This question comes in from a Linkedin contact of mine:
Hi Michael, my name is [name]. I am the Founder, Managing Partner, and PM for [name]. First, thank you for posting your videos on YouTube. They have been a great reference point for me. I have a question regarding benchmarking absolute return strategies. We have been debating this topic to no end. Our optimization models use a modified Mean Variance Analysis. Modified since we have proprietary concepts to account for higher moments and other factors which are ultimately priced into our final portfolio weightings. The problem I am having is when running the optimization models, what is REALLY the appropriate benchmark to be using?…I have actually resorted to using an equal weighted index of the identical portfolio as a benchmark to determine the investors incentive of allocating via our approach over …simply investing in the managers directly. I know this is assumption may have numerous flaws, however as a quick and dirty approach, it seems to make some sense. I will also benchmark against a portfolio using a basic mean variance approach (i.e. w/out accounting for non-normal returns, etc.). Ultimately, it doesn’t make sense to me that many absolute return managers will benchmark their performance vs. the S&P or the Barclay CTA index (which i believe measures systematic trend followers only). If you could provide me with any suggestions or thoughts. I would be very appreciative. Respectfully, [name]
There will be many different angles here and no one size fits all. Shoot, debating the concept of a benchmark alone can be lengthy. I open the topic up.
November 21st, 2009 at 4:29 pm
Maybe I’m totally lost on this one, but as a trend follower of equities, I would only use a benchmark (such as the S&P) to prove “buy and hold” doesn’t work. However, it seems to me a manager could only use a benchmark that includes positions they track. And even then, it probably doesn’t make sense, because some managers take different levels of risk. For example, trying to compare Abraham Trading and Dunn Capital to a benchmark would leave one scratching their head. I think it would be better to stick with Sharpe and MAR ratios.
But again, I may have misunderstood the question.
November 21st, 2009 at 9:40 pm
As a raw beginner, I wonder why one needs “benchmarks” in the 1st place - if Trend/Turtle methodologies permit one to analyze markets historically, & back-test a given method, to gain objective confidence in that method.
Communicating to clients, of course, may require helping them up a learning curve out of insecurity (no pun intended) that their money is being managed differently thant that of the industry “herd.”
Given the current paradigm of currency dilution via fiat money excess, wouldn’t the real problem be that of identifying the most meaningful time frames, historically, & most effective trading periods, going forward?
November 22nd, 2009 at 12:38 am
I think it is best to compare to stock indices. In the longer run absolute returns are what we all want whether we admit it or not…so comparing to a typical “hold stocks” investment is proper. That’s the baseline.
Michael you make a good point.
November 22nd, 2009 at 12:40 am
I will never do a good job convincing nervous fund managers in Geneva that volatility can be a good thing!
November 22nd, 2009 at 11:53 am
The whole question of how much you make or lose is based on an average that comes from your trading years and from historical testing, but i think a most important indicator is the downside volatility, and usually has direct correlation with the upside…
No one can make a lot but lose little, so most important is the stability in your equity up trend, the risk management controls that factor in diversity, moments of uncertainty (when price movement doesn’t conform to mathematics). Other than these risks, the rest is acceptable in a risk management system that adjusts exposure according to these factors.
So let’s say your whole portfolio is stocks and you compare with the S&P, any trend following system can match the S&P and outperform it, but the swings you take until you have reach to that point is what matters and how you decide your exposure is at each point.
Also to promise a certain average of winning based on the S&P or what ever might lead the client to find it as a benchmark, which in reality you are trading long and short so the S&P might decline slowly with high short term volatility that would not result in any significant trend because you would strike out a lot, and after sometime it has declined a lot but your equity has not gained as such because of good risk control, so I suggest not to promise profit, but to promise stability.
November 23rd, 2009 at 11:33 am
I worked with an investment firm a few months ago that was raising a fair amoount of money because they had “outperformed the DOW ?”. I don’t recall the precise numbers at the time for the DOW but at the time the portfolio was minus 41% since the inception of the firm thus if the DOW was minus 60% off it’s highs then the manager had kicked some serious ass by losing only 41%. Interestingly people were actually buying into this bs at the time.
Any trading method that trades a specific portfolio in reality has it’s own benchmark if you will if the trader follows the plan 100%. In other words any difference in results and what should have happened is the result of not following the plan in my view.
If the DOW is such a great benchmark for stocks-I don’t think it is-why wouldn’t the benchmark for commodity traders be Gold? At the end of the day I feel ANY benchmarks other than an account statement are somewhat useless. I could be wrong.
November 23rd, 2009 at 5:01 pm
In my view, you should benchmark against an index that has approximately the SAME or LESS risk than your portfolio. Assuming that you then beat the benchmark, this will demonstrate in a clear fashion your ability to produce superior risk adjusted returns.
The question, is how do you measure risk in order to do such a selection. You would need to look at factors like Maximum Drawdown, Downward Standard Deviation of returns, Ulcer Index, etc. in order to find the best fit.
November 23rd, 2009 at 8:33 pm
Benchmarking is something that brokers and mutual fund managers came up with simply to justify their existence.
It’s nonsense, because in regard to the investor, they should focus instead on a real rate of return necessary to achieve their objective. If it’s an endowment or pension, they know what return they need. If its a individual planning retirement, they need to approximate at what rate of return they need. Then, that is the benchmark.
Investors should take the very same approach as a trend system designer. First, state your ojbective. “I need X% annualized returns and I’m willing to experience Y% maximum drawdown at any point along the way”. That is your benchmark for which to measure your success. Many people fail to focus on their objectives.
In regard to using the S&P 500 or DJIA look at a monthly 10 year chart and tell me; who do you know that is suitable for?
November 24th, 2009 at 4:28 pm
One thing I was thinking of doing for myself was actually inspired from your book “Trend Following”, Michael (one of many inspirations ;-)
You mentioned (pg 15) Dr Patrick Welton who constructed 120 trend following models (reversal or not, price/volatility breakout, different durations, etc.) to show that trend following was working.
I am thinking of building a collection of (basic) trend following systems and measure their different performance (aggregated by various metrics) to get an overview of “the state of trend following”. By comparing the performance of the system that you want to trade with that “aggregated benchmark” (adjusted for risk, leverage and underlying instruments) should give you a good idea of hwo you are doing.
Alternatively I have started compiling monthly performance of what I call Trend Following Wizards (in there: http://www.automated-trading-system.com/resources/trend-following-wizards-fund-performance/)to get a pseudo Trend following index (since various CTA indexes are not solely dedicated to trend following funds)