This blog post can be downloaded here.


  • One of the most frequent questions we receive when it comes to tactical strategies is “how do I benchmark this?”
  • Another way of asking this question is, “how else can I get this exposure and what would it cost me?”
  • Strategies that provide downside protection often come with some sort of implicit “insurance premium.”
  • In trend-following strategies, this insurance premium is the whipsaw.  Ideally, this cost is lower than other means of protecting capital.

Trend-following strategies are difficult to benchmark.

Take our Risk Managed U.S. Sectors index[1].  We seek to provide significant upside participation to large-cap U.S. equities while avoiding significant downside losses.  In numbers, over a full market cycle we’re looking to capture roughly 70-80% of the upside and only 40-50% of large market losses.

The problem with benchmarking such a strategy is that what might serve as an adequatelong-term benchmark may be a totally inadequate short-term benchmark.

The S&P 500 may be a perfectly reasonable benchmark over a full market cycle.  You can easily determine if the asymmetric return profile was realized and whether the strategy was able to successfully cut out the big losses.

In the short-term, though, upside and downside capture numbers are meaningless.

Trend following strategies tend to look a lot more like protective put option strategies.  A put option gives the owner the right to sell their security at a predetermined price.  So holding a broad market index and a put on that index effectively caps how much we can lose.

Strategy Call-Option
But to achieve this protection, we have to pay a premium up-front.  In the example above, we chose 300bp (the amount that the solid line is under the dashed line).  So when the market is up 30%, the strategy is up 27%.  When the market is down 5%, the strategy is down 8%.

Now, over a full market cycle, this combination could very well achieve a 70-80% upside capture and a 40-50% downside capture.  The yearly 300bp premium causes a performance drag – hence the 70-80% upside capture – and the contract protects against big losses – hence the 40-50% downside capture.

Below I’ve plotted the yearly returns for a sector-based trend following strategy (similar to our Risk Managed U.S. Sectors index, but using sector data from the Kenneth French data library going back to 1928).  Note that all returns are purely hypothetical and backtested (these are not performance results achieved by Newfound’s investment strategy/index and Newfound did not launch its Risk Managed U.S. Sectors index until February 2015).

Trend-Following Scatter
We can see, over the long run, how similar the pay-off structure is to the put option strategy.

Perhaps, then, a put option strategy is really the best benchmark for understanding how a trend following strategy should work, especially when we are examining performance over less than full market cycle periods.

To explore this notion, we’ll price a simple 1-year European put option for a variety of different strike levels (note: the term “European” means it can be exercised only on a very specific date – in this case, a year from when we buy it).

What we can see is that if you want to completely protect your portfolio from any losses for 1-year, you’ll have to fork over 4.8% of your notional value.  In concrete numbers, if you want to entirely protect $100,000 of S&P 500 exposure, you’ll have to pay $4,800 up front.

Price of Put
As we demand less protection – that is, we buy the put option further out of the money –  the cost goes down.  But even if we allow a 10% loss before the protection kicks in, we’re still turning over 1.5% of our portfolio as an insurance premium.

Yet this ignores a very important aspect of managing options: timing luck.  Timing luck comes into play in two ways.

First, consider an example: on December 31, 2014, you bought a put option that protects against losses more than 10%.  It’s December 31, 2015 and the market sits at -9% for the year.  Your option expires worthless.

It’s time to reset your protection.  Except now you’ve already lost -9% (not including the premium we paid!).  If you want to make sure you’re never more than -10% off all-time highs, you need to buy the 1% OTM put option for an expensive 4.4%.

The second way timing luck can come into play is that options get more expensive as volatility goes up.  So now imagine you bought protection on December 31, 2007 and now need to buy it on December 31, 2008.  Over the period, volatility (measured by the VIX) climbed from 22.5 to 40.

At this point, you’re basically trying to buy fire insurance while the house is burning down.  No surprise, but our options are far more expensive than they were the year before.

So timing luck has a profound effect on the cost of protection.

One way to address the first issue is to buy options with shorter expirations.  Unfortunately, this means costs compound quickly as you roll your options more frequently.  Buying twelve 1-month options in a year tends to be much, much more expensive than buying one 1-year option.

So back to benchmarking our tactical strategy: perhaps we can use the cost of an approximately equivalent put strategy.

To balance timing risk and the cost of compounding, we’ll use quarterly put options.  Since the largest 2015 drawdown of our Risk Managed U.S. Sectors index was just under 12%, we’ll strike each quarterly option 2.87% OTM.  This way the maximum compounded loss we can endure in the year is 12%.  We’ll price our put options using the standard Black-Scholes equation, using the prevailing risk-free rate at the end of the quarter and using the VIX as our estimate of implied volatility (note: this isn’t entirely accurate, but should suffice as an approximation).

We can then show the quarterly performance of the market versus the quarterly performance of the put option strategy.


Note that despite clamping the loss at -2.87% in Q3, the total loss was -6.3%.  This is because volatility spiked as we were rolling over our contract and the new put option became incredibly expensive.

At the end of the year, the put option strategy has cost us 590bp of performance drag against the market.  Using semi-annual options instead of quarterly only brings the drag down to 550bp.

2015 proved to be an expensive year for protection using put options.

So as we evaluate the results of our trend-following methodologies, we are reminded that summary statistics are often inadequate to measure and understand short-term performance.  In the case of 2015, many trend following strategies experienced varying degrees of whipsaw.  While in the long run we believe a broad market like the S&P 500 is an adequate benchmark, in the short-run, when insurance is expensive, we believe comparing tactical to alternative protection strategies is important.

[1] This index was launched by Newfound in February 2015.

Corey is co-founder and Chief Investment Officer of Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Corey is responsible for portfolio management, investment research, strategy development, and communication of the firm's views to clients.

Prior to offering asset management services, Newfound licensed research from the quantitative investment models developed by Corey. At peak, this research helped steer the tactical allocation decisions for upwards of $10bn.

Corey is a frequent speaker on industry panels and contributes to, ETF Trends, and’s Great Speculations blog. He was named a 2014 ETF All Star by

Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University.

You can connect with Corey on LinkedIn or Twitter.