Here is the million-dollar question: When should we let go of an investment strategy?
Believe it or not, it is a lot easier to put strategies to work. Letting go of an investment strategy, however, is a much more daunting task. You might be wondering what is so difficult about it. If it is not working, just take it out. Isn’t that just common sense? Yes, the reasoning is sound. But the challenge is how do you even know if the strategy is no longer functional.
The Painful Dilemma – To Let Go Or Not
Here is the scenario. You had a brilliant strategy that you used for quite a while and it made you good money. And you felt like you had the world in your hands. Then all of a sudden, things fell apart and nothing seems to go right. Your cash cow fell sick and you run into losses. But is this just a passing ailment or a terminal sickness? As hard as you try, you can’t pinpoint the root cause. So you are now hit with a painful dilemma. Should you cut the strategy? What if you cut and then the strategy turnaround to make new highs? Or maybe you should just continue? But what if you continue and the strategy carries on its endless bleed? For those who have been through the process, I am sure this is all too familiar.
Each working strategy is the result of your hard work and effort. This can be months to years of effort starting from research, backtesting, and forward running before deploying it live. And if the strategy performed well after that for a good amount of time, it can be painful to consider dropping it when the situation arises. These are uncomfortable but necessary decisions professional investors got to deal with all the time.
Let History Be Your Guide
We don’t have answers to everything. More often than not, we got to make do with what we have and know. So if you did a comprehensive backtest, then that is the best starting point. And what is a comprehensive backtest? Besides realistic modeling, it should also cover a sufficiently long period comprising different market regimes. The reason is simple. We want to know how the strategy performs under different conditions. In particular, what are the risks, and what is the worst it has been through?
I have seen people showcasing backtests that are pathetically short like less than a year. I have also seen those who cherry-picked the periods to get a favorable result. This is not how backtests should be done. Backtests are meant to shed light on your strategy, both the good and bad sides. When you know your strategy inside out, you will be able to make more sensible decisions.
What Reference Can You Take From The Past?
There are no hard and fast rules when it comes to retiring a strategy. The considerations are usually a blend of science and art. Having said that, you can exercise the best discretions and yet still be wrong about it. That is the nature of the game. But what is more important is that you have a rational approach.
By no means exhaustive, here are some simple considerations:
1. Is the fundamental premise behind the strategy broken?
The starting point of any strategy is often some fundamental premise based on how the market behaves. So the first question to ask is whether you think this premise has broken down indefinitely. If the premise is weak to start with, then this makes the strategy a possible candidate to wind down. Strategies based on short-term empirical observations that you can't really explain can often fall into this category. But there are also those with solid premises based on long-term market behaviors that are well supported by studies and research e.g. asset allocation based on risk and trend following based on price. In this case, chances are these strategies are just experiencing a rough patch and when market conditions shift, their performance will come back. So the question is how confident are you of the premise behind the strategy?
2. Is the behavior of the strategy out of tune with similar periods in the past?
Holy grail strategies exist only in your dreams. There are only the right strategies at the right time. So all strategies will run into bad patches one day or another. A trend-following strategy suffers when the market swings sideways wildly. This occurs every now and then. Asset allocation strategies run into trouble when their correlations go to one and all head south together. Again, this is not new. It can happen when the market liquidity dries up under extreme pressure or when there is unexpected and persistent inflation e.g. after the Lehman Brothers Collapse in 2008, during the COVID-19 pandemic in 2020, and in the midst of high inflation post-Covid. Poor performance during periods unfavorable for your strategies is expected.
3. How deep are the losses compared to the past?
Now, it is one thing to expect losses during a bad patch. But that does not mean you should readily accept any level of loss in particular if you are not confident of the premise. To gauge the level of acceptable loss, you can look at how much your strategy loses at its worst point in history. But since we are dealing with the future, it is always prudent to assume that you have yet to see the worst. So you might want to set a buffer over and on top of this worst loss. When that level is breached, it can be a signal to size down or cut.
4. How long are the drawdown and recovery?
Another consideration is the inability of the strategy to recover from a drawdown. Of course, this might simply be a case of an exceptionally long bad patch rather than a fundamental breakdown. But in any case, we can never be sure and we can’t wait indefinitely. A slow bleed can be just as bad. Thus, after a certain point, it may make sense to size down or drop it. Again, you can reference the longest drawdown in history and provide some buffer to set the cut-off duration.
Conclusion
These are just some suggestions guided by quantitative measures. However, if you have a strong enough conviction that the strategy is still worth holding on to, then there is nothing to stop you from doing so. Many long volatility funds underwent a period of slow bleed as volatility waned to record lows after quantitative easing in 2008. Their big break came after 2017 as markets went through a more turbulent period. Many trend-following hedge funds also sit through years of underperformance after 2008 and they did not rebound back until recent years. Some large names were even forced to restructure their strategies to retain business. But if you are an individual investor, then you are free to make your own choice.
Want to know more about AllQuant?