The short side of trend following makes little to no money. Falling markets are much more difficult to profit from and most professional futures managers struggle with the shorts. Despite popular belief, even in 2008 it was nigh impossible to profit from the short side. The money that year came mostly from long bonds. Why is it that the short side is so different?
Professional trend following hedge funds trade all asset classes – we trade everything from the NASDAQ to live cattle, palladium to the Japanese Yen, and everything in between. When the price moves up, we buy. As long as the price keeps moving up, we hold. Reasons are irrelevant; it’s all a game of math to us.
We do the same when the prices move down. We sell short and hold, in hopes of even lower prices. We do this based on simple computer models. This basic concept has grown to a multi-billion dollar global industry. What may seem an odd way to invest has worked remarkably well for several decades.
But the short side is not very cooperative. This is a very well-known phenomenon among hedge fund managers operating in this niche. On the short trades, we see higher volatility and significantly lower profitability. Even over very long time periods, the returns on the short side can be close to zero. Even negative. There are two reason for this.
The most obvious reason is the volatility. When a market moves down, it often does so in a more dramatic fashion than when it moves up. It will often fall very sharply. This is not a problem when you are short. But bear markets also tend to have very sudden and sharp moves to the upside. These moves often trigger stop loss orders for trend followers. Thereby you often get knocked out too early. If you move the stops farther away, you risk greater losses when the bear market really ends.
The less obvious but equally problematic reason is due to simple math. When you are long and a position goes in your direction, it grows larger. Your exposure grows with profit. A long-term trend up means that your position organically expands. With shorts the situation is reversed. When a short position is going in your direction, your exposure shrinks. The notional amount naturally becomes smaller when the value declines. This problem is larger than it may seem.
The profitability of trend following trading is based on the lasting trends; on capturing the larger moves. The simple fact that successful short positions shrink organically means that there is not enough profit to be made from lasting trends.
Professional trend followers deal in multiple asset classes. It may surprise that the lacklustre performance on the short side holds true for all of them. Even currencies. With currencies you could argue whether there really is such a thing as a long and a short side, but if you trade them via futures, there certainly is. They may not have much impact from the first reason stated above, but they are certainly subject to the second.
So why don’t we just stop trading the short side?
Because profit is not everything. No, I’m serious. Really.
If you trade only the bullish trends, you will most likely have higher returns in the long run. But you are also likely to experience a few unexpected side effects. What you may notice is that the return profile seems less attractive. The drawdowns are deeper. The correlation to traditional investments, such as equity indexes, is much higher.
The short side of trend following may not be very profitable. However, the ups and downs in the returns are timed very differently from the long side. At times, when the long side suffers, the short side shows big profits. Later, when it’s the long side’s turn to profit, the short side might give up those profits again. Even if the net effect is zero, this is very valuable.
With longs and shorts combined, your returns will differ more from traditional investments as well. They will be less correlated. That means that it will be more attractive to combine your strategy with mutual funds and other common traditional investments. The efficient frontier of such a combination will be more attractive if the short side is included.
It’s not just about how much money you can gain. It’s also about how much volatility you have to use to pay for it.
The short side of trend following works as a stabiliser. That’s the point.
Andreas Clenow is author or Following The Trend, published by John Wiley.