Wednesday, October 11, 2017

Efficient inefficient #13 : Managed Futures

Today’s article is about managed futures but this strategy is really about trend following. The result of this strategy is very credible, with Sharpe ratios going as high as 1.8. Bershire Hathaway’s supposed ratio is about 0.76 and my usual backtests struggle to hit 0.6. According to the textbook, a diversified trend following trading strategy can return 19.4% with only a volatility of 10.8%.

My primary interest in this strategy is figuring how I can apply these learnings to the build-up of my momentum-based portfolio which would proceed sometime next year. As it turns out, looking at long term trends lasting about 1 year is optimal with weekly rebalancing taking place, but equities provide the lower returns than fixed income and commodities.

If you believe in market efficiency, it would be hard to accept that you can make money from trends, but the return drivers come from two main sources : 

A) People react too slowly to information

One theory is that people anchor their views to historical data and adjust their views too insufficiently to new information. Another reason is that people tend to sell winners and ride losers for too long. Central banks also exacerbate the process as they focus on reducing exchange rate and interest rate volatility. Also, market friction, prohibitions against short sales do not allow arbitrage to take place instantaneiously.

B) After a time delay, people overreact to information

Once prices move for a while, the bandwagoners start piling onto a stock. People are afflicted with confirmation bias ( Boh Koh Leng ! ) and focus on what they already believe in discarding evidence to the contrary. Investors also add to the problem chasing investments that tend to do well recently which contributes to fund flows.

My leveraged portfolio is only 50% done and it’s already calculated to return about $20,000 a year. A momentum based strategy that adopts some of the best practices by trand following investors will not only provide me decent returns, it is likely to have little correlation with my leveraged or unleveraged yields portfolios.

 


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