In the last post we looked at the Turtle Trading system and saw that its performance went from outstanding for a long period of time to flat for 20 years. This opens a can of worms:
Does Trend Following work, is it dead, do markets change, does trend following rules need to adapt to these changes?
Let’s look at the different points of view.
The EMH Crowd
The EMH crowd does not believe in anything else than the Random Walk and by definition discards any profit-generating mechanical strategy.
As much as the Efficient Market Hypothesis (EMH) is a cornerstone of most modern financial theory, it has proven to be wrong partly because of some of its assumptions (not all actors in the market are rational, market prices are not fully random and normally distributed, etc.).
One great book that discredits the EMH approach and their descendant theories (CAPM, etc.) is by Mandelbrot: The (mis)behavior of the markets. It lays the arguments against the EMH in an approachable (ie not too much maths) way.
Trend Following is dead/does not work
Curtis Faith declared that “every few years trend following traders experience a period of losses and inevitably some expert will announce the end of trend following.”
Mike Covel also has a similar quote in his Trend Following book: “every 5 years some famous trader blows up and everyone declares trend following to be dead. Then 5 years later some famous trader blows up and everyone declares trend following to be dead, etc. ”
One of the main proponents of the argument against Trend Following is infamous trader Vic Niederhoffer (who “blew up” twice). He has been highly vocal about it, declaring Trend Following as one of the top Stock Market con.
Here is another link from his website to read more about it.
Arguments like this, despite the empirical evidence against it – in the form of Trend Following Wizards success, can be taken as a motivation for healthy skepticism and push you to strengthen your statistical research.
Are markets changing? (and must Trend Following change too?)
The self-professed “Trend Following poster boy” (a.k.a. Michael Covel) authoratively declares that this is a specious argument.
Occasionally, someone trying to promote something or start a debate will argue that trend following rules must always change due to changing market conditions. This is nonsense. It is a specious argument.
This is at best ambiguous. Covel likes to cite Bill Dunn who:
proffered that his basic system rules have not changed since 1974
Now, that is seducing: it seems to sell you the idea that you can develop a system, implement it and trade it for life. However this is not strictly true. As mentioned in this interview:
Dunn annually adjusts the parameters of trading signals and each markets weighting. In February – just as the grains were about to take off – he dumped the entire grain sector. But Dunn has no regrets.
Dunn is also known to have collaborated with Robert Pardo, a strong proponent of Walk-Forward testing (see below: a constant system adjustment).
To clarify: although Trend Following principles will never change, the rules/parameters of a Trend Following system might need to be adjusted to changing market conditions.
How can a Trend Following strategy adapt to the ever-changing markets?
In an Active Trader article, Anthony Garner attempts to discuss:
Do markets change? Is it necessary to undertake continued research and development and adapt a trend-following system to maintain its profitability over the years?
The article is only available for the magazine subscribers, but the result of the equity curve can be found on the Trading Blox forum. By “tuning up” the Turtle system, Garner manages to obtain interesting stats (MAR=2.26, CAGR=35.28%). The main change to the system is the use of a longer-term timeframe.
I know I would not be happy trading the original Turtle System in the last 20 years and get a 0% return. If you started trading this system “back then”, when and how would you think it is time to switch to a revised system?
Let’s look at options:
Walk-Forward testing‘s principle is to keep running (in simulation) a “pool” of systems using different rules/parameters. At regular interval, you evaluate what systems are best (performance, robustness, etc.) and trade those until the next re-evaluation. The potential risk with this approach is that you might end up like a dog chasing your tail.
However, this approach would have you switched from the original Turtle system to the new one a while ago.
2. Alternative Walk-Forward
Markets exhibit some degree of inefficiency – and Trend Following is a strategy designed to profit from these inefficiencies. I am still refining my theoritical understanding and explanation of it, but I believe Trend Following’s performance is mostly the result of fat-tailed distributions (distribution kurtosis) and possibly autocorrelation.
If one can associate the evolution of these characteristics to the performance of Trend Following systems it might be possible to adapt the system rules/parameters to the values and evolution of the price distribution characteristics. This is a topic I’d like to investigate further.
3. Mixing Systems
Finally, and this seems to be a strategy adopted by many professionals: mix different systems and different timeframes. Here the rationale is that we cannot predict what systems are going to under/over perform and mixing several ones together will smooth out the equity curve.