Trend following systems and Stanley Druckenmiller

Last week legendary hedge fund manager Stanley Druckenmiller announced his retirement from the investment world and stated that he was going to close down his Duquesne hedge fund. Druckenmiller was part of the team (along with George Soros) that broke the Bank of England in 1992 when they bet that the British Pound would fall against the Deutschmark and racked up profits on the day of around $1 billion. Druckenmiller cites his reason for retirement as his inability to make out-sized returns over the past 3 years due to very unfavourable market conditions.

Now, I don’t know what his issue was in 2008 as our spread betting system had a record-breaking year and there were a lot of very good trending markets across many different market sectors and this enabled our trading system to have its best year on record. 2009 and 2010 I can understand though as market conditions have been tough for everyone due to excessive volatility and global uncertainty.

The question is, what does this say about the future of hedge funds and the future of trend following? Whilst many believe that this is a bad sign if someone of the knowledge and experience of Druckenmiller has struggled to make money I actually take the opposite view. My belief is that Druckenmiller quitting is actually a great sign for future performance of hedge funds and especially trend following systems and funds and my reasoning is as follows:

All trading systems regardless of what they are based on will go through periods of good performance and periods of lesser performance. This is down to the nature of the markets and the fact that no strategy can be effective in all market conditions. Trend following systems will suffer during periods of excessive volatility and non-trending markets because they rely on good trends to make profits.

What we have seen in our own research and this is also quite well known amongst experienced traders and fund managers is that investors, especially amateur investors generally tend to bail out at the worst point, usually near the bottom of the equity curve. This is usually due to a period of poor performance exceeding their threshold for what they can handle.

At a higher level, the fund manager, also feeling under pressure from his investors and due to the need of better performance also seeks to change his strategy after a prolonged period of under-performance. Once the pain reaches a certain level amongst investors and fund managers, Druckenmiller quitting is evidence that we are at or very near that point we will then likely see mass withdrawals from hedge funds.  This will mean that moving forward not everyone is chasing the same moves and many will then use different or even opposing trading strategies. This will very likely free the markets up again and return them to a strong trending phase.

When someone of the calibre of Stanley Druckenmiller calls time on his trading due to how tough he is finding market conditions, that to me telegraphs the fact that we may be near the bottom of the equity curve and that it is in fact a great time not to quit, but to begin.

The markets essentially do one of two things, they either move directionally, i.e. trend or they move sideways, i.e. consolidate. In our trading research we have seen without doubt that following a prolonged period of one, a good period of the other follows. This is in fact quite logical and can be seen in many different markets. In 2008 for example, there were many out-sized trends in many market sectors and what has followed since has been a brutal period of consolidation.

It has always been my belief, based on my own research, that following a brutal consolidation phase, the likes of which have not previously been seen to the extent that are currently seeing, that an excellent period of trending markets will follow. These large trends could be either up or down. Trend following systems don’t care whether they are buying or selling, they can make money in up or down markets.

Now, whilst it would be foolish to say that Druckenmiller’s inadvertent timing is perfect as a contra-indicator, I wonder if around a year or so down the line we can look back and say that Druckenmiller actually came out near the bottom of the performance curve. My bet is that he won’t be far off and the next few months will tell the tale. I also would not mind betting that he makes a return to the markets himself at some stage in the future.

Until next time, good trading

Phil Seaton

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