We’ve been known to help straighten out some wayward journalists from time to time, and our friend Michael Covel pointed out just such a journalist in need of some help last night via twitter:
— Michael Covel (@Covel) August 5, 2014
Now, Michael could be accused of drinking the trend following Kool-Aid a little too much at times, but there’s worse things to be passionate about, that’s for sure. And we don’t think Noah Smith is actually attacking ‘trend following’, despite the article’s headline and conclusion that “the trend is your friend till the bend at the end.”
Mr. Smith appears to be warning investors from taking on hidden risks in exchange for consistent gains, and cautioning against chasing performance. Mr. Smith appears to be telling investors in his ‘Investing’ column on Bloomberg View – to steer clear of the selling deep out of the money options. He is teaching us not to fall for the put-option fallacy, where investors get lulled into a false sense of security right before things blow up. He trots out examples of this fallacy in the mortgage backed securities bust in 2007, hedge funds in the 1990s and early 2000s, and Japanese workers (??).
The rub for Covel and ourselves is… He is warning against selling volatility. He is warning against booking small, consistent gains in return for the possibility of large future losses. But he conflates those warnings with “Trend Following,” seemingly not aware that Trend Following does the reverse. Trend Following is a LONG volatility strategy, which books small, frequent losses in exchange for the possibility of large future gains. It is quite literally the exact opposite of what is described in Noah Smith’s article.
The proof is in the past three years. The proof is in 2007 and 2008. If trend following were falling for the put-option fallacy – the returns would be a LOT better the past three years, but it’s been a skinny few years for trend following. See here, here, or here. Those selling volatility (ignoring the big risks of the past) are the ones making money, as can be seen in the short VIX ETF (XIV) or plain old $SPY. And what about 2008? What about when the hidden risks came flying to the forefront? How do you explain Trend Following’s outperformance during that time, Noah?
We suggest taking a short trip through a few blog posts and our educational materials on Trend Following, and maybe reading one or two of Covel’s excellent books on the subject, maybe rewriting the article.
— ‘Trend Following’ whitepaper
— Covel’s Books:
— Our series on how a trend following trade works:
Until then, on behalf of all the trend followers out there, we’ll echo Michael Covel’s sentiment.
“Please get a clue.”