Financial turbulence? The TRENDYX? (low-volatility) strategy is the right answer.

The recent episodes of clean air turbulence affecting some safe routes are a perfect metaphor for understanding the pitfalls of financial investment. Whether they are black swans or grey rhinos, investments are susceptible to unforeseen events or, when predictable, to events with consequences that are often unpredictable. Several instruments are available to mitigate the adverse effects of such unfavourable accidents. However, some of them radically alter long-term return prospects or, in other cases, their help tends to be unconvincing. Take low-volatility strategies, for example. If you consider them over a longer period, they look as brilliant as they are compelling. But in the short term, as in the last four years, they have been very disappointing. So, is it possible to solve the puzzle of how to balance performance and risk, as expressed by volatility measures?

TRENDYX? was born by accident. We often use moving averages as a way of understanding where the market is going. They separate trend from volatility, signal from noise. So, a moving average would be the perfect index to use in low-volatility strategies. It is smooth, close to the index it follows and minimises drawdown effects.

Having noted these potential advantages, I have disentangled the reasons for its smoother behaviour compared with conventional indices and their low-volatility versions. It all comes down to the variance of the moving average, which is always roughly a fraction of the variance of the index. More precisely, "the variance of a moving average is the ratio of the variance of the index to the number of days of the moving average chosen". A 1-day moving average is known to coincide with the chosen index, and here its variance is the same as that of the index. The variance of a 20-day moving average is one twentieth of the variance of the index. Variance is the mother of standard deviation (via its square root) and standard deviation (when it is multiplied by the square root of the time) is the mother of volatility. This property is deterministic. It is not probabilistic. This means it can be replicated. The fact that the variance of the moving average is only a small fraction of the variance of the index, depending on the window chosen, results in an exceptional risk-return ratio. Hence the idea of transforming the moving average into a new and more powerful low-volatility index and smart beta strategy.

From December 2019 to April 2024, a period dominated by an unusually devastating series of adverse events, low-volatility strategies delivered modest risk-adjusted results. The S&P 500 Index achieved an annualised performance of 11.75% with a volatility of 22%, while its Minimum Volatility version reached a performance of 6.67% with a volatility of 20%. Over the same period, the TRENDYX? strategy, based on a 10-day averaging window, would have returned 12.4% with a volatility of 6.3%.?

Of course, if the TRENDYX? strategy ever gets there, it will be through ETFs, the best investment vehicle ever invented. The road ahead is long and not without difficulties. It will be necessary to create a family of TRENDYX? indices. Since the ETF that replicates this strategy will inevitably have to be synthetic, it will also be necessary to assess the willingness of swap providers to afford the flows generated by TRENDYX? movements. Most importantly, it will be necessary to understand the extent to which the ETF industry is interested in launching this new family of low-volatility strategies.

It seems reasonable to expect low-volatility strategies to become an increasingly important part of the investor's toolkit. They exploit a well-known anomaly in financial theory that overrides the principle of higher risk, higher expected return. From this point of view, TRENDYX? offers an exceptionally favourable risk/return ratio and is a concrete help in managing the emotional component of the relationship between the investor and his or her money. Finally, TRENDYX? is potentially attractive for institutional investors who wish to strictly control the risk limits imposed by their investment policy.

At first, I was confused and sceptical. I had to do a lot of work to understand whether the idea was viable or not. I still wonder why no one has thought of this before. I was just lucky enough to get out of the conventional box and use a widely recognised and used technique. As a fan of analogue photography, I sometimes think of Oskar Barnack, the inventor of the Leica small-format camera, the forerunner of modern cameras. Barnack simply took advantage of existing movie cameras, which ran film vertically, and used it horizontally, shooting one frame at a time. The idea of TRENDYX? is simply to take something born for one purpose and adapt it for another.

Edoardo Mezza

The TRENDYX? approach New frontiers in low-volatility strategies: How to obtain equity-like returns with bond-like drawdowns and volatility on Amazon.it