August 2021 Newsletter – Keeping risk in Check – Optionality
August was the second time in 3 months, Portfolio Yoga Portfolio’s went through a change mid of the month. Stocks got removed without replacement. This has led to questions whether we are moving to a weekly rebalancing mode as is the case with everyone else. The answer to that question is a firm No.
The rebalancing will remain in monthly mode since we have enough data to showcase that monthly is better than weekly on multiple parameters.
Before I explain the reasoning behind the mid month change, let me talk about something that is happening in the world of Trend Following in India.
Before 2017 when I made a complete shift to Momentum Investing, I was a Systematic Trend Follower for a decade. I read everything that was available on Trend Following, heard multiple podcasts and learnt a lot about how to test ideas better and understand which models were flaky and which were antifragile.
Yet in 2017 when I got the first real opportunity to shift from trading to investing, I did that without the blink of an eye since I recognized the fallacies that prevented me from being a successful trader.
There are a lot of things that need to go right for the trader to be successful, but the one key and one that is constantly overlooked is the capital. I recognized that my capital was scarce to trade a diversified portfolio.
In 2012, I was working with Dr. C.K Narayan building and executing trading systems. We were trading on a broad set of stocks and Indices such as Nifty and Bank Nifty. While the strategy foundation itself was based on trend following, the way risk was managed was anything but trend following based.
We had for instance target profits, initial stop losses, trailing stops and reduction of position size as the trend went in favor of us. Literally everything you won’t find in a trend following book which generally always talks of Ride the trend till it ends.
The period we traded did not have great trends on either side and yet, thanks to the way we were able to build the strategy, we actually made money. Credit for most part belonged to my boss, CKN who had a much deeper experience than me and helped me shape the strategy in line with his experience.
Trend Following has a huge history and has been successful in what it professes to do. The strategy is not about beating the markets but about generating non correlated returns.
Since Clubhouse became available for Android, one room I try to be present in is the one hosted by Jerry Parker. Even though I myself am out of trading, I love to understand the intricacies of succeeding in a business like this. On his website, Jerry provides month by month returns going back to 1988.
What interested me was not the returns – 10% over the last 33 years but the smoothness of returns. In the first 23 years of running his fund, at the end of the year he barely had a draw-down and when he had it was in single digits. The last decade has been tougher, relatively speaking.
Way back in time, I ran a site called NiftyTiming.com. The advisory was to provide clients with the signals that got generated by a trend following system. It was a system I had coded and one that traded on the Nifty. The venture itself was short lived and I pulled the plug 3 months down the lane before anyone got hurt.
I realized I was missing something but wasn’t sure of what it was. It was only much later I understood that the risk I was taking by trading a single symbol even if it was an Index. Yet, I see advisors doing the same.
Last year was a very good one for trend following advisors who reaped the benefit of smooth trends and counter trends. 2021 even before the halfway stage was setting up for a disaster with draw-downs touching levels that would bankrupt any trader who was trading with leverage.
Unfortunately for most traders who subscribe to such strategies, they don’t have the data or the resources to ask the right questions. What this means is that the outcome is very much a subject of curve fitting.
When market doesn’t trend which is a large percentage of the time, trend following systems tend to get chopped. This is true as much for a 2 period moving average as it is to a 200 point moving average based system. The system itself doesn’t understand that the market is range bound in a tight range. But an analyst monitoring the system can definitely observe that.
I have observed one time too many the thought that one needs to stick with the system regardless of what one’s one observation is telling us to do. Yes, there is a risk of the observer getting the view wrong, the fact that one builds the system to ensure that one’s own opinions don’t mess up with the trade, the fact that this could be a slippery slope among others.
But what use is experience if one cannot at the least ensure that risk is reduced when it’s very much observable that the risk outweighs the rewards. Should one just hope the system will get lucky and we shall recover all our losses.
The biggest advantage of managing one’s own funds vs advising others comes from the fact that one’s actions are never questioned regardless of the results while the results dictate the questions when one is dealing with other people’s money (directly or indirectly).
Discretionary Advisors have it easy here. They understand the reason and while they may or may not turn out to be correct, they can provide a narrative to their actions and be done with. When it comes to systematic advisors, we are held to a higher standard.
Most Momentum advisors have gone with a Weekly rebalance schedule. I have tested hundreds of variations of momentum on weekly rebalancing and yet to come across strategies that have very low churn. Yet, somehow advisors seem to have much lower churn. Given that most of these models are “proprietary” in nature, maybe they have found a way to limit churn while still rebalancing on the weekly mode.
A system can be built to take into account everything that one wants to take into account when ranking a stock. But adding more parameters opens up risks of a nature that is not seen. Every additional parameter brings about its own issues of edge cases.
Talking about edge cases, let me provide an example of a Portfolio Stock – Linde India. Since it got into the portfolio, the stock had a one way move – down contrary to going up. Yet, the rank itself dependent on both volatility and one year returns did not budge below the cut off ranks. It finally did go below (slightly and hence an edge case) when we rebalanced for August.
I had two options then. Take the loss and move on or based on my reading of the stock, take a chance and wait it out for another month at least. Luckily it worked out fine. But this was not because I read a chart but more because I understood why ranks may move around despite having nothing to do with the performance of a stock.
What I have found for myself is that it’s better to have as few variables as possible and then add a bit of discretion when it comes to execution. The last two instances worked out fine and saved a bit, but this approach could also get it wrong.
The biggest risk of black box systems is that one doesn’t understand the deeper nuances of what goes into the system and how and why signals are generated. This results in a lower allocation than one that could be possible.
At Portfolio Yoga, I have constantly tried to be as transparent on how I rank (Sharpe Ratio slightly modified). The purpose of the advisory is not just about providing a set of stocks and signals thereof but to provide you with a framework which helps you make better decisions.
You have explained many things here, including why you did not rebalance in the case of Linde. But the mid-month rebalancing of the portfolio is not one of them. Can you elaborate please?