On Trend Following And Risk Mitigation

Jun. 24, 2015 1:36 PM ET
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Contributor Since 2015

Brian M. Spinelli is a Relationship Manager with Halbert Hargrove in Long Beach. Prior to joining Halbert Hargrove, Brian worked as a Financial Analyst with Northrop Grumman Corporation. As a Financial Analyst, he reported to the CFO and Director of Financial Planning. In this role he was responsible for financial projections, market and portfolio analysis, and financial modeling. Brian earned his Bachelor of Arts in Business Administration - Finance from Loyola Marymount University in 2002 and his Masters degree in Business Administration from LMU in 2005. Brian was awarded the ACCREDITED INVESTMENT FIDUCIARY™ designation by the University of Pittsburgh-affiliated Center for Fiduciary Studies and he is a CERTIFIED FINANCIAL PLANNER™

It appears the rising US equity market over the last few years has erased investor memories of risk and, while optimism is generally good for the market, ignoring risk, even in a good market, is simply dangerous and irresponsible. In the past, investment advisors have diversified portfolios to expose clients to just enough broad equity market exposure to keep their clients from being reactionary and divesting prematurely when the markets become stressful - a risk when an investor that has been trying to forget 2008 gets their first real whiff of a market wobble. This is a practice that needs to be re-examined and brought back to be top of mind by investors even if this bull continues its run. The approach, primarily, has been executed by using two types of investment vehicles that act as a circuit breaker in case of a market downturn:

Moving Daily Average (MDA) Systems:

MDAs are based on the idea that serial correlations exist in many investment markets, Modern Portfolio Theory notwithstanding, and that a disciplined, trend following system based on easily discoverable market prices can add value to a broadly diversified investment portfolio. Serial correlations, in this case, determine how well a past price of a broad market predicts the future price. So, what does this mean for investors? Positive MDA signals indicate to stay invested, while negative signals indicate liquidation.

Clearly, taxes and transaction costs play a role, while "whipsaw" - negatives that form from false positive signals - mean that the systems do not always provide a return benefit though they usually still provide some volatility reduction. By adding some straight-forward trading rules, such as time/magnitude thresholds, the dreaded "whipsaw" can be partially mitigated. Because of the expected error rate in the signals, investors can use a portion of an asset class allocation, a "sleeve", to hold a passive representation of that market or go to cash per the signal.

MDA is a subset of a good deal of historical and analytical data relating to trend following systems in general. More than a decade ago, Trend Following by Michael Covel persuasively analyzed the successes, and failures, of what have come to be known as Commodity Trading Advisors or "CTAs". In most cases, those who did three things - develop a reasonable system, applied risk controls to diversify their holdings, and maintain their discipline in turbulent markets - succeeded handsomely. Like most things in life, it was discipline that seemed to separate winners and losers.

Managed Futures Allocation:

Managed futures allocation would be better characterized as pure trend following with reasonable costs. The pursuit for a solution in client portfolios is sought to avoid performance based success fees and black box based approaches. The options available for consideration needed to directly lay out the decision rule process couples with competitive implementation abilities. Proper risk controls and focus on diversification are also required.

2014 was generally a good year with large trends in currency, commodities, and financials with a bit of reversal in equity markets. The ability to short, without a geopolitical position or an embedded business model, worked well. It's also suspected that government debt levels (interest rates and currencies) and commodity prices will provide trending opportunities in the next several years.

Why do the two strategies look interrelated?

The strategies involve judgments or triggers dependent on trending markets, and, in many cases, a purely mechanical rule outpaces the very best active management process or, at least, it seems to make the case for rules-based diversifiers, which would include MDA and "managed futures".

So, to sum up, why should these strategies be included in your portfolio?

· MDA works by reducing volatility over time, thus allowing a higher compounding rate for wealth;

· Trend following systems attempt to exploit momentum; the "good" ones do so with rigorous risk controls and diversification. They might be included in order to further diversify sources of return ("momentum" in additional tradable markets) and to provide inexpensive, usually positive return, tail risk insurance; thus,

· In several ways, they target the same goal: diversification with less exposure to the expected return reduction of fixed income.

Diversification means having to say you're sorry (and that's a good thing)

While there are times in various financial markets where disciplined systems outperform seasoned judgment; the reverse is also true. Neither should be used in isolation.

To paraphrase Erich Segal, diversification means having to say you're sorry - a diversified portfolio will, very likely, have outright losers in it. But, even if that's the case, using the trend following systems above will reduce the cost of diversification or turn a return decrement to a positive - something you definitely won't be sorry for.

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