What are the alternatives to long-term equity investments?

What are the alternatives to long-term equity investments?
Many experienced investors swear by the “buy-and-hold” strategy. However, it has its disadvantages: big market slumps shrink investment values as well. You don’t need to worry about this if you have enough time to wait for the market to recover. But what if you don’t? The advance in computer technologies allowed creation of completely different strategies – strategies that can generate interesting returns even during market reversals. And that’s what QuantOn Solutions focuses on.

Every investment strategy carries some risks. Every strategy is different. There is a wide range of risk-management techniques available in the financial field. Today, we’re going to introduce two basic approaches – a convergent and a divergent risk-management strategy while I’ll point out to differences between two different investment styles. The first one is a classic buy-and-hold approach: You buy and hold stocks according to some key. The second is one is called the trend-following approach within which you divide your capital into several approximately equal parts and then then spread among a large basket of markets, mainly by the use of technical analysis. You speculate both on growth (long positions), as well as decline (short positions). Your primary objective is to profit significantly on long-term trends, which, however, also means that you’ll have to endure many losses caused by false entry signals generated by your strategy.

The person who chooses the first strategy gets exposed to the convergent risk. They are likely to believe that there are stable and predictable market conditions. Investors who employ trend-following strategies are exposed to the divergent risk. They see the market as a constantly changing cycle of unknown, volatile, and mostly unpredictable events.

How do these differences manifest in practice?
Constancy and persistence versus inconstancy and opportunism
We’ll demonstrate the principle on a simple probability-based game, such as flipping a coin. Let’s say that if our tip is right, we take a quick win, if it isn’t, we double the bet. This is the well-known Martingale System which has been used by many madmen, for example in sports betting. If the madman was smart enough and set limits for profit and the risk he was willing to accept, I see no problem in this approach. The truth is that the longer we apply this approach, the higher the likelihood of an unpredictable series of losses that can “wipe out” our entire capital, even within one trading day. Convergent strategies work on a similar principle – they increase bets after each loss in the same way. They are also based on the faith that a win will come eventually and the investment will return. The common strategy for dealing with a series of losses is a “dilution of losses” through raising bets. But if an unprecedented series of losses comes, the strategy suddenly becomes – euphemistically said – undercapitalized.

Divergent systems work the opposite way. You don’t base your system on faith and if the market (or coin flips) develops differently than you expected, you don’t raise your bets – on the contrary, you stop placing them immediately. If the system is successful, you multiply your bets. Therefore, divergent strategies work on the principle that when a system finds a certain advantage or a profit opportunity, it exploits it as long as possible. The statistic analysis of both approaches shows that they have different distributions of returns – as can be seen from the above example, convergent systems generate many small profits with occasional fatal losses in the long run. Divergent systems, in principle, work exactly the opposite – they generate many small losses and hope to profit on an extraordinary favourable movement. Contrary to the constancy and persistence, which characterize the buy-and-hold approach, this strategy is based on opportunism and inconstancy. But don’t get discouraged by positive or negative tones – investing is not similar to interpersonal relationships and it shouldn’t be influenced by emotions.

Stable world versus the world of coincidences and reversals
When we interconnect these theoretical concepts with the investment practice of long/short equity funds or trend-following systems for trading shares, we can easily identify market conditions under which the systems will deliver the best results. Let’s leave coin flips and have apply the two approaches to an example situation from real market environment: value investing, also called private equity (i.e. investing in a company with a long tradition) is rather a convergent approach. The strategy uses leverage in a more “predictable” investment environment. It is based on fundamental analysis and belief in a long-term success of the company’s core business. The investor considers the market environment as more or less effective and rather stable, the information is known and directly reflected in the market, the market itself is highly competitive.

On the other hand, investing in start-ups and “growth investing” are totally divergent approaches. Less weight is put on fundamental analysis because the correct, “fair” assessment of a company is biased by many unknown factors, i.e. such assessment has to be far more complex. Most of the most successful venture capitalist managers diversify their portfolios by buying many smaller shares in a large number of companies. They count with losses and aim at finding a future giant, such as LinkedIn. Such approach to the risk is ideal for random market environments with unknown conditions and numerous random events with unknown impacts on the portfolio. The same characteristics has the classic trend-following system.

I don’t know what’s going on and why it’s happening. I’m following the market’s movement
Creation and deployment of a trend-following investment system follows these principles – it opens many small positions in many different markets and systematically cut losses as soon as the trend moves against open positions. This means that the system generates more losses than profits, but profits prevails over losses in the long run. Typically, the system’s success rate is lower than fifty per cent. The system stands on two pillars: position sizing, i.e. proper capital allocation among individual markets, and trend signals (for example, crossing of moving averages or a typical breakout signals where we speculate on breaking of a certain price level, such as a long-term high or low). It should be added that trend-following strategies aren’t discretionary, they can’t be “manually managed”, they are completely systematized and algorithmized because they fill trade orders in many markets. A trend-following strategy doesn’t rely on any fundamental model, it doesn’t focus on a specific asset class, and they are typically based on the long-short model (we open both long and short positions). This strategy is also “agnostic” as to the reasons of market behaviour – the system only follows market trends. Therefore, it has nothing to do with fundamental analysis.

Diversify, diversify, diversify
Trend following is a relatively young investment approach, it’s creation was allowed by the development of information technologies and automated trading systems. However, it’s not too young and we are able to evaluate the real trading results. The results of many hedge funds which have been using trend-following strategies over the last thirty years correspond to theoretical assumptions: trend following as an asset shows a positive slope of the yield curve, plus the potential to bring profits even in times of market slump. Drawdowns of trend-following systems are generally shorter and up to one-third lower than drawdowns of buy-and-hold strategies. Drawdowns often appear when the market offers no opportunities and has no clear trend. Most profits are generally generated during periods of unexpected market events and large movements. And then there’s one big plus: the trend-following strategy does not behave like any investment asset, i.e. there is no correlation. This makes it a useful tool for portfolio diversification.
Most investment strategies are based on the convergent risk principle, which means that they can generate devastating losses during unexpected market events. Trend-following and similar strategies use the divergent approach to risk and are therefore immune to market drops during crises. This system basically calculates with volatile growth and it is able to generate big profits under extreme market conditions. The following table demonstrates the results of the trend-following system.

Source: Trend Following with Managed Futures (2014), Alex Greyserman and Katharyn M. Kaminski
Source: Trend Following with Managed Futures (2014), Alex Greyserman and Katharyn M. Kaminski

 

Over the last twenty years, the trend-following strategy has closely beaten the S&P500 index. However, what is more interesting, the divergent trend-following tracking system combined 50/50 with a convergent style of equity investment gives even better results and increases the Sharpe ratio by 50% with the acceptable maximum drawdown of 22% (which is much lower than the drawdown of long-term investing in shares). The benefits are obvious: by incorporating the trend-following strategy into the classic equity investment approach we can achieve a higher level of portfolio diversification. Most experienced hedge fund managers combine several strategies in order to bring the distribution of returns as close as possible to the normal random distribution and thus achieve the highest average yield. Through this approach, portfolio managers gain better control over yield variability – in other words, they seek to achieve more stable returns, even at the cost of higher potential profits. They emphasize risk control – the standard deviation is significantly lower. However, individual investors aren’t fund managers. And such a trading system isn’t cheap – don’t try to build it at home, unless you have at least a million dollars to play with. You can entrust yourselves to a fund manager using such a strategy. This could definitely be a great way to diversify your portfolio.

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