Taking stock of wealth, investments and performance

Chasing performance is the shortcut to underperformance.

The end of a calendar year is when many investors take stock of their investments and how well they performed. Many of us can't help contemplating all the ways we could have done better... had we dumped this investment sooner, invested more heavily in that one, etc. But this way of looking at things is neither helpful nor constructive.

The most important considerations in investment management should be (1) one's investment strategy, whether it be value investing, arbitrage, short selling, event-driven or trend following; and (2) the quality of the process of its implementation.

Trend following: unpredictable feasts and famines

As a strategy, trend following tends to be a sequence of feast and famine - months of strong positive performance invariably give way to months of flat or negative performance. Unfortunately, there is no predicting when a feast might end or how long the famine could last. The year of the last great financial crisis (2008) was one of the best years for trend followers; my own fund at the time, Galstar Derivatives Trading (GDT) generated a positive net profit of +27%. But with 2009 arrived the 'famine.'

Among the trend followers who reported results, the best performer was BlueTrend fund managed by BlueCrest Capital Management (+5.4%). Renaissance Technologies RIFF fund earned 3.8%, but most trend followers by far sustained significant losses: Aspect Capital lost 11.25%; Hawksbill Capital lost 15.32%; Man Group's AHL Diversified (world's largest CTA fund at the time) lost 16.9%; John W. Henry & Co. lost 24.06%; Superfund lost 29.46% and Clarke Capital lost 29.78%. Our own GDT shined dimly in that year at +1% net of fees.

If it seems too good to be true, it probably is!

Taking stock of one's performance and comparing it with other funds always highlights a handful of the season's champions. You're always glad when you did alright, but you can't help wondering how the stars du jour performed so well. In 2009 one such star came to my attention: Ebullio Commodity Fund whose performance was nothing short of spectacular with +91% in 2008 and +30% in 2009. I can confess, it’s always perplexing to struggle on through months of lousy performance and then learn that some Lars Steffensen has been killing it the whole time, running circles around you and most other managers... Inevitably, you wonder whether they know something you don’t.

But investment speculation doesn’t easily lend itself to clever gimmicks and if something seems too good to be true, it probably is. In a newsletter I published at the time, I wrote as follows: 

"As far as I can discern (and this view is probably largely correct), these funds use various option trades that concentrate very large quantity of risk on high probability bets. These can have spectacular payoffs, but things can go wrong."

Of course, questioning the bright shining stars of the day is delicate business - you always risk coming across as a sore loser, jealous of a much smarter rival. But as it turned out, I was not wrong. After their extraordinary 2009 came 2010 and in January of that year Ebullio took a 70% loss followed by another 86% hit in February, for a total peak-to-trough drawdown of -96% in only two months! This episode yet again underscored a hugely important lesson for all investors which I revisited in my April 2010 newsletter. A few excerpts and two charts I prepared are below:

Ebullio vs. Galstar, Jan. 2008 – Feb. 2010 (i=31. Dec. 2007 = 100): consideration of risk must always take precedence over the consideration of returns.

Ebullio offers a profound lesson in risk management. If you looked at the chart above in December 2009 you’d be duly impressed by Ebullio and underwhelmed by GDT. By March however, for every $100 invested in January 2008, you’d have $120.90 in Galstar, but only $10.33 in Ebullio. Pursuing such spectacular returns is a bit like playing Russian roulette with one bullet in a 2000-slot revolver. If the odds of getting killed are very small, you may think that the risk is worth it. But if you run such risks repeatedly, a mishap becomes increasingly likely.
What is the fundamental difference between Galstar and Ebullio? Galstar uses 88 independent, autonomous trading strategies in 35 financial and commodity futures markets. Each of these strategies acts like an individual trader that has a risk budget (an amount of money to use for trading) and a fixed position limit (usually one or two contracts). Galstar’s risk is thus dispersed among many independent risk-takers who can only do so much damage to the fund if their bets are wrong. In the case of Ebullio, Niederhoffer, LTCM, Amaranth, Sentinel and numerous others, the entire fund – in some cases much more – was regularly risked on a single idea or trade. Being right 1000 times is of no use if 1001^st trade can wipe out all the capital you’ve built up over the years.

Indeed, LTCM whose all-star quant team was led by two nobel laureates, Robert Merton and Myron Scholes suffered a similar fate in 1998

For more than four years LTCM was the bright shining star of investment funds, only to suddenly crash and burn in 1998. For investors who allocate money to investment managers or implement promising looking strategies it is critical to try and understand the strategy, the investment process and the risks that are involved. Anything that delivers returns substantially higher than mid-teens to low 20s (say, 14%-20% per annum before fees), and such things are being promoted and talked about almost every day, should be treated with extra caution.

It's easy to see why many investors might have jumped on the opportunity to invest in LTCM or Ebullio before their demise: both funds looked great with spectacular looking statistics. But the risk events that were baked into both funds' strategies would change that - suddenly and without warning, turning a stellar looking investment into a disaster.

It's always about strategy and about quality

Rather than chasing after performance, which has a strong tendency to yield underperformance, investors would be better served by allocating risk to strategies that make sense and by taking care that they can implement a high quality process in pursuit of such strategies. This can be as simple as owning some precious metals and scaling down one’s expenses, or as complex as navigating the trends that will unfold with the coming commodity super cycle.

Preparing to navigate the storm

This discussion is highly relevant to current conditions and the challenges that lie ahead. Not only will we experience economic, political and social crises in the Western world, we must also face the challenge of preserving the wealth many of us have worked to build up, and with it an important degree of liberty. “In the general course of human nature,” wrote Alexander Hamilton, "a power over a man's subsistence amounts to a power over his will." Preserving wealth will prove an important part of us defending our free will.

Alex Krainer – @NakedHedgie is the creator of I-System Trend Following and publisher of daily TrendCompass investor reports which cover over 200 financial and commodities markets. One-month test drive is always free of charge, no jumping through hoops to cancel. To start your trial subscription, drop us an email at TrendCompass@ISystem-TF.com

For US investors, we propose a trend-driven inflation/recession resilient portfolio covering a basket of 30+ financial and commodities markets. For more information, you can drop me a comment or an email to xela.reniark@gmail.com