Ed Mamula.com

In the last 24 hours, I’ve seen no fewer than six news articles that point out the fact that noted trend follower John W. Henry’s Strategic Allocation Portfolio is in a deep drawdown.

Here’s an excerpt from the article referenced above:

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How bad does it look? You can see the figures at Henry’s own Web site, and they are astonishing. Since December 2004, his main investment fund has lost a stunning 36%. And according to a report in the May 29 Wall Street Journal Henry’s slide continues, as Merrill Lynch has redeemed $600 million from the firm.

While a simple index fund over that period would have turned each $10,000 into about $12,450, Henry’s “Strategic Allocation” fund has turned the same amount of money into a mere $6,360. Except we’re not actually talking $10,000. We’re talking hundreds of millions of dollars.

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36% drawdown over 2 and a half years is stunning?  Was it more stunning when the S&P 500 index shed approximately 50% of its value from 2000 to 2002?  How about the fact that the NASDAQ composite index is currently at a roughly 50% drawdown that is over 7 years in duration!  Everything is relative, but only the recent is sensational…

Equity Curve Timing at its Worst

Notice that Merrill is redeeming funds.  On the surface, this may seem a prudent way to conserve capital, but now they will need to find someplace else to invest that money.  Like a trader who jumps from system to system each time one of them is in a drawdown, this tactic makes it very difficult to succeed in the long run.  All systems will have drawdowns, and while much has been said about the deep drawdowns that trend following systems experience, I’ve seen very little written on the fact that when they recover from that drawdown, they tend to do so with blinding quickness!

Value of Diversification

I don’t tend to follow the results of John W. Henry’s Strategic Allocation Fund, but I do watch the returns of the Financials and Metals portfolio with great interest.  At the time of this writing, the Financials and Metals would have turned a $1,000 investment in 1984 to over $100,000 today.  An equivalent investment in the S&P 500 index would have grown to just under $16,000.  More importantly, both the Financials and Metals and the Strategic Allocation Fund show a slight negative correlation with the S&P 500.  This is the classic “one zigs when the other zags” type of investment assets that we would want to have in a well-diversified portfolio. 

Opportunity for investing

I don’t recommend any investment products, and the primary purpose of this site is to follow the returns of my forex trading systems.  Incidentally, my systems are trend following in nature and have recently come upon hard times as well.  With all of that being said though,  the recent media attention to the Death of Trend Following smells like a bottom.  Remember, proper equity curve timing is never easy.

When developing a forex trading system, we should constantly attempt to validate the fact that we have an edge, whether it’s an entry edge, an exit edge, and/or a position sizing edge. 

How can we tell if we have an entry edge?  One method that I’ve seen much written about is to compare our entry rules with a system that enters the market randomly.  Given a static set of exit and position sizing rules, we can then immediately see if the performance that our entry generates is any better than a random entry. 

The method above is somewhat problematic.  It forces us to define and implement a form of random entry, and may lead us down the path of running monte carlo simulations to gain confidence in how our flavor of randomness looks compared to the “typical” random path….does it feel like we’re straying a bit from our original goal of finding an entry edge?

Here’s an alternative to comparing our rules with random entry.  Compare our rules to the OPPOSITE of our rules.  It may not be scientific, but it is certainly enlightening.  Sometimes we’ll test a set of entry rules that produces poor results.  It should be very easy to reverse our rules (go short where we would have gone long and go long where we would have gone short) just to see the effect.  Sometimes we’ll find that the opposite of what we were testing is successful, and we’ve backed into a successful counter-trend entry signal!  (presuming that we had been originally searching for a trend following entry)

The situation where this testing method comes in handy is when we have a profitable system, and we presume that our entry rules play a part in it.  If we reverse the rules and the system promptly loses all its equity, our confidence in the original rules increases.  If the opposite of our rules is ALSO profitable, well then, congratulations!  Our exit and position sizing rules are carrying the day!

The scenario above is just one example of where we can train ourselves to ask the question “What if I’m exactly WRONG about how the markets work?”  Sometimes, tests like this create ”aha! moments” that allow us to make new breakthroughs toward trading success.