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.

 

I realized that I’ve been taking some ignorant swings at “Random Walk” and the Efficient Market Hypothesis.  I hadn’t really read anything related to random-walk since Economics 101.  This realization, coupled with the fact that I literally live in the shadow of a wonderful public library that I have NEVER used, led me to take the short, direct walk to the library to get the book and review it.

All in all, the book is a good read and a valuable read in the sense that stock investors who take its recommendations to heart are far less likely to shoot themselves in the foot by overtrading, chasing performance, etc.

The basic premise of the book is that price movements in the stock market resemble a random walk, and that past price movements are not predictive of future price movements.  The book does make passing mention of a LONG TERM UP TREND in equity prices roughly equivalent to the long run rate of earnings growth, but rather curtly declares that transaction costs are prohibitively high, and therefore, short-term trend trading is not superior to a buy and hold approach.  In fact, it categorically goes through most widely followed methods of stock picking and explains why these are inferior to index investing.

Get it?  Two things : Future stock prices cannot be predicted, and nothing beats buying and holding a diversified portfolio that is primarily made up of US stock index funds.

Here are some important limitations to consider, however.

The conclusions about efficient pricing and long term upward bias apply to the STOCK MARKET ONLY.  Furthermore, while the book explains why fundamental and technical analysis “do not work”, it pre-supposes that an inability to predict the future movements of stock prices necessarily means that one should not be able to outperform the market over a long period of time.  Keep in mind that the book had already acknowledged the inconvenient trend phenomenon but managed to “normalize” it away.

My own evolution as a trader has taken me away from active stock investing.  In fact, the relatively small percentage of my assets that are currently held in stock funds are actually invested in index funds.  Why?  The risk-reward relationship for successful stock picking is relatively small due to the high costs and/or inavailability of high degrees of leverage.  I personally find my skill set more suited for forex trading, but this is by no means a recommendation that everyone run out and start changing their dollars for euros and pounds and whatnot.  Forex trading is purely speculative, and speculation and investing are really two entirely different animals.  Month after month, my forex trading results are convincing me that speculative, short term trend following in the forex market can and does produce returns that are not only outstanding, but also uncorrelated to the returns in my stock portfolio.  This is diversification at its best. 

Despite my rather facetious rant against index funds in a prior post, the vast majority of us will be investing in stock funds via tax advantaged accounts like IRAs and 401k’s…for this purpose, Random Walk’s advice is practical, easy to implement, and perhaps the best way to get rich slowly and enjoy a financially free future.