William Hester of the Hussman Funds offered recent insights for the typical mutual fund buy and holder (the insights are nothing new for trend followers):
The storm began to brew last summer when investment consultant and historian Peter Bernstein wrote an article detailing the changes that can be expected in the field of money management. There are few people in the business as respected as Mr. Bernstein, who is the founding editor of the Journal of Portfolio Management and the author of several books including Against the Gods: The Remarkable Story of Risk. His words were a jolt to an industry that had become comfortable with its own dogma. The mental models and industry standards that were created during the great bull market are outdated and will be ineffective for the type of asset returns of the next decade or so. “What we have been doing has begun to outlive its usefulness; the world in which we invest today bears too little resemblance to the world of yesterday. That’s why managers with the greatest level of skill should be free of constraints, says Mr. Bernstein. He quotes the work of Richard Grinold and Ron Kahn, authors of the well-respected Active Portfolio Management: A Quantitative Approach for Providing Superior Returns and Controlling Risk. In their book they show that the more highly skilled a money manager activities are, the more opportunities the manager should be given to provide extra return. Judging performance by peer comparison alone misses the point that assets are managed to meet future liabilities. The true benchmark for any particular investor is the return required in order to meet those expected liabilities at the date they are expected. The herding of investors into popular stocks and industries during the bubble, and their subsequent price volatility, should cause investors to question whether the popular indexes and style groups are the optimal benchmarks. In this sense, the notion of uncorrelated returns – especially, absolute returns, has a compelling attraction,” says Mr. Bernstein. Mr. Bernstein thinks mutual funds will move toward a hedge fund model. Money managers will have freedom to select securities within an entire asset class; they will have the ability to hedge their portfolio in numerous ways (provided that the manager holds the portfolio’s risk level to assigned parameters); they will do most of their own research, or pay for objective opinions; and the performance of money managers will be judged by the return of their portfolio versus its risk. “When returns are not as easy to come by as in the past, the constraints on manager activity imposed by benchmarking are archaic. Indexing has become more costly and more risky. And new techniquesŠthat widen a manager’s range of choices will always make sense in comparison with the old way of doing things.
Source: full article at Hussman Funds
Bernstein’s observation that “what we have been doing has begun to outlive its usefulness” is the kind of statement that arrives slowly in institutional finance and then all at once. The mental models built during the bull market, benchmark relative returns, style box constraints, peer comparison as the primary performance metric, were designed for an environment where the market went up reliably and the question was merely how much of the upside a manager captured relative to an index. In an environment where the market does not go up reliably, those models produce nothing useful. Benchmarking against an index that is declining tells you how much less you lost than the benchmark. It tells you nothing about whether you met your actual objectives.
The move toward absolute returns that Bernstein describes is precisely what systematic trend following has always been. Trend following is not constrained by a benchmark. It is not evaluated by peer comparison. It is evaluated by whether it produces positive returns across market cycles, regardless of what any index does. The freedom from constraints that Bernstein sees as the future of institutional management is the operating premise of every serious systematic trend following operation. The insight is not new for trend followers because they never accepted the benchmark constraint in the first place.
The reference to uncorrelated returns is the other key point. A manager whose returns are uncorrelated with the broad equity index provides genuine diversification value, not just exposure to a different slice of the same market. Trend following’s historical correlation to equity markets has been low and often negative during the periods when equity markets fall most severely, precisely when the diversification is most needed. This is not a coincidence. Trend following captures large directional moves in whatever direction they occur. When equities fall severely, other markets are frequently trending, and trend following systems are positioned in those markets.
Frequently Asked Questions
Why is indexing described as having become more costly and risky?
Because passive indexing worked well during the sustained bull market of the 1980s and 1990s when the primary question was how much of the upside a manager captured. In environments where the index itself declines significantly, indexing guarantees full participation in the loss. The benchmark constraint that produced acceptable results in a rising market becomes a binding constraint that prevents the manager from protecting capital when it is most necessary.
What does “free of constraints” mean for investment managers in Bernstein’s framework?
Freedom to short as well as go long, to hold cash when no opportunities meet the criteria, to trade across asset classes rather than within a single style box, and to be evaluated on absolute return versus risk rather than on performance relative to a benchmark index. These freedoms are standard features of systematic trend following approaches that were never constrained by the benchmark framework to begin with.
Why are uncorrelated returns described as having compelling attraction?
Because in a portfolio context, an asset that produces positive returns when other assets are declining provides genuine risk reduction rather than just diversification across correlated positions. Trend following’s historically low and sometimes negative correlation to equity markets during severe downturns means it provides the most value precisely when a traditional equity portfolio needs it most.
Trend Following Systems
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