Becoming a Better Trend Follower
This summary is written by Rich based on a conversation in our CTA series between David Gorton, the founder and CIO of DG Partners, and the podcast hosts, Niels and Alan.
About DG Partners
DG Partners was founded in 2002 and spun out of J.P. Morgan, where Gorton ran one of the prop divisions in Europe. The company manages around $3 billion, with most of it in trend following.
Gorton talked about his background in prop trading and how he developed a core trend or classical approach to trend following, which is very much moving average and oscillator-based.
He believes that trend following is useful in a variety of portfolios because the returns are robust over long periods of time due to the persistent inertia in markets. However, trend following doesn't always work, as markets go from one unstable equilibria to another, and there are prolonged periods where trend following isn't as effective, such as during the "dead decade" of financial repression.
David Gorton discussed his focus on pure trend and how his firm adjusted their models to account for the prolonged period of financial repression and low volatility in markets. Gorton explained that they tried to look at alternative sources of alpha but ultimately decided to abandon them and pursue a purely systematic, purely trend-following strategy to try and be a better trend follower.
They identified weaknesses in classical trend following, such as data mining biases towards being long and being in all markets all the time, and developed a conceptual approach to trends that only sought to be in the meat of the trend, recognizing that they would miss out on the profits in the early stages.
Their newer approach allows them to capture the meat of the trend while not giving back too much and taking profits when markets become overly exuberant.
DG Partners developed a conceptual approach to trend following as an alternative to the classical trend-following strategy that they had been using. The aim of this approach was to try to identify the meat of the trend while avoiding the risks associated with data mining and biases towards being long in markets that have gone up for extended periods.
Their conceptual approach focused on developing a response function that would allow them to react to the price movements and volatility of the market in a more targeted manner. They sought to identify the key drivers of a trend and use these as the basis for their trading decisions, rather than relying on a broad-based data mining approach.
The conceptual approach also focused on being more selective in the markets that they traded, rather than being in all markets all the time. This was seen as a weakness of the classical trend-following strategy, which was often exposed to prolonged periods of sideways market movements that could be detrimental to their returns. By being more selective, they could focus on the markets that were showing the strongest trend signals and avoid those that were chopping sideways.
Overall, the conceptual approach was designed to be a more robust and efficient way of capturing the meat of the trend, while minimizing the risks associated with data mining biases and being in all markets all the time. It is important to note that the specifics of their conceptual approach are not publicly available, as they are proprietary to DG Partners.
Limitations of the Sharpe Ratio
David discussed the limitations of using Sharpe ratio as a measure of performance and emphasized the importance of positive skewness in trend following.
He believes that Sharpe ratio is a restrictive kind of measure and it doesn't give a complete picture of the performance of an investment strategy. David prefers making 10% with a Sharpe ratio of 1 or 20% with a Sharpe ratio of 0.5, rather than making 2% with a Sharpe ratio of 5.
Moreover, he noted that Sharpe ratio does not take into account the skewness of returns. Traditional assets like equities, fixed income, and property tend to have negative skew, where their worst months and years are much worse than their best ones. In contrast, classical trend following strategies tend to have positive skew, where the majority of profits are made in periods when traditional assets are performing poorly.
He also mentioned that some trend following indices, like the SocGen Trend Index, do not demonstrate much positive skew anymore, possibly because of the presence of other types of strategies employed by larger players. Therefore, David suggested that investors should not rely solely on Sharpe ratio to evaluate the performance of a trend following strategy and should look beyond it to evaluate the overall benefits that the strategy can provide to their portfolio.
He also agreed with Cliff Asness's idea that trend followers have positive alpha concentrated in periods where traditional assets are performing poorly. David believes that investors increasingly understand the negative skewness of traditional assets and the positive skewness of trend following, which makes it an attractive investment option.
Niels and David discussed the concept of crisis alpha, which David believes is not an accurate term for what trend followers provide. Rather than a tail risk hedge, he sees trend following as a risk mitigator that aims to produce stable, non-correlated returns to equities and fixed income, with the potential for positive returns in sustained periods of risk-off.
While trend following strategies may produce positive returns during market downturns, David argued that it is not their primary goal. Rather, the goal of trend following is to produce positive alpha (i.e. returns above a benchmark) in a consistent and stable manner, while avoiding correlation with other asset classes. This can help investors achieve their long-term investment goals while reducing the risk of catastrophic losses.
David also addressed common misconceptions about trend following, including the idea that it is a trade to be timed and that good performance in one year means bad performance in the next. He argued that timing trend following is difficult and that past performance does not necessarily dictate future results. Instead, he sees the current market environment, including the absence of a Fed put, as potentially favourable for trend following over a multi-year period.
Alan and David discussed the concept of trend following and the balance between capturing the meat of the trend while not giving up the skew. David explained that by focusing on the conceptual trend, which involves not using data in the entry point, they miss the beginning of the trend and have to be more aggressive with their entry point.
They also discussed the idea of non-trend and factor models not being a good fit for their strategy. In terms of speed, they have made minor adjustments, but changes in the model are done cautiously.
David explained that they have a dynamic approach to risk management, which takes into account the fact that they may not be in all markets all the time, and they have a fixed allocation in classical trend.
They have also developed a system called trend efficiency, which informs them on the risk allocation for each quarter. They take a relative approach to risk allocation, which considers the signal-to-noise ratio and the noise in the trend. The goal is to have stable, robust returns, and they are cautious about making significant changes to the model.
Trend efficiency is a risk management tool that helps inform them on how to allocate their capital across different markets each quarter. Instead of a fixed approach to capital allocation, they take a relative approach that considers the signal-to-noise ratio and the noise in the trend. This means they look at the strength and quality of the momentum signal in each market and allocate their capital accordingly.
The goal of this system is to achieve stable and robust returns, while being cautious about making significant changes to the model. By using a dynamic approach to risk management, they aim to maintain a diversified portfolio while mitigating risk. The approach of trend efficiency allows them to be flexible in their allocation while still maintaining a long-term goal of stable returns.
David and Alan discussed the importance of stability and risk mitigation in their strategy. They want to have a stable and robust approach, and they are cautious about making significant changes to the model. They review their classical trend following and risk allocation quarterly, and they make small changes at the margin.
They add new markets cautiously as assets grow, and they test them for diversification benefits. They aim to add new markets that are not too esoteric and meet strict liquidity requirements. They have around 130 markets in their portfolio and are always looking for new ones that offer diversification benefits while being sufficiently liquid.
They have strict liquidity requirements for markets they trade, and they avoid anything too esoteric that might get stuck in a crisis. They run potential new markets through tests to see if they offer diversification benefits. They prefer markets that have sufficient liquidity, but they recognize that these markets may be less liquid and therefore have less investment compared to the main parts of the book.
During the discussion, Niels asked David about their approach to volatility and if the dark period taught them anything about looking at volatility differently. David replied that they did not focus much on volatility during the dark period and that they did have a project on volatility some time ago.
He said that volatility is a massive component of their portfolio construction, and they need to research and innovate cautiously to maintain a stable approach. In terms of execution, David said that they work quite hard on it as it is their fiduciary duty to pay as little execution costs as possible. They have refined their execution process over time, but there are diminishing returns to all investments.
Views of Replication Methods
Niels asked David about trend replication strategies and the risks involved in estimating exposure without having a model.
David mentioned his experience with a sophisticated investor who claimed to have replicated his trading strategy, but their model failed when regimes changed. He noted that there is danger in replicating an index without understanding what drives it.
David emphasized the importance of finding a manager who can consistently beat the index, considering the stability of the firm and looking at the net of fee basis, and thinks investing in a replicator instead would be insane.
David expressed scepticism about these replication strategies and notes the risk of replicator risk. He also mentioned the importance of understanding what's driving the CTA index before attempting to replicate it. However, Niels suggested that these strategies, packaged in ETFs, may be useful for small investors who want exposure to trend-following. David agreed with Niels' point, but still believes that there are risks involved with replication strategies.
Risk Management Approaches
David explained that their systematic approach to risk management is endogenous, with risk management being built into the models and not run by stop losses or anything similar. They use a rigorous approach to going in and out of risk with various price data.
In building a portfolio, they consider the implicit correlations between positions, and use a reasonably medium-term correlation measure. They also have exogenous limits on the model that prevent the portfolio from recognizing short-term, big correlation changes.
They also have a risk committee that meets weekly to discuss market dynamics, positions, risk metrics, and fundamental risks. They make decisions based on all of these factors, and sometimes exercise discretion in the model.
David said liquidity is always a chief concern for any risk manager. He noted that systematic strategies are an important part of markets and that there has been a disintermediation of the banking system post-financial crisis. He also mentioned that there may be a false sense of liquidity in end investors' holdings and that it is important to think about the likely bid-offer spread when stress testing markets. David said liquidity is fine right now, and they did not find any difficulties last year, but they are naturally reducing risk in an absolute sense when things start to move profoundly.
The discussion moved on to liquidity concerns in the market, with David stating that liquidity is always a concern, and systematic strategies are an important part of the markets.
He explained that there has been a disintermediation of the banking system post-financial crisis, with a lot of risk placed in the hands of end investors, and that there may be a false sense of liquidity in their holdings.
David explained that when stress testing the markets, one must consider the bid-ask spread, and that liquidity is fine currently.
The discussion then moved on to funding liquidity and how that is a risk that systematic trend followers need to conceptualize, with David explaining that he thinks it is an interesting point and that the only way he can rationalize the lack of pain in the market thus far is due to the fixed rate lending being done by the authorities who are not accruing a loss.
The Role of Trend Following in a Larger Portfolio
David discussed the appropriate allocation to trend following in a larger portfolio, such as an endowment. He suggested that a healthy allocation would be around 5-10%, which would be a better use of capital than leveraging long the fixed income portfolio. However, he also acknowledged that running models might suggest a higher allocation of 30-40%, but he deems this allocation to be unreasonable.
David also addressed the concern that the more cash that goes into a strategy, the more likely returns are to diminish. While he agreed with this concept, he believes that trend following has not yet reached a tipping point where it is too big for the markets. He suggested that the returns from any strategy are likely to diminish as more cash flows in, but at the current moment, trend following is still at a good distance from that tipping point.
Misconceptions of Trend Following
David disagreed with the notion that all trend followers are the same. He believes that while there may be less dispersion in trend following strategies compared to other strategies, there is still dispersion and better and worse managers. He emphasized that it is important to make changes and improvements to the strategy over time and to be transparent with investors about those changes.
Outlook for 2023
David said that he is not overly concerned about the future. He believes that it is unlikely that the industry will have a year as solid as the previous year.
He is excited about potentially raising more assets this year and believes that his company is in a good place. However, he is concerned that lackluster returns in directionless markets could lead to investors getting bored and forgetting about trend following.
He emphasized the importance of maintaining a dialogue with investors and ensuring that there is an allocation to trend following even in choppy markets.
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.
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