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Best of TTU – Why Trend Following Is Not A Black Box

Often, a Trend following strategy is described as being a 'Black Box', as if something bad was going on.  So it was refreshing to hear Scott Foster talk about Trend Following as being in fact, a 'White Box', or a 'Transparent Box', in comparison to other algorithmic strategies, which are often embraced by investors to a much larger degree... so I’m delighted to share this blog post with you, from a conversation I had with Scott Foster, where he also touched on the essential question: Why are there trends, and why ought there be trends in the future?If you would like to listen to the full conversation just go to Top Traders Unplugged Episode 27 and Episode 28.

Will Trends Always Exist In The Market?

Niels:  But that was a very important explanation and it ties into so many other things and want to go further than this but I want to actually ask you a question that actually doesn't relate to short-term trading, but it's my kind of trying to understand what it is you are saying and putting it into a slightly different perspective and that relates to more generally speaking about trend following because, obviously, as we know, you mentioned 1994 and I remember seeing all the great guys sitting lined up at a conference in Chicago and talking about a very difficult period, but they were convinced that this was just a difficult period and things would come back. But let me ask you this, trends in markets in general, not necessarily short term, but just generally, is that kind of based on universal truth, because at the end of the day trends reflect human behavior and human behavior will never change, and what we are seeing now then, where perhaps there have been a lack of trends for a period of time is just part of a normal cycle.


Scott:  Absolutely. I often express my- I won't say unhappiness, but, I think trend followers could do a much better job of explaining what they're doing. Everybody seems to want to be a scientist. There's nothing wrong with that it's just that...I gave a talk a few years ago in Monaco on this about the difference between what we would call black box and what I would call white box. I was trying to make a differentiation between some forms of systematic trading and some forms of systematic/algorithmic trading and the fact that the best majority of people outside, they're in the alternative industry and won't invest in systematic strategy because they don't feel like they have the expertise to understand them or the mathematical skills to, and I was trying to make a case that, well, as it pertains to the vast majority of managed futures, they're not black box, and the reason being is what are they going after? I tried to make a case that they're going after a universal. When you ask a trend follower why do you make money? If they start talking about formulas and all of this type of stuff, the question is (really the only way they can make money is if there are trends)...the question is why are there trends and why ought there to be trends in the future? A trend follower asked, how are you going to make money in the future? I think they should respond because trends cannot not exist.

'If a Trend Follower is asked, how are you going to make money in the future? I think they should respond: 'because Trends cannot not exist.''

What exactly in particular does that mean? Well, it's what you said, it's the fact that at least in a free society, markets exist to create efficiencies for the greater good and if the price of wheat...if we start running out of wheat, the price has to go has to ration the remaining supply, it has to ration the remaining demand, it has to increase the supply. It has to incentivize people to plant more wheat because we are running out of it and if we didn't have... futures markets were created for that purpose, and without them the prices of food would be fluctuating all over the place. At the end of the day, there are inefficiencies that you can arbitrage out of the market, and there are inefficiencies that you can't arbitrage out of a market. The ones you can't arbitrage out of the market are natural law inefficiencies. They are universals as you've called them, and I've called them. Trends are one of them. If you are running out of wheat you can't arbitrage that out, the price is going higher and nobody can stop it unless the government steps in and subsidizes something or gets in the way of it, the market will go where it needs to go until there is an equilibrium between the buyers and the sellers. So in theory and this is Austrian theory, the trends are necessary. There are short time periods, and this is what is hard to explain to people who are following trend followers because usually the time periods of equilibrium are not as long as they have been.

commodities pic

So there are times when trend followers...some of the markets just randomly happen to be fairly valued, and nothing changes that in the future, but unless we become perfect prognosticators, and you know exactly how much of any given commodity is going to be needed a year from now and exactly how much supply to create to meet that need, which nobody can know that.  The trend will tell you what to do. The trend will tell you whether you need more wheat or you need more copper or you need more whatever you have until there's equal amounts so that everybody's needs are served.

Right now I think it's pretty obvious at this point to everybody that the Federal Reserve and government intrusion in the marketplace, particularly with suppression of interest rates, has been devastating for price discovery in pretty much off all traded markets. When you control the price of money, you control the price of everything. When there is a threat of constant intervention through regulation, taxation, and nobody really knows because the government and the Federal Reserve don't know where they are going with this. They pretend that they do, but they don't, and most businessmen know they don't know, and there's no exit strategy and so it's created an incredible suppression of price trends and it's created volatility with no direction. It's wreaked havoc on the markets, but eventually, if you look at it and say what is this ultimately? This is ultimately price control, and price controls ultimately create the exact opposite of their intended effect. The question is how long is it going to take? The markets will eventually go crazy. They are going to go where they need to go, where they have not been allowed to go. Hopefully, that won't be too far in the future so that the business is still around that exist to take advantage of it, but I think it's probably closer than it's been, but I probably would have said that a year ago. I think it's a certainty, it's just a question of how long can the government, and global governments keep this illusion up, because right now, as you mentioned earlier, the perception is, based upon spreads, yields on junk, there is no risk - the lowest volatility levels and fixed income foreign exchange ever. Stock markets just a month ago finished 40 straight days without moving a percent, which it hadn't done for 20 years. The market is not pricing any risk into the situation which is irrational, but irrationality can last longer than a lot of friends can stay solvent.

magician hands

"You stop trading one model because it's doing poorly and then you add one that's doing well, then all of a sudden the one that you just dumped has a huge recovery, and the one that you got in does poorly. Do that a couple of times in succession and you're looking at double your max drawdown..."

Niels:  Back to the magic, the perception is there is no risk. It's very interesting, but let me ask you this. First of all let me just say that I can imagine with the explanation that you gave about philosophy and universal truth, that there isn't that much room in a due diligence questionnaire to fill out the box where it says I believe in universal truth as one of my founding principles. Let me ask you then this question, if that's the case, and this is the way that you develop models, which is quite different from most other managers, is your model decay, which a lot of short term managers are saying that there is model decay in the way that they trade and maybe a model last 2 years, but is my understanding correct then that in fact you don't really see that as such, or at least not to the same extent?

Scott:  That's true. Model decay is not generally something that I worry about. For me, for a model that starts to underperform what it has in the past...we tend to be a lot more qualitative about that. To give you an example of how one of our models might decay as opposed to somebody else’s models because again, we're not looking at... parameters in our models are not numbers with lots of decimal places to the right. They're mostly binary switches, if this happens we do this, if this happens we do this, if this happens we do this, because it's much more qualitative. It's almost like how a discretionary trader would trade a two or three day move in the marketplace based upon how he would feel like he's reacting to a bunch of other traders that are doing something. The decay would be something that is more tied to the structure of the market and very little to do with the parameter sets or other things. For example, quite a long time ago, we had some models that were trading off where the opening price was and back at that time period and for many years prior to that there was a real psychology about a gap. A lot of people have written about it, will the gap be closed, will this happen and so forth.

I had some models that I thought there was a reason why they would be under certain conditions overreaction on the open, and then I would go against that as part of our reversion strategies or repertoires and it tied out to this particular psychology and what was going on here. Over time, that model started to deteriorate, and you get to a point where, you're always reviewing performance everywhere, what's going on here, then the light bulb goes off. Well, as electronic trading and off hours and Globex started to become more and more prevalent, and as more people in Europe and Asia were having access to the same or similar markets, risk was being able to be transferred more effectively around the clock, so the pent-up demand on the open was slowly diminishing. There still is some, but it's usually retail people executing on the open while the professionals pull all their orders, and they create the big zig zag in the first 10 minutes. It's in different character than it used to have. When we understand that this is the psychology that we're doing. We're tying this out to this one principal, but the market structure itself is no longer offering us the opportunity to utilize that principal in this construct, then we make an adjustment to it. That type of thing isn't happening. It's not like all of our different models; we think that every day they're slightly deteriorating by .01%, and it's always a clock. I don't think that way at all, as a matter of fact nothing is more surprising to me when I dust off a model that I haven't even touched in 15 years, and it's at new equity highs. It's one of those things that make you feel great. Most of the times that I can track back to underperformance or poor performance for any stretch of time, rarely can be tied to a bad parameter set. Usually it's tied to a principle that wasn't fully tied out... you're always balancing trying to make decisions about things.

One of the biggest risks is changing anything about your models because you can have incredible slippage. You stop trading one model because it's doing poorly and then you add one that's doing well, but then all of a sudden the one that you just dumped has a huge recovery and the one that you got in does poorly and all you have to do is do that a couple of times in succession and you're looking at double your max drawdown and all your clients are going away. A process by which you implement changes is as important as the changes themselves. But a big part of that is understanding what's driving the changes, because things that are coming from a universal are a lot different than things that are coming from the particulars, in my opinion anyway.