Book Review: Trend Following (5)

There are many places where I agree with Michael Covel.  Here are two:

  • Trend following, or, price momentum, is a good strategy.
  • Most investment advisors charge a lot, and on average deliver suboptimal performance.
  • The weak form of the efficient markets hypothesis doesn’t work.

Most of the Wall Street establishment, and those trained by universities and the CFA program believe that the weak form of the efficient markets hypothesis works.  I.e., You can’t make money from past price and volume information. This is why most of them don’t use price momentum.  They would get laughed at.  The weak form of the EMH is holy stuff.

Beyond that, the fund manager consultants try to cram every manager into a simplistic risk control model, leaving managers little room to hold cash, or invest in promising places that don’t fit the narrow pigeonhole that the fund manager consultants use to simplify their work.  Someone who rotates styles, sectors, domestic versus international, or who simply raises cash when opportunities don’t seem so good are anathema to the fund management consultants, no matter how good their performance is.

But as time has gone on, the behavioral finance folks have shown that valuation, price momentum, normalized operating accruals, and other factors have significant predictive potential on future returns.  Hedge fund managers, who have less of a tendency to listen to the fund management consultants, and a greater tendency to do what works, do use trend following, or price momentum in their investing.

What if Everyone Followed Trends?

Suppose everyone except Warren Buffett decided to follow trends.  The market would become very volatile, as was suggested in Investing by the Numbers.  (By his model, anytime momentum investors are more than 20% of the market, things go nuts.)  Buffett would make money hand over fist as he would sell holdings as they soared over fair value, and buy as they crashed well below fair value.  The valid strategy that is less employed makes more money.

There would be another effect.  There is a limitation on the ability to short on the market as a whole, if the borrow is enforced.  The whole world is 100% net long every night.  Shorts and leveraged longs are side-bets in the game of investing.  The more trend followers there are, the more that shorting capacity would prove to be a constraint, because once things start going down, the available shares to borrow would disappear.  The profitability of trend following in a bear market relies on a small enough number of parties selling short.  Everyone can’t sell short at the ame time.  Everyone can’t go to cash at the same time.  The assets must be owned by someone at the end of each day.

There’s only one strategy that could be followed by everyone — Indexing (and not fundamental indexing).  Returns to any strategy decrease as more pursue it.

On Audited Track Records

Bill Miller had a great audited track record, and it imploded in two years, largely because he did not understand the financial stocks that he owned.  While working at Provident Mutual, I interviewed a growth manager who used price momentum heavily, and had a tremendous track record.  I pointed out 10% of his portfolio that had poor earnings quality, and he gave me a “you don’t know the right things to look for” answer.  In the next week, a number of those companies preannounced earnings shortfalls.  The marketing guys came over to me and said, “You called that one.”

In truth, I didn’t.  Rarely do things happen that fast.  But that manager did disappear within a few years, despite his great past track record.

There’s a reason why we say, “Past performance does not indicate future results.”  Because it doesn’t.

I am not saying that I manage money better than Michael Covel, or anyone else.  He has done better than me, even though I have done better than 90% of all long only equity managers over the last nine years.

I do not have an audited track record, but only because I don’t want to pay for something that I don’t have use for.  I am not broadly advertising my services.  If an institutional investor would want to use me, I would get my returns audited.

I write my blog because I enjoy teaching, nothing more.  It fills a hole in my life, a part of a need to give back.

In closing, I can endorse “Trend Following” because its basic premise is true.  Follow price momentum and you will beat the equity market 80% of the time.  I just did not enjoy the lack of logic from Mr. Covel.  Correlation is not causation.  Making money in the past is not proof.  Picking and choosing trend followers does not constitute proof.  Take a more humble attitude, and you have a good book.