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Why Trend Following Beats Long/Short Hedge Funds

A recent article in on the CNBC website, entitled For Hedge Funds, a Half Percent Is the New Move, told about the trouble hedge fund managers are having keeping their wits in this very tough market. The article made the point that "some hedge fund managers scaled back the size and scope of their bets in recent weeks, a pullback that was reflected, say traders, in muted monthly returns."

The article went on to say "hedge funds were up .5 percent for the month of August." It further stated "the modest, if positive, returns reflect a decline in overall risk, some traders said, after unpredictable central bank activities, volatile oil prices, ephemeral new regulations and ongoing trouble in Europe rendered some money managers fearful to act."

So as one who has allocated to hedge funds, met with hundreds of managers over the years and is an active trader myself, here is the problem. They, the hedge fund managers, have no system for determining market exposure!

You heard me right!

So what do I mean?

What I mean is the average equity oriented long/short manager focuses on one thing, the quality of company earnings or the lack thereof. They are long companies generating quality growth and earnings. They are short those companies delivering poor earnings. The trigger for unlocking their investments is the market, they hope, will take notice.

The amount of long exposure relative to short is purely a matter of ideas. The more long ideas relative to short, the more long exposure. The more short relative to long, the less exposure.

Oh of course, you can argue that more and more of them are using ETFs of different kinds to hedge worries and what the manager considers excess exposure but this is just a gut instinct on their part based on experience. Believe me when I tell you that experience alone cannot prepare you for today's market!

So why do trend followers beat long/short hedge funds?

Simple, we have a system for determining exposure that is not based on instinct (experience). It is totally non-discretionary.

As an example, investors are always fully allocated to the markets. However our models may have us long the S&P 500, EAFE and the High Yield indexes, but short the NASDAQ. In this simple example, our models are controlling exposure, not our gut feel. Assuming a equal weighted portfolio, you would be 75% long and 25% short or 50% net exposed to these markets.

So why then does the trend followers (equity anyways) beat the long/short guys (in August and also I would argue year-to-date) because we stuck to our system and made more money. That system may seem counterintuitive at times, but in a market like this it is your salvation!

The hedge fund guys used hedges to bring down their exposure because they thought something might happen. In a word, they were guessing!

The trend follower was not guessing, he was reacting and following the ongoing trend.

That is a big difference. Reacting vs. guessing. My expectation is you will see as I do that maybe hedging in this market for long/short managers can actually harm returns vs. preserve them.

So what will you be doing going forward? Reacting or guessing?