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Podcast #31: How trend following can make buy and hold better



In this episode, Shray and Sandeep discuss how adding a trend following layer to a long-only portfolio can help enhance returns and lower drawdowns, in the context of Capitalmind Chase – our own such strategy.


Shray Chandra: Hi Everyone and welcome to Episode 31 of the Capitalmind Podcast. Deepak is busy answering MBA exams – yes you heard that right he’s actually answering MBA exams – it’s a regulatory thing. So because of that we’ve decided to do a very different episode and we’re doing it with one of our newest colleagues – Sandeep Rao.

Sandeep joined Capitalmind a few months ago and had built his reputation by running the successful site which was a blog dedicated to quantitatively trading the indexes on a short time frame. He’s also worked on creating market breadth studies, and designing trend following strategies. And it’s that – the trend following strategies – that’s what we’re getting into today. Let me also add, Sandeep isn’t what you might expect for a typical derivatives trader – he’s got a bust of Marx on his desk!

Sandeep Rao: I wish I knew this thing was going to become contentious – I should have got Adam Smith’s bust as well – just to make it even.

Shray: We’ll tweet that out when you actually do that. Congratulations on putting your money where the mouth is with the launch of Capitalmind Chase – a systematic trend following strategy and the returns/back-test and all the numbers – they’re absolutely astonishing. When we look back since 2008, this strategy has delivered something like an average return is 26.3 with a Median 18.9 %. And it’s outperformed a Nifty Buy and Hold Strategy pretty much every year (since 2008). In fact, I believe that’s one of the reasons you’re such a critic of blind buy and hold approaches.

Sandeep: Thank you Shray you are right I have a lot to say against Buy and Hold

Shray: As you know, normally when people come to us with a back test that looks like it’s going to take over the world, we look for the fine print – or the things that can’t be replicated. This time we’ve done that exercise. Our fairly particular customers that have done that exercise as well. And enough people think there’s something here and have actually put their money behind this to give it a shot. So Sandeep that’s why we’re here and we’ve brought you on to this episode of the podcast. We wanted to dig into this strategy and everything about it. Let me get started with my first question. What is trend-following?

Sandeep: Let me split this question into two parts.

The first one: I’ll start with what the word trend and what do we mean when we use that word.

So a Trend is price persistence in a direction [agnostic to which direction]

What that means is, if the price starts moving up it continues to move up for a while, likewise if the price starts going down it continues to go down for a while.

There are two more aspects to trends

Trends are fractal in nature, what that means is if I share two charts and don’t tell you what time frame they belong to. They will look very similar. But one can be hourly and the other can be yearly. They look very similar.

Two, they are present across asset classes. You find trends in commodities to equtiites to real-estate. That’s what a trend is.

Now moving to what Trend-following is: Trend following is a method of measuring or quantifying trends so as to trade them.

It’s essentially a systematic way or quantitative way to identify the beginning and an end of a trend and you also need a product to trade it.

So you can do it on a single product or across a basket of products. On Capitalmind Chase we are doing it on a single product [for now, it’s the Nifty]

So that’s what is trend-following.

Shray: I’ve seen the charts, you’ll know a trend when you see it. But if we get a bit existential here – why do these trends exist in the first place?

Sandeep: Anecdotally and historically we know that trends exist. I’m equating the word trend here along with fads and bubbles which we know exist.

Right from the times of Tulip mania in Holland to the more recent Housing bubble that led to the 2008 crisis.

If you ask me – as to why do they exist/come about – I would say that we as a species have not evolved much in terms of how we behave in crowds and that [dynamic] in turn leads to trends.

I know my answer is very meta but that’s what it is.

Shray: Ok. The answer is human nature in a way right? So is there literature supporting this or just observations from traders and practitioners like yourself?

Sandeep: If you look at Academia or Academic Finance – and go back to the 60’s and 70’s – they were more interested in questions around Capital Asset Pricing and Efficient Market Hypothesis almost till the 80’s. That’s what had everyone’s imagination captured. There was Sharpe, Merton, Markowitz, Samuelson and Fama that group, from Chicago and MIT largely. They were all trying to look at markets from an efficient markets or capital asset pricing mindset.

On The Other side of EMH was Market Inefficiency and Anomalies – work on that side started late 70s and 80s – Shiller was a prominent critic of the EMH hypothesis. Trend belong to this inefficiencies/anomalies side.

Post 80s there has been considerable work that has happened on market anomalies and inefficiencies caused by human behaviour.

In the 90s we had Jagdeesh and Titman, who established the existence of time series momentum in price, which is a kind of trend following system.

So yes, today – there is a fair bit of support for the idea of trends from academia.

Talking about academia, I’m reminded of an interesting anecdote – Sometime back I was reading this book “More Money that God” by Sabastian Mallaby. And there is a chapter in the book about Samuelson, titled Samuelson’s Secret. The economist Samuelson who contributed to EMH.

It looks like Samuelson was one of the initial backers of an extremely successful, quantitative trend following [trading] firm ny the name Commodity Corporation which is a bit of a paradox – I would have expected Samuelson to be a passive investor in index funds. But he somehow did believe in market inefficiencies as well!

Shray: There is literature and a bit of weird details there. Can you come to the practitioners or traders part? What do they have to say?

Sandeep: Practitioners always knew trends existed – go back to Ricardo [in the early 19th century] who also happened to be a trader [seems to have said Cut your losses short and let your profits run] and Keynes who also a trader.

More recently, I mean from the 1960s onwards – Hedge-funds and CTAs across the world, even before literature started emerging about trends – practitioners were trading trends and implementing trend following systems. So practitioners were ahead of the time.

They’ve also written a lot about trends and trend following, in the form of white-papers, but I don’t really quote them as they are sort of interested parties in this.

Shray: You’ll know a trend when you see it, Trends exist and have backing in both academia and in practise – so if I do all this effort – what’s the potential or the upside from doing this? Vanguard and their ETFs have taken over the world right – so why should I spend time doing this?

Sandeep: Yes, there is indeed a lot of effort in doing this [and we tackle that later] so let’s look at the potential benefits.

First thing – you’ll be able to save yourself from sharp drawdowns and protect yourself from the downside.

Second – we should be able to generate alpha on the upside [thanks to our futures position]

Third – when you put these together: you’re protected on the downside and on the upside you’re making something like 2x returns – so that really sounds worth it!

Shray: Yeah! I’m interested – but how? Is there leverage of some unusual risk here. What am I missing – 2x on the upside and no downside – you can see why this sounds too good to be true right. So can you elaborate on this?

Sandeep: I know where you’re coming from. So let me ask you a question. You’re a passive/buy & hold investor – you’ve not done too much in derivatives. So let’s say as a Passive Investor – what kind of risk reward do you realistically expect?

Shray: You’ve chosen a very opportune time. Rewards seem to be barely beating fixed deposit returns. Let’s say 8% for sake of argument. And the risk that I’ve experienced twice are 30% drawdown but temporary in both cases fortunately.

Sandeep: You expect a CAGR of 8% but once in a decade you can see a drawdown of 30-40%. That’s what a buy and hold investor can expect.

But what if you bought or exited at the wrong time? Even in a buy and hold type strategy with the wrong entry point could mean several years of basically no returns. With that as the context let’s see what we’re trying to do here.

We’re trying to protect our downside. We start with investing in a Nifty ETF/Mutual Fund and a Futures contract. For the ETF we invest say (75 units * 11,000 ~ 8.5 lakhs) into the ETF. The ETF is the passive component.

And the active component of this strategy which is traded through Futures. The active component is both long and short depending on the time. When the market goes up we should be long on the Futures component and the ETF is long anyway so we make the 2x. When the market goes down we are short on future and long on the ETF so they should offset each other. This gives us a far better profile than just buy and hold.

In terms of risk, including 2008, we’ve never had anything greater than an 11% drawdown in this strategy. This is far better than buy and hold where we’ve seen a far greater drawdown.

Shray: Btw – The current 8% return I hope that’s not what buy and hold yields going forward. I hope that’s just a quirk of this timing.

Earlier this summer, there was this horrific article about some early 20s guy on Robinhood who was playing around with some options and he woke up one day to see a negative 1 million balance on his account and the guy ended up killing himself.

Why I bring that up is – can you tell me, the moment we have instruments we’re not that familiar with, what is the worst case scenario or what is the worst that can happen? Can we also technically wake up to see a catastrophic loss.

Sandeep: I hope not! Let’s start with the worst that’s possible.

We are levered on the upside. If our system signals a Long – we are long on the Futures and the ETF is always long anyway.

The worst that can happen is if we are long on Futures (and ETF) and the market crashes and gaps down – that’s bad because we’re going to lose on the ETF and the Futures as well.

Now how much can the market fall? If you look at the market design we have circuit breakers on the index – the first one is at 10%, then 15% then 20%. If it falls 10% then trading halts for 45 mins, if it falls another 5% (15% total) then we have a halt again and if it finally hits the 20% limit – trading halts for the day.

Let us assume we were long and the market falls the full 20% and it’s only then that we exit – at that point we will be down 40% on your capital. This hasn’t happened in the past but this is a good definition for a worst case scenario.

Shray: That doesn’t paint as bad a picture as I was fearing. In this event that hasn’t happened yet, you still lose a percentage of what you’ve put in – not more despite the futures! But since you make money on the way up and don’t lose on the what down – I’ve thought of a market regime/dynamic that might be bad – if the market doesn’t go up or down and we’re stuck in a period of sideways movements – that’s a market regime that’s bad for Capitalmind Chase or trend following strategies right [No clear trend]?

Sandeep: Yes, choppy markets are bad for us and there are months of choppy markets. The futures component keeps getting whipsawed, there’s no trend to ride on and we keep booking losses on the Futures and ETF hasn’t made any money.

We’ve had regimes like this in the past like 2011 or even 2017 but these generally last for a few months and after those months we get a trending phase where we cover our losses and add to our returns as well.

It’s important that we continue with this strategy for a long period of time so as to cover these phases and get the best out of the trends when they manifest.

One of our Premium Subscribers Neeraj said something which I think was very profound.He said, Long term investing is highly overrated and Long term trading is highly underrated I think that’s quite true.

If you are in the system for a long period of time 3-5 years- you’ll end up very positive and end up able to ride the regime and wait out the not so great regines.

Shray: This feels very contrarian to me – so used to hearing Warren Buffett style buy for the long term narratives – can you elaborate on the strategy. How do you “know” when the market is going to go up and you position yourself long on the future and how do you “know” when the market is going down and you position your Futures contract short. That [prediction] a pretty key part right?

Sandeep: We don’t know if the market is going to go up or down. We don’t try to predict, we follow some quantitative methods to compare some current price to previous time series or prices to see if prices are likely to trend up or down. In capitalmind we use moving averages – fast ones (10 days) and slow ones (60 days).

If the 10 day average price is above the 60 day average price we go long, if it’s the reverse we go short. We hope the price continues in that direction but it may not. Sometimes when this happens the trend stays for weeks together and we make serious money there. In other instances, the trend just chops around and you don’t make anything.

Shray: That doesn’t sound too difficult – these moving averages are well understood concepts, I’ve seen them on broker screens. Is there more to this strategy than the Rules you’ve laid out or is there some secret Sandeep Rao’s discretion you’ve not shared that is important?

Sandeep: Of course there are some dynamic and proprietary aspects to it in terms of specifically what time do we enter and so on, but it’s not rocket science.

Coming to the discretion part there is no discretion whatsoever – in the quant world they say – You test what you trade and you trade what you test.

The whole idea of backtesting would fall flat on its face if we include any discretion in the system.

The answer to your question – is – No – No discretion whatsoever.

Shray: Something that’s been puzzling me. Your pitch is fairly compelling and there are a few folks on Twitter discussing this as well. But I’m not getting calls from bank relationship managers and people pitching products like this – are there other products/offerings that incorporate this logic or in principle?

Sandeep: I get where you’re coming from.

But if we look at the universe of products available for investors of different categories, you may be able to find products with a trend following component in almost each category.

Let’s start with:

Mutual Funds – There are these Dynamic Allocation funds, some of which have a trend following component. Regulations do not allow MFs to include Derivatives. Cannot bet on the downside. Even though they have a component of trend following but they can’t cover the downside.

ETFs – Very similar to mutual funds. We don’t have Inverse ETFs – so can’t bet on the downside.

PMSes – Yes our own Capitalind Wealth portfolio includes Momentum which is based on the trend following principle though again it’s long only. Again Regulations do not allow PMSes to include leveraged products in their portfolio which means we cannot use Derivatives.

AIF – Category 3 – can include derivatives and long short positions but the problem with AIF category 3 is the tax structure, specifically the HNI surcharge makes it very difficult for fund managers to generate meaningful absolute returns with AIFs.

Shray: I agree with you. Mutual Funds and ETFs wouldn’t want to sell something complicated like this, PMSes have limitations and AIFs can (i’ve seen a few) – the tax surcharge does kill the returns. So the best way to do it is by following someone like you ?

Sandeep: Your snark is acknowledged but the point remains there’s no other choice. There could be individuals like us or Investment Advisors, but products available for investors in the market. You’ll find long only stuff but not long-short.

Shray: Let’s get to the implementation you’re working on – Capitalmind Chase. What was the goal behind the CM Chase product? Why did you choose to launch it?

Sandeep: If you looked at the Capitalmind portfolios, prior to launching Chase, we only had long only Categories and Strategies. Long Term, Multicap and Momentum.

While CM Momentum falls under the trend following bucket but it is about capturing alpha on the upside and does not explicitly cover the downside.

The ‘design principle’ if I may use that term – was to create a simple accessible strategy which would not only protect us on the downside but would also add alpha on the upside. After all markets go up more often than they go down, leveraging that was important (and that’s why we didn’t use options, to get alpha on the upside).

Since a lot of existing subscribers already have considerable long only investments, either through our own portfolios or otherwise, we thought including Capitalmind Chase as a part of it would add some meaningful diversification.

Shray: I think your point is a bit broader. It’s not just Capitalmind products, as a retail investor everything I have in the retail space is Long Only. I remember attending this conference with investors from different asset classes. Venture Capitalists made it clear they were in the hits business. If they made 10 investments, they relied on 1-2 to make all their returns.

That was clearly not the case for Retail and if you exit during one of those 30% corrections – that’s what causes a lot of investor wealth destruction. You’re almost trying to balance the scale. Make money or at least don’t lose money on the way down,.

Some Rapid Fire Questions now. How much capital do I need?

Sandeep: 8-9 lakhs at the moment. Notional value equivalent (1 lot of Nifty futures multiplied by Spot)

Shray: Who is this strategy for?

Sandeep: Anyone who has a long only exposure to the stock markets through ETFs or Mutual Funds or Stocks and does not have any protection on the downside.

For this strategy you need to have access to your trading platform during market hours.

There’s a futures product involved so you’ll need a basic understanding of how derivatives/futures work.

Shray: Equally important – Who is this Strategy not for?

Sandeep: Definitely not for someone who can’t actively trade or who will miss the signals which come during market hours. You’ll need to act on all the signals since we don’t know which ones will work.

You need to be ok with lumpy returns. There will be phases of losses and then 1 big trade which will cover all of them and give you a return as well. You need to be ok with that return profile

Need to have investments in the market which you’ll like to hedge against. Either ETFs or Mutual Funds. If you don’t have any investments trading only the Futures component is not something we would recommend.

Shray: What do you mean by active? How active is active?

Sandeep: If you look at the data, we get on an average 5 to 6 signals in a month for the futures component. There are months when you get 1-2 signals and months when you get 8-9 signals. The 1-2 signal months are the ones where you make money.

Shray: This is compelling to me and others who have signed up to give this a spin – if someone is listening to this podcast and find it interesting where can I read more? Either about this strategy or trend following in general?

Sandeep: The best content according to me is on the Capitalmind site (slightly kidding) – series I’m doing (we’ve done about 6 posts right now) which has a lot about trend following and Chase in particular.


Beyond that, there are Books by Andreas Clenow on Trend following and there’s another one called Crisis Alpha by Kathrin Kiminsky where she says during times like March 2020 trend following strategies do far better than others because they capture downside movements and act on it.

Shray: Thanks a lot! This was an interesting episode! We’ll have Deepak back next time. If you’d like to read more about what Sandeep has to say on Twitter – he’s at @mysandz. Deepak is at @deepakshenoy and Capitalmind is @capitalmind_in. So thanks and let’s see where these trends take us!


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