The Trend Program

Kaufman trend

 

In this program you can choose:

  • Daily or Weekly Stocks and ETFs
    • (Daily includes Income Focus)
    • (Weekly includes Sector Rotation and Income Focus)
  • Daily or Weekly Futures
  • Both Equities and Futures

Most have multiple portfolios to help fit your investment needs.

TREND is a macrotrend program, which tries to capture the long-term price trends that relate to economic policy, or structural shifts in supply/demand. The concept is the basis for most of the hedge funds and managed account programs and has been a stabilizing and profitable component for 30 years.

I can personally say that I both love and hate trend-following, and both at the same time. There is no doubt that trend-following works, but it can have large drawdowns when the major trend turns. During the past few years, macrotrend strategies, most popular among futures traders, have had smaller than average returns because the trend in interest rates, the primary driver of the  economy, has been slowly changing from up decreasing to increasing. However, in 2013 performance began to improve.

Trend-following for equities has captured large gains during the bull market of the past three years. By simply eliminating those stocks that are trending down, or lagging the overall market, you can create a portfolio with returns even better than the spectacular 38% in 2013.

Trend programs benefit investors the most during a bear market, simply because they will exit all stocks trending down. While everyone recognizes a bear market, most investors are not willing to close-out their positions, hoping for a quick reversal to the upside. It’s easy to understand why. The downturns and retracements in the stock market are usually short-lived. As soon as you sell your position the market turns back up. But that’s not a good reason to stay long all the time.

Returns, Discipline, and Insurance

Using a trend system needs to be viewed as insurance, but insurance with a very good payout. It will allow you to stay in a bull market, as we've seen in the past few years. But the best results for futures was in 2008 when the stock market collapsed, and the best improvement in systematic equities trading was also in 2008 where returns beat the index by up to 30%. In 2008, trend systems in Futures gained from 20% to 70%, while in a long-only stock portfolio they lost 10% to 20% rather than 40% to 50%. If you could sell short in the stock market, you would also have netted a large profit. The cost of using trend following are returns that may lag the stock market in a good year, but in a bad year losses are cut significantly. It can also reward you during bull markets, as we see now. The long-term returns of a trend-following system are more stable than the stock index, that is, they have lower risk for the same return.

The need for disciplined trading cannot be over-emphasized. Of course there are brilliant discretionary traders, but that requires exceptional talent and huge amounts of time. You don’t make profits by luck, and you don’t do it without investing considerable effort. And discretionary traders are usually “systematic.” They don’t use a computer to produce trading signals, but they have a routine and look for special set-ups. No one survives without discipline.

Not All Trend-Following Is the Same

There are similarities and differences in trend-following strategies. All of them must capture the largest part of the trend, but some do it by trading in and out of smaller moves, while others try to hold the same position for as long as possible. Both approaches have merit because they target the same concept — only trade in the direction of the trend. The unique features of our macrotrend program are

  • It scales in and out of positions as the trend increases in strength and changes direction. All positions are risk-adjusted (also called risk parity) for increased diversification.
  • Multiple trends are used based on a range of non-linear calculation periods to avoid a program that is biased toward faster or slower choices.
  • Multiple confirmations are used so that we add to the position as the trend solidifies.
  • Entries may require a price reversal, which avoids chasing the market, clustering with other macrotrend orders, and improves results.

Chart 2 is an example of the varying position size of the Trend program applied to SPY. Note that the position size is above zero during an uptrend and below during a downtrend, yet it quickly turns from down to up in 2002 when the new bull market begins.

The Best and the Worst

The performance of trend-following varies across sectors, some of which exhibit clear tendencies to trend more than others. This is seen by looking at the futures markets. By far the best sector is interest rates with its pattern tied very closely to Central Bank policy. That sector has provided the largest injection of profits for trend-following programs. The next best sector with good trends is currencies because they benefit from the movement of money to countries with higher rates net of inflation and geopolitical risks. Energy and metals are moderately trending, generating large profits when crude goes from $40 to $150 and back to $40, and gold from $500 to $1900; otherwise, they offer good diversification. Agricultural products are least desirable because the seasonality conflicts with the long-term trend, further complicated by carrying charges and inflation. While they can be profitable over time, they have large swings in performance. They also offer important diversification.

Equity markets have a history of being erratic trend performers, although you wouldn’t know that from the past few years, or during the run-up to 2000. But after 2000, and in 2008, stock markets around the world plummeted. The U.S. markets took 5 years to recover the old highs. We can see the behavior when we look at Chart 1, the information ratios, where QQQ is ranked lowest.

Within a futures portfolio, equities offer excellent diversification and a chance to add to the gains; in an equity-only portfolio they can be very erratic. Their ability to trend can be measured by the level of price noise, discussed in the first chapter of Trading Systems and Methods, Fifth Edition.

Daily and Weekly Income Focus Programs

Interest rates have been the biggest source of returns for futures traders since 1980, and the basis of income for many investors. But the choices range from money market to U.S. 30-year bonds, and from AAA corporate bonds to issues with high risk.

In the uncertain 2016 stock market, many investors are putting more weight on income producing assets, and either the daily or weekly Income Focus program will fill that need. Returns are augmented by frequent interest income, and the component ETFs have a low correlation to the S&P.

In an article by Mr Kaufman, “Uncovering the best tradeable bond fund,” published on the Forbes website in August 2016, the 15 most liquid interest rate ETFs were reviewed for the most likely to perform best based on consistency and returns. The conclusion was that high-yield bonds (JNK) and municipal bonds (MUB) were the clear choices, ranking best regardless of the whether you applied medium or long-term trends.

The Method

We took that two ETFs and added preferred stocks (PFF), boosting the long-term returns and adding some risk, but still keeping the risk well below most normal investments. We then track the trends of these three markets and allocate the investment equally when two or three are trending up, or placing all the funds in one ETF if that is the only one trending higher.

If none of the interest rate ETFs are moving up, we leave all funds in the money market, the cash 3-month T-Bills. This may seem a futile effort at the moment, because interest from money markets are near zero, but that may not always be the case.

The Results

The chart below shows the Net Asset Value of the Income Focus Program from October 2007, when these ETFs became available for trading. Note that the drawdown in 2008, caused by the financial crisis, was only 17%, far smaller than the 50% seen by the major index markets, Ivy League Endowment managers, and many other investors.

income-focus-n

For the period of nearly 10 years, this program showed an annualized rate of return of 10.1% with an annualized risk of 7.4%, giving an information ratio of 1.37. These results are net of an $8 per trade cost. The information ratio is a measure of reward to risk, and can be seen as representing the smoothness of returns. In contrast, the S&P has a ratio of about 0.30 indicating that you need to take $1 of risk to gain $0.30 of return.

We believe that this program will satisfy the need of many investors looking for decent returns but much lower risk. It is available as part of the Daily Equity Trend Program with a target investment of $30,000 ($10,000 per ETF), but can easily be scaled to any investor’s needs.

Weekly Income Focus

Because trends in MUB, JNK, and PFF are generally smooth, this method is easily adapted to weekly data. Over time, returns are slightly lower and risk is slightly higher, which is normal when you manage positions weekly rather than daily. But the end result is nearly the same, a steady gain in returns with far lower risk than most stock or ETF portfolios.

Weekly Equity Trend Program

The Weekly Equity Trend uses the same logic as the Trend program, but applies weekly bars ending on Friday, rather than daily data. Contrary to some opinions, a weekly trading program is not a lazy alternative, but a viable strategy in itself, with some advantages over the daily Trend program.

  •  Weekly data is smoother than daily data. It reflects the trends better; therefore, it is more reliable.
  • It requires a smaller investment in trading time and is more practical for many investors.
  • Long-term performance, both returns and information ratio, are better than the daily Trend program.

Its obvious disadvantage is that it may take longer to exit a trade because orders are only placed once each week, on Monday’s open. For the long-term investor, the information ratio shows that the Weekly Trend has an edge over the daily Trend. Read more about this in A Better Trend (go to New Articles/Member Articles  on the home page), and Equity Trend Following -- In Depth (also under Articles).

Weekly Sector Rotation Program

This program, introduced in February 2016, is a variation on classic sector rotation, a strategy that has been successful for decades. Normally rebalanced only monthly, we have made this more responsive by changing to weekly and adding a hedge when the major index markets turn down.

The program is based on "persistence," the tendency for a price to continue in the direction it was going. We pick the 3 best ETFs from the 14 most liquid sector SPRDs and allocate 1/3 of the investment to each. These are reevaluated each week. If the major index (SPY) is in a downtrend, we replace those sector ETFs with two long bond funds.

You can read more about this on the Home page under How It All Works\Sector Rotation.

Trading Futures Markets

Futures markets offer many advantages over stocks:

  • Far greater diversification
  • Ability to leverage up and down
  • Lower relative commission costs
  • Less counterparty risk, that is, a futures market is not likely to be suspended and always has intrinsic value.

But they have the disadvantages:

  • They require a larger investment
  • Leverage, if not properly managed, can lead to larger equity swings
  • They are not a hedge against a declining stock market

Because the performance of futures is uncorrelated to stocks, it has been misinterpreted as making money when the stock market is declining. Not so. Uncorrelated means the performance of the two are unrelated. They can both profit on the same day or both lose on the same day. However, there is only a 25% chance they will lose on the same day and the percentage loss may be very different. To perform in an opposite way is negatively correlated, a much more unusual situation.

Futures Portfolios

Futures offer true diversification, spanning a wide range of financial and commodity products. Traditionally, Commodity Trading Advisors and Hedge Fund Managers have use portfolios with fixed allocations, that is, markets have been pre-assigned a specific allocation. For example, the 10-year Note may use 3% of the investment, the emini-SP assigned 5%, and so on. These allocations are based on a long-term history of performance. While this worked for many years, it has not done well over the past 3 to 5 years. It obligates the program to trade markets that are underperforming.

KaufmanSignals has developed a new, dynamic way to choose markets to be added and removed from the portfolios. You can find a detailed explanation in the Articles menu, under "Dynamic Futures Portfolios." Essentially, we use multiple criteria to rank the markets, then choose the best from each sector. This means we can avoid trading markets that are not performing well for that program. If there aren't enough markets that qualify in that sector, then we simply trade fewer markets.

Market exposure is still determined by risk parity, that is, all trades and all markets have equal risk, whenever possible. Sector volatility is also equalized and some constraints are put on the risk of the entire portfolio. Our benchmark portfolios target a volatility of 14%, which can be personalized by each investor simply by increasing or decreasing the position sizes equally in the portfolio.

As you will see in the Monthly Performance Summary, this approach shows that it can be profitable during periods when traditional fixed allocations are not. Read more about this in the article.

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