Traders' Roundtable

Copy of article posted to Traders' Place:

It has long been my contention that markets have become less kind towards trend following models in recent years. My view is that markets do change and that models therefore need constant adaption to survive, witness the recent demise of JW Henry and the dreadful performance in general of trend following models over the last two years.

One concept that I have often admired but never tested is that of Perry Kaufman’s Efficiency Ration to be found on page 134 and onwards of his book “Smarter Tradingâ€

Looking at an expanded version of the chart, what it shows is that the efficiency of trends (at least 6 month trends as defined by this index) improved to well above average between mid 2008 and 2009 and then slumped to an historic low for much of the period since.

As with all indicators I have come across, they are great at giving historical perspective and putting the past into context. We can see that the past couple of years have been horrible for trend following by the briefest perusal of CTA results for those years. And this indicator tells us why this has been the case (in technical terms at least).

What this indicator does not do is to allow us to predict whether the next day, month or year will be any kinder to a trend following strategy. It shows that trends have become less efficient year by year over the past 40 years but does not tell us what will happen over the next 40.

Funny that Y2000 (12/31/1999 to 12/31/2000) is so quiet on that graph; it was one of my best years for real-life, real-money LTTF system trading. A quick lookup shows that well known, publicly confessed trendfollowers Dunn, Eckhardt, Tactical, Quicksilver, and Winton all had great years in 2000 as well.

Funny but perhaps not startling; systemA correlation to systemB is almost always less than 100%. ManagerC correlation to managerD is almost always less than 100%. So it isn't a complete stunner that indicatorG correlation to systemH is less than 100% as well.

I think the thing to remember is that my chart above is of one specific parameter run: a rolling 120 day period. The idea was sparked off by reading Estlander's year end report to investors where they showed a graph purporting to show the absence of clean 6 month trends in the last two years. I believe this indicator does the same.

No doubt if one ran 20, 40, 60, 80, 200 day rolling periods, one would come up with some different definitions of periods which were good or bad for trends. As we both know, one need to define the trend length, and all I have done so far in the above post is to define the trend as 6 months. Which is evidently the trend length that Estlander believes is important to their systems. As you rightly say, different managers will seek to capture trends of different periods. Or in some case all periods...but who knows without seeing their algorithms.

In any event, I doubt very much whether this or any other indicator has much useful predictive vale in actual trading or investing. Like so many tools, it is great at telling you what you should have done with hindsight.