Equity Trend Following – In Depth

Portfolios of Stocks

Our dynamic stock portfolios select 10 or 30 stocks from the (approximately) 300 tracked, seeking those stocks that have performed well, are active, and have a higher beta than the overall market. We expect that profile to outperform during good years, and cut losses during bad years. Current performance can be found on the Performance page. The Equity Trend program has continually outperformed the SPY and over the long-term the risk was 1/3 of the SPY.

Positions are sized by dividing by dividing the same investment amount, for example, $10,000 by the price of the stock on the day prior to entry. While this is not as good as true risk parity, it is a reasonable approximation of risk because stocks have been selected that are actively traded. We also avoid low-priced stocks which can be unusually volatile and erratic.

To see the current performance, go to the top of the Performance Report or look at the detail further down for each portfolio that may interest you.

You may also choose to create your own portfolio from the daily signals in the Trend Stocks All Signals report. See the article “How To Construct Your Own Portfolio”, accessible in the Members area.

Diversification

It is not possible for most investors in equities to use leverage, but it is possible to duplicate a great deal of the diversification of futures using ETFs, such as GLD (physical gold) and TBT (20-year bonds). For only equities many stocks are highly correlated to one another, more so because of arbitrage to the major indexes, such as S&P futures or SPY (SPDRs). When the average of actual stock prices fall below the index by enough to be profitable, professional traders will buy all stocks in the S&P and sell the index to capture the arbitrage. This increases the similarity of price movement.

Traders interested in a well-diversified portfolio similar to futures markets can pick an equal number of interest rate, equity sector, country, and various commodity ETFs when constructing their own portfolio.

High Beta

The portfolios generated by KaufmanSignals expect to outperform the overall market by choosing stocks that have

  • Higher volatility
  • Greater activity
  • A better history of successful performance using this strategy

This results in a high-beta portfolio. High-beta portfolios will also have higher risk. We count on recognizing when the trend of each stock has turned down, or the trend is weaker relative to other stocks, then remove them from the portfolio. We rotate out those stocks that begin to underperform in favor of those that are stronger; therefore, we believe in persistence. If the entire market turned down, we would eventually have no positions in the portfolio. While rare, this would prevent large losses in the total investment.

Special ETF Portfolios

There are two interesting ETF programs:

Sector Rotation

We track the trend of 15 SPDR Sector ETFs and, using our portfolio selection algorithm, we pick 5 sector ETFs that are expected to outperform the others based on performance ranking. Because this is a Trend strategy, we are buying the strongest rather than another type of rotation in which the weakest is bought in expectation of a recovery.

The time frame for these trades are based on the Trend program; which would be considered medium-to-long term; however, the process of switching sectors based on ranking shortens the holding period. This portfolio, which can be followed in the monthly Performance Report, has outperformed both the 10 and 20 ETF portfolios; however, because it trades only 5 ETFs, it will have intrinsically higher risk than a broadly diversified portfolio, regardless of past performance. Data begins in 2009 due to the start-up and liquidity of many of the sectors ETFs.

Income Focus

We use a small selection of interest rate ETFs with high dividends to create a low-risk portfolio with potential income exceeding typical risk-free returns. Those ETFs are MUB (Municipal Bonds), JNK (High-Yield Bonds), and PFF (Preferred Stocks). The investment is split equally amount those ETFs that satisfy our trading conditions. When none of the ETFs satisfy  the conditions, funds are held in the money market. Current performance can be found at the top of the monthly Performance Report and more detail further down in the report.

WEEKLY TREND

The Weekly Trend uses the same logic as the daily 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. By the numbers, the following table shows the advantage of staying with the trend in 2013. The first four columns show the annualized returns. For the long-term investor, the Ratio column is the best indication of performance. For updated performance, please go to the home page and click on the Performance tab.

Trend weekly v daily performance table 2013

You will find that the smaller portfolio of 10 stocks typically outperform the larger portfolio. At the same time, the smaller portfolios will  have more risk because they are not as well diversified. This trade-off has always existed when choosing a portfolio.

A Reminder of the Risk

The past few years have seen a remarkable bull market, all the more interesting because it was unexpected. A great deal of investor money has been out of the market waiting for confirmation the economy was improving. As of the end of 2013, money is now flowing in. That may signal another surge in prices or the end of the move. Only time will tell.

It is not unusual for the Trend programs, both daily and weekly, to have drawdowns of 20%. The major index markets have shown much worse. Following a drawdown is often another trending period, where investors who have been hurt by the price reversal sit out waiting to be sure that the drawdown is over. It reinforces the idea that “timing is everything.” You can’t trust your intuition when it comes to investing because there is too much emotion. A systematic program is far more dependable, and history shows it is far more profitable.

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