From a Systematic Hedge Fund Manager: The Single Most Important Performance Driver for Investments

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Be consistent and long-term focused. That is the adage that has always been spread throughout the community.

But why? Why does being consistent matter? Why should investors not play Tai Chi with the market, reacting to its every move and chasing the best possible returns? Does it make sense to stick to a strategy when it is “underperforming” the market indexes? Is it not painful?

This article by Patrick aims to break down:

  1. how market states affect investment performance and,
  2. caution investors on switching to a strategy that has performed well.

Editor’s Notes: This post has been reproduced from the original blog, Ramblings of a Systematic Trader.

About the Author: Patrick Ling

– Masters of Science in Wealth Management, SMU
– Bachelor of Civil Engineering (2nd Upper Class) from NUS

Patrick is a portfolio manager of a systematic hedge fund.

He has extensive experience, having spent more than a decade in the asset management and banking industry working through various roles since 2005. These include managing private client portfolios, covering hedge fund clients for equity derivatives products and strategy, product control on derivative and structured products and fund management.

Most people overlook the importance of market states as an investment performance driver. In actual fact, market states can easily override even the best-executed investment strategies.

The analogy is that market states are like different events in the Olympic games while investment strategies are like the various athletes that excel in different games – the best gymnast is bound to come in last in a 100m sprint event.

Conversely, the fastest sprinter will be unable to do a simple gymnastic routine. It is thus clear that investors should be aware of what market states are and how this affects their investment strategies.

What On Earth Are Market States?

There is no clear definition for the market state but just think of it as describing the market environment. When the market environment changes, some market commentators call it “regime change”.

This is simply moving from one market state to another. There are a few basic types of market states.

I will describe them below and point out what kind of strategies thrive and flounder in the respective market states. Note that the charts used are actual price charts.

#1 – Bull, Trending

Bull Trending
  • This market state is friendly to most investment strategies except for directional strategies that try to fade trends.

This market states is characterized by a consistent upwards trend with minimal minor corrections along the way.

The potential pitfall for mean-reversion strategies (such as deep value) is that you end up fighting against the tape all the time since values generally rise. This market state is also tough for long volatility strategies since volatility stays low and the contango term structure acts as a huge drag on performance.

#2 – Bull, Volatile

Bull Volatile
  • This market state is friendly to most investment strategies except for some nasty draw-downs along the way.

Characterized by a rising market punctuated with steep corrections in the range of 15-20% along the way.

It is most unfriendly to trend-following strategies as they keep getting whipsawed. Mean-reversion strategies may thrive in this market because they can capitalize on the steep corrections when it happens. Long volatility strategies may also thrive if they are able to capitalize on the volatility spikes along the way.

#3 – Sideways, Narrow Range

Sideways Narrow Range
  • This market state is also neutral to most strategies.

Characterized by a broad range-bound market with well-defined support and resistance lines.

Mean-reversion strategies thrive especially if there are many peaks and troughs bouncing between the support and resistance lines.

Trend-following strategies that use faster and more sensitive trend indicators might get whipsawed.

#4 – Bear, Trending

Bear Trending
  • This market state is the most unfriendly to almost all strategies except for trend-following strategies and funds that specialize in shorting the market or buying volatility.

Characterized by a consistent downtrend with minimal minor recoveries along the way.

This market state is also unfriendly to relative-value strategies because, in this environment, liquidity becomes a premium and relative-value strategies are typically short liquidity.

Value-oriented players may be tempted to double down since what was cheap before often becomes cheaper.

#5 – Bear, Volatile

Bear Volatile
  • Characterized by a falling market punctuated with sharp rebounds in the range of 20-30% along the way.

This market state is also unfriendly to most strategies except for funds that specialize in shorting the market and long volatility funds.

Mean-reversion strategies may also thrive in capturing the sharp rebounds. Long-only funds may be tempted to think that the worst is over after seeing the sharp rebound, only to have the market continue to fall.

Examples Of Market States Driving Performance

Examples of market states driving investment strategy performance can be seen by looking at the past performance of some hedge fund indices compiled by various sources such as Hedge Fund Research.

In my earlier post on investment philosophy, I’ve said that it is difficult to stereotype investment philosophies.

Similarly, it is difficult to classify investment strategies neatly.

However, the performance of the respective indices should reflect the average performance of their strategies pretty well due to the law of large numbers.


Most of the names of hedge fund indices are rather self-explanatory with the exception of Systematic Diversified. Systematic Diversified is actually the classification for Commodities Trading Advisors (CTAs). CTAs are mostly trend-followers.

2008 Global Financial Crisis

One good example of a bear trending market state was in 2008, right in the middle of the Global Financial Crisis.

S&P 500 2008

Most hedge fund strategy indices registered negative performances except for trend-following and short-dedicated strategies.

2009 Great Recovery

2009 marked a transition to a bull, trending market state.

S&P 500 2009

Those hedge fund strategies that suffered during 2008 started to recover. Trend-followers gave back some of the gains made in 2008 as short positions were slowly reversed into longs. Short-dedicated strategies gave back most of the gains made in 2008 since they remained short throughout the recovery.

2010-2012 Eurozone Crisis

From 2010 to 2012, the market state became bullish but volatile due to the Eurozone crisis.

S&P 500 2010-12

Most hedge fund strategies continued to recover from the beating they took in 2008 albeit with intermediate draw-downs. Trend-following strategies began to go nowhere during this period due to the sharp whipsaws along the way.

What Is The Implication?

The importance of being aware of the impact of the market state on investment performance is that as investors, we should be aware that the market always moves from one state to another.

If we simply focus on investment performance without understanding how the different investment strategies generate profits, we might end up chasing after a performance at the wrong time.

We might jump into a recently performing strategy just when the market state is about to change to favour another investment strategy.

The converse is also true.

We might dump a non-performing investment strategy just when the market state is starting to favour it again.

In my opinion, the optimal solution is to construct a sensible investment portfolio consisting of multiple strategies that thrive in different market states since there is no way of knowing in advance what will be the prevailing market state.

Once this investment portfolio has been constructed, stick to it and only rebalance when necessary.

Using the Olympic games analogy, it is like China sending athletes to compete in all the events and being assured that it will at least win some medals regardless of which event is currently in the spotlight.

Editor’s Notes:

Consistency matters because strategies don’t always outperform the market. No single strategy does.

And honestly, that doesn’t really matter because anyone able to compound their money at 15% a year consistently for 15 years with meaningful savings and investment rates can achieve massive wealth.

As can be seen, if you compound your wealth steadily, you’re sitting on a portfolio worth nearly a million dollars in 15 years with reasonable savings of $1,000 a month and starting with $50,000.

Imagine starting at 25 years old, then being 40 years old and sitting on a million-dollar portfolio.

So don’t bother paying attention to what the market has or doesn’t have. Simply focus on consistent returns.

The question that follow this line of thought then is how do we construct a multi-strategic portfolio capable of giving us 10-15% returns (or more), with low volatility ,and with reduced risk against Global Financial Crisis like the 2007-2008 recessions?

The answer lies in the strategy and portfolio construction.

Notice that the model would have gained 16.4% in 2007 and only experienced a slighltly negative drop of -5.7% in 2008.

Meanwhile, this is what happened to everyone else across sectors.

Not pretty.

What about across countries?

In other words, there’s no dodging financial crisis unless you keep an eye on risk and you build a multi-strategic portfolio.

Yes. The portfolio does so-called “underperform” bull markets that deliver sexy returns, but keep in mind the downside is very “sexy” too. Sexy enough to give you a heart attack.

  • If you are interested in how to build such a portfolio that delivers consistent 10-15% returns as see above (14% shown in the model above)
  • If you want to reduce the volatility of your portfolio value and you hate seeing your stocks swing up and down every day
  • And if you want to guard your investments against crazy market crashes and drops

You can sign up for a seat here to find out how.

If not, stay focused on consistent returns, and remember how market states drive investment performance.

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