TIP333: Trend Following w/ Niels Kaastrup-Larsen

Episode Summary

Executive Summary: Niels Kaestov-Larsen explains why 2020 was a stress test for trend following, not a failure. He argues the strategy’s rules-based discipline, diversification across markets and styles, and ability to stay liquid through futures helped it navigate the crash and rebound. He also critiques Sharpe ratio-only thinking and shows how trend following can improve portfolio resilience.

Main Topics: 2020 as a stress test for trend following (Priority: 5/5): The discussion opens with how the COVID crash and V-shaped rebound created an unprecedented environment for systematic models. Niels argues the year demonstrated robustness because models followed price signals without hesitation, reducing equity exposure and turning short other assets when trends broke. How systematic models absorb new market history (Priority: 4/5): Niels explains that trend-following systems do not 'learn' in an AI sense, but new periods like 2020 influence parameter selection through the historical lookback window and systematic recalibration process. Central bank intervention and crisis protection (Priority: 5/5): He contrasts trend followers with risk parity and other long-only strategies, arguing that trend following would have been well positioned even without the Fed bailout due to short equities, long bonds, and short commodities. Futures liquidity also mattered. Why trend followers differ from one another (Priority: 5/5): The conversation emphasizes that trend following is not one strategy. Results vary by what markets are traded and how systems are built, including entry rules, exit rules, position sizing, and speed of the model. Trend strength barometer and regime dependence (Priority: 4/5): Niels describes a trend barometer measuring the share of markets in trend, arguing that trend following performs best when roughly half of markets trend and struggles when fewer than 25% do. Portfolio benefits and diversification (Priority: 5/5): He cites simulations showing that adding trend following to an equity portfolio improves return, lowers drawdowns, and boosts Sharpe-like outcomes because correlation to stocks is near zero. Risk metrics beyond the Sharpe ratio (Priority: 5/5): A long explanation argues that Sharpe ratio misses drawdown pain and path dependency. He recommends ulcer index, ulcer performance index, conditional drawdown at risk, pitfall indicator, and serenity ratio as better measures of true risk.

Key Arguments: 2020 validated robustness of systematic trend following because models reacted to raw price data, not headlines or emotions. Trend following benefited from disciplined exits and reversals: Niels says long equity exposure was cut by about 87% during late February as the uptrend broke. Trend followers would likely have been positioned defensively even if central banks had not intervened, unlike long-only or risk-parity approaches that suffered from correlation breakdowns. Trend following is not homogeneous; performance depends heavily on market selection, weighting, system speed, entry/exit logic, and risk management. Diversification across trend-following managers matters because even if correlations are high, returns differ materially across styles and horizons. Most of a trend follower’s edge comes from a small number of strongly trending markets in a given year, while many trades are losers; success is about risk control and letting winners run. Futures are preferred because they are liquid in crises, cheap to trade, and eliminate bank counterparty risk. Sharpe ratio is incomplete because it ignores drawdown depth, duration, and return path; drawdown-based metrics better represent investor experience. Adding trend following to equity portfolios can raise returns while reducing volatility and drawdowns due to low/near-zero correlation with stocks. Volatility trading requires a different systematic approach than trend following; their volatility strategy seeks patterns in the VIX forward curve and can flip long/short quickly.

Data Points: Track record length: more than 46 years - Dunn Capital’s trend-following track record Equity exposure reduction: about 87% - Models reduced long stock exposure in the last week of February 2020 2020 trend-follower returns: flat to up about 10% - Approximate performance range mentioned for larger trend followers in 2020 Risk parity benchmark: down a lot in 2020 - Referenced as underperforming in the crisis due to correlation breakdown Correlations among long-tenured managers: 0.6 to 0.8 - Typical correlation range among trend-following managers Markets traded: 55 markets - Dunn Capital’s global futures portfolio Average daily trades: about 25 trades per day - Routine daily adjustments across the portfolio Per-market adjustments: one adjustment trade per day per market - How positions are maintained and rebalanced Trade success rate: about 40% winning trades - Typical trend-following trade-by-trade profitability Cash collateral/margin: about 15% margin, 85% cash held - For client capital invested in the strategy Low-rate environment: since 2008 - Cash returns on the unused portion of capital were near zero Lookback/timeframe study range: 20 days to 300 days - Used to identify historically optimal trend timeframes Preferred trend timeframe: about 180 to 240 days - Most years performed best with medium-long timeframes System recalibration frequency: weekly since 2006 - Fully automated parameter recalibration Trend-barometer difficult zone: below 25% of markets trending - Conditions described as extremely difficult for trend followers Trend-barometer break-even zone: around 45% (roughly 40% to 50%) - Approximate threshold for neutral performance conditions Strong-year condition: 9 or more months with weak trends usually leads to negative performance - Historical observation from the trend barometer 2020 strong readings: 6 readings at or above 50 - Trend-barometer evidence of a positive year for trend followers MSCI long-term return: about 10% annualized since 1985 - Standalone global equity benchmark performance Relative flagship performance: about 25% better than MSCI - Approximate comparison of Dunn’s flagship program versus MSCI Drawdown reduction with 20% trend allocation: from about 55% to about 40% - Simulated impact on worst drawdown in a blended portfolio Sharpe ratio improvement: about 25% higher - Estimated improvement when trend following is added to equities Volatility strategy best years: 2017 and 2020 - Best performance in historically low-vol and high-vol regimes respectively

Pivotal Quotes: "the trend is your friend, the rules are your guardian angel" — Niels Kostov-Larsen: He uses Richard Dennis’s phrase to emphasize that discipline and process matter more than narrative or emotion "we are first and foremost risk managers" — Niels Kostov-Larsen: Explaining how trend-following portfolios are built around risk allocation rather than return chasing "the strategy does not care about the fundamentals or the news flow" — Niels Kostov-Larsen: Describing why systematic trend following avoids emotional decision-making in markets like Tesla or Bitcoin

Implications: For investors, trend following is best viewed as a diversifier and crisis-resilience tool, not a standalone return engine. The industry should focus less on headline Sharpe ratios and more on drawdown-aware risk metrics and systematic discipline.