Is the degradation of trend following performance a cohort effect, instrument decay, or an environmental problem?

It's probably bad luck to say this, but the most recent poor performance of CTAs and trend following managers this year appears to have been reversed. My own system is up over 12% since the nadir of the summer drawdown, and is now up for year; admittedly by only by 5.5%. 

Nevetheless, it's true to say that trend following performance appears to have been degrading over the last few decades. If I can literally talk my own book (the book in question being Advanced Futures Trading Strategies - AFTS), then in one chapter I note:

Having said that, it does look like the returns from strategy nine are falling over time. The inflationary 1970s were particularly strong, with a total non-compounded return of over 500% over the decade (if we had been compounding, our returns would have been even more spectacular). We then made over 200% in each of the next three decades. But since 2010 our average return has roughly halved.

But where the better returns in the 1970's (and to a lesser extent 80's, 90's and 00's) because we had a better environment for trend following, or because we had better instruments, or because over time instrument performance decays?

Let me explain. Back in 1972 when my backtest begins, there were just a few instruments. In the first few years only 11 instruments were around, out of the 100 or so in my usual list of liquid instruments I use for testing. And they were weird: seven were agricultural commodities, two are currencies and two metals. Perhaps the better performance of trend following in the 1970's was because the instruments we had then were just better at trend following? Or, perhaps it's just that when an instrument is first traded it does very well, because there aren't many other smart people hanging around to extract 'alpha'?

So, let's see which of these three explanations is most likely.

I'm going to start with the fastest EWMAC 2,8 crossover I use. In AFTS I noted that the two fastest crossovers have suffered particularly bad degeneration in performance since about 1990. These returns are before costs, so the after cost performance would be even worse.

There are quite a few of these graphs in this format, so let me explain. Each line is a different cohort of instruments. So the blue line for example, is all the instruments that began trading in the period 1971-1980 inclusive. On the y-axis is the average SR for those instruments in the five year period beginning in the date on the x-axis. So for example, for the instruments that began trading in the first ten years, from 1981-1985 their average SR was around 0.30; a little higher than the next cohort of instruments that just came in. 

* Important note. The date an instrument starts trading is the earliest point I have data for it. It may have been trading long before then.

Let's now review three possible explanations for the reduction in trend following p&l in the fifty years or so, and see which most represents the empirical results.

First of all we have a cohort effect explanation. Instruments which enter the dataset later have worse performance, so they drag down the average performance. This would look something like this:

You can see that the older an instrument is, the better it's performance. To combat this effect we could just avoid trading newer instruments.

Next we have an instrument lifetime decay effect. Each instrument does well when it first enters the dataset, but then it's performance decays as it ages. As a result, as more instruments are old and fewer newer, and the average performance falls. An extreme version of that effect would look something like this (I've drawn the horizontal lines slightly apart for clarity, they should be on top of each other): :

To deal with this we'd have to be constantly adding new instruments that haven't yet been affected by the influx of sophisticated traders looking for alpha. This is the opposite of what we'd do with a cohort effect.

Finally we have the general enviroment effect. All instruments have roughly similar performance in each period, which gets worse over time. This would result in something a bit like this (I've drawn these lines slightly apart for clarity, they should be on top of each other): 

There is no solution here. We are buggered. We need to get out of the trend following game. Or at least hope that this is just a temporary setback; after all people have tested trend following rules over hundreds of years so a few decades of bad performance is nothing to worry about.

Looking back at the EWMAC 2,8 graph, there is no support for the cohort effect. It looks like there is some evidence of an instrument decay, most strikingly for the 1991 cohort. However this only contains 7 instruments, so it's one of the smallest cohorts, so the significance is questionable. Overall though, this does look an enviroment effect with noise. 

Let's step down the speed to EWMAC4,8:

Looks like a very similar picture. How about EWMAC8,16?

Again apart from the 1991 cohort, this looks pretty much like a gradual decline due to enviromental effects. Now let's turn to EWMAC16,64, which readers of AFTS will know is the best following of my momentum indicators:

Feels like we're watching the same film over and over again, doesn't it?

EWMAC32,128

EWMAC64,256

Not quite as clear, but we're trading very slowly now so would expect more noise.

To summarise then, it looks like the decay of momentum performance has been solely down to  general enviromental effects, rather than a cohort effect, or the decay of instrument performance. This is bad, because it means we can't do anything about it by restricting ourselves to older or newer instruments. This is good, because instrument diversification really is our best chance of being profitable traders and making the most out of a weakening signal. I wouldn't want to suggest that you should do anything different than trading all the instruments you can get your hands on.

And to reiterate, let's hope this is a temporary situation. For me personally, as someone who isn't tied into a CTA box, I'm happy to continue trying to trade as many different risk / return factors as possible.

Bonus postscript: Here's carry!

This does look a little bit more like a decaying instrument story...