A puzzling trend following question
I did, however, get a thoughtful response from one reader that I couldn't answer. Specifically, I pointed out that the Trend Model account achieved its returns when the US stock market had risen steadily in the last year with no major corrections. Pullbacks were brief and shallow.
The underlying model is mainly based on the application of trend following techniques to commodity prices and global equity prices. Moreover, trend following models are notorious for subpar returns in trend-less markets which subject them to getting whipsawed in and out of positions. The chart below shows the actual (not back-tested) Trend Model signals and showed periods of whipsaw.
Trend Model Signal History
I wondered out loud that the best stress test for this trading strategy would be when stocks were to undergo a volatile corrective period like 2010-2012.
Is the Trend Model long or short volatility?
Here is the question that I couldn`t answer. Trend following strategies are generally thought of as having a long-volatility characteristic (via Futures Magazine):
Simply stated, trend following is at its core a long-volatility strategy. In other words, it makes money when volatility expands (i.e. during trending moves). Conversely, it suffers frequent but small losses during non-trending periods in exchange for such infrequent but large gains. During non-trending periods the strategy attempts to tread water through the judicial use of stop loss orders until some market movement provides a large outlier move in which the strategy can profit.Is it ironic that my Trend Model is performing well in an environment where pullbacks are minor and stock market volatility, as measured by VIX, is low, but I wished to see it stress tested in a corrective period when volatility, as measured by VIX, is high? Given the market action in the past few days and the most recent Trend Model market call (see A Yom Kippur bottom? Or just more volatility?), I may get that stress test very soon..
Does the Trend Model have a long or short volatility exposure? Is it behaving in accordance with other trend following systems? What am I missing?
Trend Model performance vs. CTAs
Trend following models have had a difficult time in the last few years. The BarclayHedge CTA Index shows how poorly CTAs did starting in late 2010, though they recovered late last year. The actual performance of the Trend Model account was stellar in the last year (much like the BarclayHedge CTA Index). On the other hand, the above chart of the actual Trend Model signals starting in 2009 were quite good as well (unlike BarclayHedge CTA).
Is there a disconnect here? Is this an anomaly in the characteristic of my Trend Model? If anyone has any thoughts, please either post it in the blog comments or email me at cam at hbhinvestments dot com.