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> a) Has long-term trendfollowing stopped working in
> most markets ?
I am a believer in the inherent return hypothesis in futures markets. To
quote from Charles Lightner's excellent article on the subject in Mar '99
TASC: "The inherent return hypothesis may be formulated as follows: The
essential nature of the futures markets and of the relationship between the
commercial participants and the noncommercial investors involves the
provision of and payment for a valuable service, risk transfer. The payment
is made via transfer of trading profits. The mechanism of profit transfer is
positioning in the direction of the price trend." A follow up article by the
same author (sorry, I don't have the reference handy) showed that trend
following profits were *not* generally available in the cash market, thus
confirming the hypothesis of "payment for risk transfer service" through the
vehicle of futures contracts.
If this is true, then trend following should continue to work as long as:
1) There is price risk in the underlying cash market.
2) The ratio of hedgers to specs in the futures market is balanced.
Concerning item 1), as price risk decreases, the cost of risk transfer
service should decrease. Hence, there should be fewer profits to specs who
provide this service and get paid via the mechanism of trend following
profits.
Concerning item 2), as specs begin to dominate a market, or as commercials
leave a market, there are too many "hands in the pie" (former case), or not
enough people making pies (latter case) hence the trend following profits
available are spread too thin among too many specs. Hence fewer profits for
each spec participant.
I would expect that if trend following profits for a particular futures
market have decreased, that decrease could be explained by one of the above
conditions.
It may be prudent for a spec participant in the futures market to pay
attention to fundamental changes in the underlying cash market such as those
related to technological advances in production, for example, that would
decrease price volatility in the long term which in turn would tend to
decrease the amount of future trend following profits.
> b) Which is the "edge" of the individual trader over
> the large money-managers in today's marketplace ?
In trading, one should know the source of their profits. If the inherent
return hypothesis is true, one does not really need an edge over big
money-managers. It is not really a zero-sum game against them, but rather
zero-sum against hedgers. It is more like McDonalds vs a Mom and Pop burger
joint rather than a Saturday night poker game. McDonalds and Mom/Pop are
both being paid by customers, not each other. As long as there are enough
customers to go around, both can be profitable.
Personally, I converted to trend following about 5 years ago. I have been
trading a real money system religiously for 3 1/2 years. No pulled signals,
everything 100% mechanical. There has been some tweaking during that time,
mostly related to leverage and portfolio selection issues. My results seem
correlated to big trend following CTAs except that I am using extremely high
leverage compared to CTAs since it is my own money. This correlation is
informal as I have not done a serious study since I do not have access to a
CTA performance database. Since the tweak I did in Sep '00, the system's
real money Sharpe Ratio is 1.62. Just to be clear on how I calculated it:
Ave monthly return: 12.44%. Monthly Stdev: 26.68%. (Like I said, very high
leverage compared to managed money.) Sharpe Ratio = (12*12.44) /
(Sqrt(12)*26.68). However, as of Mar 31, 2002, the system has a total return
of (1.1244^18 - 1) = 725% in 18 months. It has been somewhat gratifying to
know that I can get the same kind of performance, Sharpe Ratio wise, as guys
making millions on fees/incentives just using a simple trend following
direction signal and sound bet sizing.
Scott Hoffman
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