The Portfolios Explained
Kaufman Signals currently publishes 5 Portolios.
( DE1 / DE2 / DE3 / DF1 / WE1 )
Please click on any of the Table of Contents items for a full explanation of each of the portfolios offered. Subscribe to Kaufman Signals
DE1: Daily Trend Equities
The macrotrend program, taking advantage of long-term price moves. These trends are most often generated by interest rate policy, which comes from the Fed and other central banks. These trends can last for years. Interest rate policy also affects currency, where money flows to the country with the highest interest rate net of inflation and may also be a safe haven during a crisis. Most often money has moved into the U.S. dollar, U.S. bonds, and the U.S. stock market.
This program has a unique portfolio selection process. It ranks the stock performance according to how well the stock performs using our strategy, then automatically picks the best ones to trade. We can exit a stock if the trend turns down or if it drops in the ranking, that is, if other stocks are performing better.
How Often Does It Trade?
The program usually has 4 to 8 trades per week and trades are held an average of 28 days. It has fewer trades when prices are moving our way and more when the market or individual stocks reverse direction. The positions are long-only.
The daily stock program has the advantage of being able to respond quickly to changes in market sentiment. Yes, as with other trend programs, there can be risk when all stocks turn down at the same time. Stocks such as Apple or Tesla, which have had significant gains, may still be in the portfolio for a few days after prices reverse. The program may hold a position through a volatile period in order to net a profit at the end.
Exiting a Bear Market
Trend programs benefit investors during a bear market, simply because it will exit stocks that are 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 seems to turn back up. But that's not a good reason to stay long. The internet bubble of 2000 and the financial crisis of 2008 prove that.
Extreme Risk Exit
The program monitors the risk of individual stocks and the entire portfolio. When an individual stock exceeds the high-risk threshold, we exit any positions in that stock and it is blocked from taking a new position until volatility drops.
The volatility of the entire portfolio is also monitored daily. When a combination of high volatility and portfolio losses occur, we exit the entire portfolio. We reenter when volatility falls below our threshold and the portfolio again shows profits.
The portfolios generated by Kaufman Signals expect to outperform the overall market by choosing stocks that have
- Higher volatility
- Greater activity
- A better history of successful performance using this strategy
By eliminating many stocks that barely move, and others that are not “trending,” we are able to construct a portfolio that has had returns better than the broad market index. But a high-beta portfolio will also have higher risk. We count on recognizing when the trend of a stock has turned down, or the trend of the stock is weaker relative to other stocks, then remove it from the portfolio. Using our special algorithm, we rotate out when a stock is underperforming in favor of those that are stronger. If the entire stock market turned down, or the overall market became extremely volatile, we would eventually close out all positions. While rare, this can prevent large losses in the total investment.
» Income Focus
The Income Focus program benefits from interest income to offset much of the downturns in performance, It trades only three ETFs: municipal bonds (MUB), high-yield stocks (JNK), and preferred stocks (PFF).
The strategy has positions in all three ETFs, in equal risk amounts, when all trends are up. If only two of the ETFs are trending up, we allocated the full investment to those markets. If only one is trending higher, it gets the full investment. If all three ETFs are trending down, the investment goes into 3-month Treasury bills.
See the performance report for a history of returns and a current chart of performance.
Daily DowHedge Program
Using the same concept that the best performing stocks will continue to perform well, we trade the best 10 stocks in the Dow. These are ranked for performance each day and will change when one stock is doing better than another.
We also monitor the volatility and risk of the portfolio returns and may exit the entire portfolio when the risk exceeds our upper threshold combined with losses in performance. This is similar to the risk rule in the Macrotrend program.
Get Daily Trend Equities – DF1
DE2: Daily Divergence Equities
Divergence is a well-known concept that recognizes when two related markets are moving away from each other. We often see this in the major index markets, the S&P, and Utilities, or in two related stocks such as Micron and Intel.
Our method is called technical divergence, and it occurs when the price moves higher, but a momentum indicator moves lower, or when the opposite pattern happens. “Momentum falling” really means that prices are moving higher at a slower rate, a situation that most often predicts change.
The chart below gives two examples of stochastic divergence (using our own formula), both with prices rising and momentum falling. In both cases this pattern is followed by a drop in prices, then a continuation of the trend.
Our Divergence strategy will trade the reaction that follows the divergence pattern.
- This is a short-term strategy, holding a position for an average of 5 to 8 days.
- It has a low correlation to trend-following because it is taking positions either opposite to the direction of the trend, or at a time when prices are moving sideways.
- It has a high likelihood of success on individual trades.
- Profits per trade are smaller than trend-following because trades are held for less time.
- It works for stocks, ETFs, and futures using the same rules and specifications
We believe that this program will capture profits during periods where the trend is uncertain and can add important diversification to most investment portfolios.
Get Daily Divergence Equities – DE2
DE3: Daily Timing Equities
The Timing Program uses a strategy based on pairs trading logic, also called relative value arbitrage, as written in Mr. Kaufman's book, Alpha Trading (Wiley, 2010). Opportunities in pairs are based on identifying when two related stocks are moving apart, entering at extreme divergence and exiting when they return to near normal, all based on using the Stress Indicator.
Instead of matching two stocks we match a stock with a correlated stock index. When the stock declines to a relatively oversold position compared to the index, we can buy that stock. Because stocks have a high degree of “noise,” erratic up and down price moves, this has proved to be a successful strategy.
But there are a number of issues that make pairs trading difficult for most investors.
- The large number of stocks that have to be scanned looking for opportunities.
- The need to sell short one stock against another. Short sales may not be possible in every stock. They require “borrowing” the stock and paying the dividend as well as interest on the cost of the stock, reducing the potential gain.
- The arbitrage between two similar stocks yields frequent but often small profits.
To avoid these issues and make the strategy more profitable, our Timing program:
- Only buys the undervalued stock when a combination of a Stress signal (found in the book, Alpha Trading) and minimum correlation threshold occur (see #3). It does not sell any stock short.
- Measures all stock signals against the SPY, QQQ, or IWM, rather than another stock, which opens up a much broader set of opportunities.
- It chooses the equity index that is most correlated and decides if the stock is oversold relative to that index. If there is no valid correlation, there is no trade possible.
- It only buys the stock. It does not sell the index. We found that selling the index reduces the profits to a very small return, yet the long stock position in itself has a good return.
- It exits when the pseudo-arbitrage is satisfied or the correlation disappears.
We believe that this program will add significant diversification to most investment portfolios.
Get Daily Trend Equities – DE3
DF1: Daily Trend Futures
This 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 over 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 also can have large drawdowns when the major trend turns, especially using leveraged futures. Because of that, our strategy has a portfolio selection process that can remove a poorly performing market before the trend changes direction.
Unlike many large hedge funds that have very broad diversification, we believe that fewer futures markets, chosen for performance, can drastically improve results.
Trend programs in the futures markets take advantage of a bear market because it can take short positions in a downturn or a financial crisis. There are no short sale restrictions.
Returns, Discipline, and Insurance
Using a trend system needs to be viewed as insurance, but insurance with a very good payout. Experts have called the use of futures as “crisis alpha.” It will allow you to stay in a bull market, but it has good results when the market collapses. In 2008, trend systems in Futures gained from 20% to 70%, while most stock funds lost 40% to 50% in because they could not sell short or act quickly.
The need for disciplined trading cannot be over-emphasized. There are brilliant discretionary traders, but that requires exceptional talent and huge amounts of time and money. You don't make profits by luck. 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. 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.
More On Futures Portfolios — High beta
The portfolios generated by Kaufman Signals expect to outperform the overall market by choosing markets that have
- Higher volatility
- Greater activity
- A better history of successful performance using this strategy
By eliminating markets that barely move, and others that are not “trending,” we are able to construct a portfolio that should have returns better than the broad index. But a high-beta portfolio will also have higher risk. We count on recognizing when the trend has turned down, or the trend is weaker relative to other markets, then remove them from the portfolio. Using our special algorithm, we rotate out when they begin to underperform in favor of those that are moving directionally. When the market turns, we can take either a long or short position.
Futures offer true diversification, spanning a wide range of financial and commodity products. Futures portfolios cannot be dynamically allocated by individual market performance because there would be a tendency to concentrate in markets from the best sector, interest rates one year, equity index the next, and crude oil in another. Choosing too many similar markets will greatly increase the risk. Instead, we force a minimum amount of diversification to keep risk as low as possible. Markets are equally-weighted by risk. This assures diversification, liquidity, and stability.
Portfolios in futures allow us to set a target volatility. The target volatility is defined as 1 standard deviation of the daily returns. We use 14%. That means there is a 16% chance of losing 14% over some long period of time, and a 2.5% chance of losing 28%. Investors who feel that risk is too high can scale down the risk by trading smaller positions across all markets. Always reduce all positions by the same percentage to maintain diversification.
We offer futures portfolios of $100,000, $500,000, and $1 million, each using margin of about 25% of the total investment when targeting a volatility of 14%. The actual leverage is about 12:1. Results of these portfolios can be found by clicking on the Performance tab in the ribbon.
Get Daily Trend Futures – DF1
WE1: Weekly Trend Equities
A weekly trading program is not a lazy alternative, but a viable strategy in itself, with some advantages over the daily Trend program.
All Weekly Trend Programs
- Weekly data is smoother than daily data. It reflects the trends better; therefore, it can be 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, is similar to the Daily Trend program.
The Weekly Trend
The Weekly Trend Program uses the same rules as the Daily Trend Program but has 2 or 4 trades per week based on Friday's closing prices. Trades are generally held for 4 weeks. The positions are long-only.
An important feature of the Weekly program is that it will exit all positions during the week if portfolio volatility exceeds our risk threshold. Waiting until the end of the week is not responsive enough when the risk is high. The program will also reenter during the week when volatility falls below the threshold. Traders are notified when these events happen.
Weekly Income Focus
The Weekly Income Focus program also uses the same rules as the daily program and benefits from interest income to offset much of the downturns in performance, It trades only three ETFs: municipal bonds (MUB), high-yield stocks (JNK), and preferred stocks (PFF).
The strategy has positions in all three ETFs, in equal risk amounts when all trends are up. If only two of the ETFs are trending up, we allocated the full investment to those markets. If only one is trending higher, it gets the full investment. If all three ETFs are trending down, the investment goes into 3-month Treasury bills. See the performance report for a history of returns and a current chart of performance.
This program is long the 10 best performing DOW stocks, which also tend to be the stocks making the biggest moves.
When volatility gets to an extreme, as measured by SPY options volatility, the program sells one-half of all positions and sells short the 10 worst-performing Dow stocks.
It resets the full position size when volatility returns to normal.
Rather than selling short, investors can hedge the portfolio by buying the triple-leveraged Dow ETF (SDOW) when the system triggers that signal.
On January 2, 2023 we introduced a new “Sector Rotation 2” program. While we use the classic approach of looking at past returns over the last few months, we rank those returns and select the best 3. Previously we had used a larger set of sector ETFs; we have now reduced that set to 10 Sector SPDRs: XLY, XLF, XLB, XLP, XLV, XLU, XLT, XLK, XLE, and IYR.
This is our own version using these 10 SPDR sector ETFs, ranking the returns, then choosing the best performers. We count on persistence to generate steady returns. The results are a significant improvement over the original version and can be traded with a small investment. We recommend starting with $30,000 and scaling up. Smaller amounts may be affected by transaction fees.