It has long been my contention that markets have become less kind towards trend following models in recent years. My view is that markets change and that models therefore need constant adaption to survive. For example, witness the recent demise of J.W. Henry and the dreadful performance in general of trend following models over the last two years.
One concept that I have often admired but never tested is that of Perry Kaufman’s efficiency ratio, to be found in his book Smarter Trading.
A trend follower wants and needs to avoid false signals due to noise. A trend following model will reap the greatest and cleanest profits when a market breaks out in one direction and never looks back – a perfect (non-achievable!) trend would go from point A at the bottom left-hand corner of a chart to point B at the top right-hand corner in an absolutely straight line with no retracements.
Kaufman’s efficiency ratio has values ranging from 0, where markets are very noisy, to a theoretical +1, where markets are perfectly directional.
For a given day, Kaufman’s ratio is calculated as:
the absolute value of net price change over time (e.g. 120 days) / the sum of the absolute value of all day to day price ranges over the same time period
You can readily see that if a price goes smoothly upwards from day to day with no retracement (ever!) the index for any given day will equate to 1.
I developed code based on true range rather than close to close price change (arguably not what Kaufman intended). I ran this code over an entire portfolio of over 100 instruments from 1970 to date. Each day I added each individual instrument efficiency ratio for the whole portfolio and divided the day’s total by the number of instruments for which I had a price on that day.
The charts below show the combined efficiency ratio at portfolio level on a daily basis. I calculated the efficiency ratio for periods of 20 days, 60 days, 120 days and 240 days. There is a chart for each.
The results would seem to indicate fairly unequivocally that markets as a whole have become less trend friendly/more noisy over time and that the last two years look particularly inefficient and trendless for the calculation periods I used.
Of course this situation may reverse but certainly the past 40 years seem to have been a period of increasing deterioration. Trend following as a strategy undoubtedly seems to have become more difficult in recent years and deteriorating risk adjusted returns in the CTA trend following community seem to confirm this.
Anthony Garner is author of A Practical Guide to ETF Trading Systems.