Trend Following Strategy: What To Buy, What To Hold Now

To improve diversification and prevent single-company or single-industry blow-ups (like gold miners, from which we are still recovering) I’m always looking for mutual funds, closed-end funds, or ETPs (exchange-traded products) that provide much of the upside of the well- or luckily-selected leaders in a sector or national market and which mirror our own strategies.

One of the strategies we like to use when we believe the market is looking toppy are trailing stops. I’ve never found a fund that does this for us — until now. We still need to watch these mutual funds and ETFs every day to decide when it's best to use them and when it's best to select individual
equities but at least they reallocate like we like to do.

There are a number of these ETNs offered by the Royal Bank of Scotland (whose preferreds we own in the Growth & Value Portfolio) but some have too little volume to consider. On the other hand, there are two that I be-
lieve merit your attention. Even these are thinly traded compared to more established ETNs and ETFs (they are only a couple years old) so, for heaven’s sake, buy in multiple tranches and use limit orders!

The RBS US Large Cap Trendpilot ETN (TRND) fits my goal to “automatically” add exposure “when the fish are running” and reduce it when they are not. Here’s how they do it: they use a trend-following strategy to provide exposure to buy the S&P 500 Total Return Index
when the indicator they use says to be invested, and when the indicator says “Danger, Will Robinson, Danger!” to invest in an index that instead mirrors 3-month U.S. Treasury bills. If the level of the S&P Index is at or above its historical 200-Index business day simple moving average for five consecutive business days (a “positive trend”), TRND will faithfully track the return of the S&P. Conversely, if the level of the S&P 500 is below the 200-day moving average for five consecutive Index days (a “negative trend”), then TRND will effectively switch to cash instead of the S&P.

Two things to be concerned about with such a strategy and two to like:
This is trend following. TRND will always be a couple to a few days late in buying in and getting out from the actual bottom or top. I don’t see that as a huge disadvantage. Nobody catches the exact tops and bottoms; that’s a fool’s errand. Second, you might be whipsawed occasionally, although the 5-day rule tends to mitigate that somewhat. So what’s to like? Risk mitigation! The grayer my hair gets, the less I like to see large losses. Just one blow-up from one company or industry (did I mention gold miners?) can destroy all our/your hard work.

By building a foundation of ETNs like TRND, we can be sure we capture most, but never all, of a series of “perfect” calls by the alleged smartest guys in the room. In a previous article, I showed how we, even with our
blow-ups, as well as others with a buy-and-rebalance 60% equity/40% bond portfolio absolutely trounced the self-proclaimed smartest guys in the room, the hedge funds.

Buying TRND will increase our edge even more. Through the end of the 1st quarter, the benchmark S&P was up 10.6%, TRND was up 10%. Since inception, the benchmark S&P was up 24.6%, TRND was up 21.8%. John Paulson’s gold hedge fund during this quarter? Down massively. Which would you rather own?

TRND is currently trending well above its 200-day moving average so it may come down a good bit before the “go to cash” signal is given (though that will change as the 200-day MA catches up. But lately we’ve been buying more of the RBS NASDAQ 100 ETN (TNDQ) than TRND.

TNDQ, the younger brother of TRND, is even more thinly-traded. I have been slowly buying it for clients but, in order not to move the market, in 250- and 500-share lots. Because of the NASDAQ 100’s recent un-
derperformance, TNDQ is much closer to the 200-day MA, so if there is a decline, it will go to cash much more quickly, preserving more of our capital.

Like TRND, TNDQ invests in either the NASDAQ 100 Total Return Index or the yield on a notional investment in three-month U.S. Treasury bills. The difference is, since this index tends to be more volatile, RBS buys
the NASDAQ 100 Index when it is at or above its 100-day simple moving average for 5 days and goes to cash when the index closes below its 100-day simple moving average for 5 consecutive sessions. We now own both.

Bond Traders

When we “buy bonds” we buy mostly bond mutual funds, closed-end funds and ETFs for our clients and ourselves, not individual bond offerings. There are exceptions; our Molycorp 6s of 2017 are an example. These are a special situation that combine convertibility, a short maturity and significant upside potential. They also offer higher risk and demand a boatload of patience!

I believe that selecting a “bond fund” that has the ability to do more than buy an index of bonds and hold them, as most ETFs do, is the way to go.
I have also identified an ETF that provides similar opportunity for capital gains as well as risk-off income. Well, as risk-off as high yield ever is. When you buy a junk bond, you always run a risk, however remote, of de-
fault. That’s true of any bond, but clearly more likely with a company with a “C” financial rating than one with a “AA” rating.

But when you buy a huge package of diversified junk bonds, the gains you make typically compensate you very well, even after including the occasional default. I think this will be the case in spades for the Peritus High Yield ETF (HYLD). HYLD is an active ETF that focuses on the junk segment of the bond market. Its managers look to take a value-based approach, using their judgment and long experience to pick and choose carefully rather than simply track an index of come-what-may.

They also do something else I think is much smarter than their peers; they invest mostly in the secondary market, where news-driven anomalies occur all the time. The well-prepared take advantage of those discrepancies. The real benefit of buying in the after-market is that they can buy bonds that are trading at well below what they believe their real worth is, removing a great deal of interest-rate risk, particularly for the short end of their maturity holdings. Skill doesn’t come cheap. The ex-
penses for this fund are currently 1.35%. However, I’d rather pay 1.35% and make 8.5% than pay some sluggards who merely buy and hold whatever is in an index 0.5% but return only 4%.

Three-quarters of the fund is in bonds rated no less than B- by S&P and no single bond accounts for more than 2.5% of assets. While the managers insist upon good diversification across sectors, there is currently a slight bias in favor of health care, in my opinion a great bet to
make. HYLD offers low duration and a fine yield, while providing the opportunity for capital gains as well.

We never try to “time” the market going whole-hog in one week and then selling everything the next. But our gradual approach, stair-stepping in and stair-stepping out means that, as our trailing stocks are triggered on the long side, we look to assets that provide downside protection but still afford the opportunity to earn a good return. I think HYLD fits the bill. It’s a thin trader, so use limits...

What to Hold

At times like this, when the market may be approaching a top, we still don’t go overboard and sell everything. After all, the bias of the market is to drift upwards in the absence of bad news. It goes up roughly 2/3 of the time and down only 1/3 of the time. (The past 13 years being a no-
table exception, of course) So here’s what we are sticking with and a brief reason why.

We’re sticking with our long/short mutual funds because, while they may be roughed up in a general decline, their charter allows them to get knocked down along with the market but to get back up and fight again another day. The best most mutual funds can do is go to cash. Most of the time they aren’t that smart so they fall back on the crutch that, long
term, the market always comes back.

We’re also keeping most of our balanced funds. Their track record in the bad times is a good one and we want to keep some of that long-side positioning. We’ll keep Lynas (LYSDY) because we are so far underwater they wouldn’t bring us much, anyway, and because China’s days of
manipulating the REE market are coming to a close. When the world’s economies pick up, these economy-sensitive issues have the potential to blow the doors off.

We’ll keep our boring telecoms because they provide great income and “relative’ stability and we’ll keep our First Trust NASDAQ ABA Community Bank (QABA), and likely add specific smaller banks, because they are
bastions of safety. Finally, we’ll keep and add to our more stodgy “big energy” firms such as Schlumberger (SLB), Royal Dutch Shell (RDS.A) and Statoil (STO). Whenever they decline, we buy. It’s worked for us for 40 years.