Thursday, March 17, 2011

Perfect strategy to hedge the trendfollowing approach

For those who haven't heard about "trendfollowing," please look it up.  For example, check out and  I believe in trendfollowing in general, and the results speak for themselves.  There's a human psychological explanation for why it works, and the purpose of this post is not to address all the nuances of trendfollowing.  In contrast, I intend to introduce an idea I've never read about before, that marries two strategies that perform well over time, but at completely different time periods.

It's been well-documented how the various leveraged funds decay over time.  Without getting too much into detail, this is due to daily rebalancing.  For example, FAS and FAZ, two triple-levered financial ETFs, are both down over the course of the last year, even though one is long and one is short.  The natural strategy is to short both of them.  The problem with that is when there are extended intermediate term trends, you can get hurt badly, as you are getting heavier in the position that has been losing, and lighter in the position that has been winning (see ERX vs ERY since the latter half of 2010, for example).  Sounds to me like the opposite approach of trendfollowing.  So why not marry the two?  Combine the short-term mean reversion benefits of shorting levered funds with the intermediate term benefits of trend-following, and you have combined 2 inversely correlated strategies that win long-term, but which win at different times.

In picking a diversified list of assets, I would come up with with the following levered funds:
short TMO and TMF
EM Equities
short EDZ and EDC
Domestic sector-based equities
short FAS and FAZ
short ERX and ERY
short DRV and DRN
short TYP and TYH
short DAG and AGA
short DTO and UCO
short DGP and DZO

I would be very interested in hearing how a simple strategy of shorting all these, and occasionally rebalancing, combined with a trendfollowing approach, may enhance return vs drawdown characteristics.  I would also be interested in trading with you!