Where is the value-added for trend-following strategy? Many believe that the strategy has been commoditized, but there is a difference between simple trend-following and more complex strategies. Put differently, there is the difference between generic trend-following and skill-based trend-following. I have more than once argued that trend-following signals could be a flat fee business, but investors should pay a premium for risk management and portfolio construction.
This difference between generic and complex trend-following is craftsmanship alpha, the excess return that is generated from properly assessing and managing a portfolio of trends.
This difference between generic and complex trend-following is craftsmanship alpha, the excess return that is generated from properly assessing and managing a portfolio of trends.
This value-added or craftsmanship alpha was nicely shown in a short paper called, "Protecting the Downside of Trend When It Is Not Your Friend" in the Journal of Portfolio Management. Simple additions of complexity can add significantly to return and risk control. The authors show that a little complexity to signals and better portfolio construction will lead to meaningful gains in the Sharpe ratio. Of course, as complexity increases the core trend-following risk premia can There is obviously little value-added if there are no trends; however, even in those cases, a well-diversified portfolio may limit losses. Adding some complexity will avoid momentum crashes when there are sharp trend reversals.
The craftsmanship alpha for trend-following can be divided into two key areas, signal and portfolio construction. The simplest trend signal can be a single moving average across all markets. The simplest mechanism for portfolio structuring is to just form an equal volatility weighted portfolio. The choices made by the firm defines its personality and skill. This would be the craftsmanship of the manager.
From very simple cases, there can be increasing complexity. For example, a number of different timeframes for trends can be added. The style of identifying trends can also be diversified. There also can be mechanisms for profit-taking or identification of periods susceptible for mean reversion. Trades can also be ranked or conditioned based different criteria. Risk management can be added to offset losses before a reversal signal is generated.
In the case of portfolio construction, there can be a move from equal volatility to equal risk contribution. Managers can also account for the quality signals, correlation, and liquidity. A large number of tradable futures does not mean that all should be included in a portfolio.
There will be diminishing returns to complexity. Complexity will also increase trading costs. Investors pay for a manager's skill at making these trade-off decisions. The result can be measured, but the choices require a craftsman.
In the case of portfolio construction, there can be a move from equal volatility to equal risk contribution. Managers can also account for the quality signals, correlation, and liquidity. A large number of tradable futures does not mean that all should be included in a portfolio.
There will be diminishing returns to complexity. Complexity will also increase trading costs. Investors pay for a manager's skill at making these trade-off decisions. The result can be measured, but the choices require a craftsman.
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