it's impossible to consistently predict future market movements. Instead, the focus is on identifying patterns and trends in market data and using these patterns to inform their investment decisions.

With AHL, diversification is key to managing risk and generating consistent returns over the long term. The goal is to invest across a range of asset classes and use a variety of trading strategies to ensure that the portfolio is well diversified.

Russell shared what he would look for as an investor, “What I would want, as an investor, is to make sure that you're running a systematic strategy. So in theory, a systematic strategy is built on a set of rules and it follows that set of rules. I would want some reassurance that as you evolve, as you perhaps modify the strategy or improve the strategy, you're confident in that process; the process is well built, and it's well engineered, and it protects the integrity of the system as well as improving results going forward. I think that's the bit that I would focus most on.”

The firm believes that there are opportunities for alpha generation in both up and down markets, using trend following strategies to capture market trends and momentum as well as mean reversion strategies to take advantage of market reversals.

AHL's approach to risk management involves setting strict limits on the amount of capital allocated to each investment and constantly monitoring exposure to different market factors. Stop-loss orders and other risk management tools are also utilized to limit potential losses.

Trading Philosophy and Beliefs

Russell pointed out that opportunities and inefficiencies exist across markets, and in order to capture them, one needs to be able to move positions around to trade efficiently. Knowing what not to trade is as important as knowing what to trade, and AHL spends a lot of time researching the drivers of return and identifying inefficiencies. 

It was shared that trend following is one of the most elegant and straightforward strategies, and it works due to three reasons: information diffusion, autocorrelation in the drivers of market returns, and human behavior. However, each strategy has its own inefficiency that it's trying to exploit, such as liquidity or information inefficiency.

There is an emphasis on the key to successful systematic trading as being able to efficiently capture small opportunities and inefficiencies in the markets, while also knowing when to avoid certain trades. The discussion turned to the concept of crisis alpha and how trend following tends to perform well in periods of equity stress, and it was noted that there can be a trade-off between making the strategy more digestible for investors and maintaining certain risk properties or crisis protection, and that this can be managed by employing a more reactive system.

Views of Replication Methods

Niels asked Russell about his views on trend replication or CTA replication, which involves creating models to explain the returns of hedge funds and CTAs and replicating their exposure through a smaller number of markets. Replication has become popular in 2022. Russell is cautious about this approach, noting that it is easy to replicate past performance, but difficult to replicate relatively sophisticated strategies going forward. 

Russell shared that the idea behind trend replication is to replicate the returns of trend-following strategies at a lower cost. However, it is easy to replicate past returns, but it is difficult to replicate sophisticated strategies going forward. Moreover, the success of replication depends on the strategy and how it is being implemented. While creating a model to explain returns is good, replicating positions ahead of time and trading them efficiently is critical to make a better system. He cautioned that investors should focus on expected returns going forward and have conviction that the strategy will work. Therefore, it may be challenging to have conviction in trend replication going forward in their ability to produce returns.

Importance of Adaptive Processes and Trade Execution

Russell discussed the value of research in systematic investing and the importance of making improvements to trading systems to keep up with the evolving market. He explained that making small tweaks to a trend-following system is not as impactful as adding genuinely diversified markets or models that are different somehow. 

Russell also talked about execution and how good execution allows the trader to harvest a richer set of alphas, introducing many different types of alphas that can be traded around the edges while still retaining the overall risk properties of the system to improve the expected return.

Why Dynamic Position Sizing Can be Beneficial

Niels asked Russell about his views on dynamic position sizing versus static position sizing in trading. Russell elaborated that dynamic position sizing, also known as dynamic position management, refers to adjusting the size of a position based on the current risk environment. This means that if the risk in the market is high, the position size would be reduced, and if the risk is low, the position size would be increased. The purpose of dynamic position sizing is to control risk and preserve capital, especially during periods of high volatility or stress in the markets. By adjusting position sizes, traders can stay in the game during stressful markets and maximize their chances of optimizing returns. 

Russell explained that risk is easier to predict than returns and is time-varying. He gave an example of the credit markets in 2007 where volatility was low for several years until stress started coming into the market, and credit spreads began to move significantly. Position sizing allows traders to control risk and preserve capital in these kinds of markets. While stop-loss systems can control risk, they may not allow traders to stay in the game during stressful markets. Russell believes that dynamic position sizing allows traders to run their systems in any market condition.

Reasons for Trend Following Underperformance at Times

Alan asked why trend following sometimes stops working or performs less well. Russell explained that some people believe it is because the strategy has become too crowded, but he argued that this hypothesis can be tested. He suggested splitting a trend into an entry point, maximum, and exit point to analyze the return due to the trend and the reversal. He noted that adding trend followers to a system doesn't make the trend any worse; it just overextends it. However, all the trend followers exiting at the same time can make the reversal worse.

Russell thinks that the reason for trend following not performing well during the 2010s, in liquid markets, is that there was very compressed volatility and high correlation due to interest rates and coordinated central bank action. This environment was not good for trend following as it required low correlation and markets to move. Russell concluded that markets less influenced by central banks continued to trend well during the last decade.

Use of Trend Following in Portfolio Allocation

Alan and Niels asked Russell about the role of managed futures and trend following in the context of a larger portfolio. Russell emphasized the importance of modeling whole portfolios and thinking about tail scenarios as well as averages. He suggested that trend should be a genuinely diversifying return stream to any static investment, and therefore, investors should keep the bulk of their portfolio weights the same and allocate 10-20% to trend.

Regarding the question of timing, Russell noted that it is difficult and that investors need to be able to react quickly. He suggested that it is unrealistic for most investors and recommends that they be tolerant of periods of poor performance and adopt a long-term outlook.

Cash Management Methods for Trend Following

Niels asked Russell about cash management and what Man Group does with the cash that sits in the various funds they manage. Russell explained that they have a cash management team and invest in T-bills and various kinds of secure government debt to get the best yield in a risk-free sense. 

Man AHL's cash management strategy involves investing in low-risk, highly liquid government debt instruments to generate a risk-free return on excess cash holdings.

Ideas about Trend Following that you Disagree with Most

Niels also asked Russell what is the one thing he hears about trend following that he disagrees with the most. Russell indicated that he disagrees with the idea that taking big directional positions will blow up the portfolio, and instead, he emphasizes the importance of managing risks and thinking about how the system evolves and is dynamic. 

What Should Investors Ask in Terms of Due Diligence

Finally, Niels asked Russell what question he thinks investors should be asking during due diligence, and Russell highlighted the importance of having a well-built and well-engineered process that protects the integrity of the system and improves results going forward.

What the Future Holds for Trend Following

As a final question Niels asked Russell about his thoughts and concerns for the year ahead. Russell reflected on the changing and uncertain world we live in, and how his team is focused on making sure their technology and research platforms are fit for purpose as they navigate the fast-moving market. He emphasized the importance of blocking out the noise and focusing on what can be done to improve things. 

Russell Korgaonkar shared that, at the date of this recording, he is optimistic about the future of systematic trading and the use of technology in the investment industry. He believes that the industry will continue to evolve and that there will be opportunities for firms that are able to adapt to changing market conditions and embrace new technologies.

---

This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.