Holy Grail and trend-following

 

If a trend-following system is too slow, you risk a Type II error by missing a turning point.

If a trend-following system is too fast, you risk a Type I error by reacting to noise.

The Holy Grail of trend following is a dynamic system to adjust speed depending on market/economic conditions.

- from Campbell Harvey Regimes Notes 

I think this is the best way to think about the trend-following problem - a choice between making a type II or type I. You cannot escape this problem. Reduce type II and you take on more type I risk. Statisticians will often try and to set the type I to 5% and then have a suitable type II at 10-20%. Traders have to ask the question of what are the cost differences between type I and type II errors. If you are too fast, you will increase trading costs while if too slow, you will miss opportunities. Harvey in his regime work looks at four states of the world based on observable market regimes which fits nicely into the idea that trend-following only focuses on price information.  The bull market has short and long-term returns both moving higher. A bear market has short and long-term returns moving lower. The rebound has short returns positive while long-returns are negative, and corrections have short returns negative versus long-term rates.

His work on regimes shows that return performance can be sorted by these four states, yet further work can be developed to account for other state variables.  

See 

It is all about the market regime or similarity

Momentum and turning points - Working through corrections and rebounds

Currency factors as cluster approach

 

There has been extensive work on currency factors such as carry, value, momentum, and volatility, yet currencies may be unique from equities. The movement of returns in currency may be based on factors that are based on how they may cluster. In "Currency Factors", the authors focus on clustering of currencies into baskets and not traditional factors. They find that G10 currency co-movements can be explained by a limited number of clusters, a dollar currency and a European currency cluster. These clusters can be further extended to a commodity factor cluster and a world factor cluster based on trading volume. This suggests that a mental model of viewing currencies within their cluster and then within traditional factors may be a method to form quick judgments on the co-movement across currencies.

There are limits to the value from a crowd of economists

Is there a wisdom of crowds effect for macro forecasts? The answer is yes, per the new paper "On the wisdom of crowds (of economists)", but the impact of looking at more economists diminishes quickly. Whether the MSE, the change in the MSE from adding another economist, or looking at the relative improvement, the answer is all the same.  Check or average a few economists but the marginal impact of looking at a large group is minimal. Most economists seem to come up with similar forecasts which is not surprising. No economist wants to be an outlier relative to their peers, and most economists use the same models or frameworks which means they are likely to derive the same result. There is no value from looking at a big crowd of economists on the big macro questions. 

Robo-advisors - keep the rules simple

 

More investors are using robo-advisors to get investment advice. Relative to doing it yourself, the robo-advisor may be an improvement. Is this better than a financial advisor is a different question and remains to be answered. We know that the robo-advisor is cheaper, so the investor is receiving net savings versus the standard fees that are usually charged. 

Do you get more sophisticated advice? A recent study shows that the advice given is rather simple and focuses on only a few factors - what is your horizon, goal, and loss reaction are the top three. These simple rules are driven a lot of client money and will tie the movement of savings to a limited set of variables. See "What drives robo-advice?"