CHAPTER 9
The Hidden and Unhidden Risks of Trend Following
Trend following strategies require dynamic allocation across many different asset classes. The dynamic nature of these strategies creates new challenges for traditional methods for dealing with risk. When it comes to risk in trend following, many traditional tools may mislead investors, sometimes providing a false sense of security, whereas other times overestimating the overall riskiness of a trend following strategy. In this chapter, four main sources of risk in alternative investments are discussed. These four include price risk, credit risk, liquidity risk, and leverage risk. Trend following is compared with other dynamic alternative investment strategies to demonstrate how price risk and leverage risk are the two key risks to evaluate in trend following. Following the discussion of core risk exposures, the Sharpe ratio and hidden risks in the Sharpe ratio are discussed. Following the discussion of the Sharpe ratio, the chapter turns to dynamic leverage and margin to equity. This discussion demonstrates how dynamic leverage can be used to inflate Sharpe ratios.
■ Directional and Nondirectional Strategies: A Review
Alternative investment strategies, of which futures-based trend following is one particular strategy, represent a wide range of dynamic investment approaches. These strategies differ from traditional investment strategies that focus on a passive, as opposed to an active, investment approach. The flexibility ...
