Prioritizing Outlier Gains Over Smooth Returns in Trend Following

The core idea here is that true trend following is a strategy built to hunt for outliers, which requires rejecting the goal of smooth returns. Many investors treat trend following as a way to generate crisis alpha, or a hedge against market crashes, but this is a strategic trap. The real value of systematic trend following is its ability to capture massive, non-linear gains across a wide range of assets, including individual stocks. Investors who prioritize low volatility and high Sharpe ratios over long-term compounding consistently miss the 5% to 10% of trades that generate the vast majority of total returns. For the sophisticated investor, the advantage comes from the willingness to endure the fire of underperformance and volatility, which is necessary to capture the right-tail events that market-cap indexing and conventional portfolio construction ignore.

The Hidden Cost of Crisis Alpha

The industry often markets managed futures and trend following as crisis alpha, or a safety net for when equities collapse. Jerry Parker calls this a form of Stockholm syndrome. By forcing a strategy to act as a hedge, managers often compromise the very mechanics that make trend following work. If a strategy is tuned to be smooth or to protect against equity drawdowns, it often sacrifices the aggressive, unconstrained participation in trending markets that produces real wealth.

Some CTA said we have been down that route and says I am going to choose worst performance for my fund, my livelihood, my family, my trend following loving clients because I will be able to convince others that I need a big allocation to me and I will do better with, I will be the one who will actually add some crisis alpha, even though my overall performance will be worse.

-- Jerry Parker

The consequence of chasing this crisis alpha is a feedback loop where managers prioritize client comfort over performance, ultimately delivering a product that fails to do either job well.

Why the Obvious Fix Makes Things Worse

Conventional wisdom suggests that investors should sell when a trade hits a logical peak, such as silver at $120. However, Parker notes that the most important part of trend following is that it has no interest in today's trade. By attempting to optimize for the current moment, investors inevitably exit too early, missing the parabolic moves that define the strategy's success.

If you want to cut off the fat tails on the right hand side and reduce the skewness and really limit the outliers too and have more of a normal distribution just destroy everything that trend following is made of, all of his great characteristics, then that is seductive for clients to tell them there is no opportunity cost here.

-- Jerry Parker

Systems thinking reveals that the obvious decision to take profit is a first-order benefit that destroys the second-order payoff of an outlier move. The system responds to this optimization by normalizing the distribution of returns, which effectively kills the strategy's primary engine of growth.

The 18-Month Payoff: Why Breadth Beats Indices

Most investors focus on indices like the S&P 500 because they are comfortable and familiar. Parker argues this is a failure of system design. An index is an average, and by definition, it mutes the very trends that produce wealth. By trading individual stocks rather than indices, a trend follower gains breadth, which is the ability to capture idiosyncratic moves in specific sectors while others remain flat.

This creates a competitive advantage because it requires patience that most participants lack. When the system is struggling, the temptation to fix the process is high. But the data suggests that the only way to capture the next renaissance in a sector like cocoa or energy is to stay in the game, even when the immediate feedback is negative.

Key Action Items

• Audit Your Allocation: Move beyond the crisis alpha narrative. Evaluate your trend-following allocation not as a hedge, but as a primary growth driver that captures outliers. (12-18 month horizon)
• Embrace Volatility on Winners: Stop trying to prevent profits from turning into losses. If you cut winners too early to lock in gains, you are systematically destroying your portfolio's skew. (Immediate implementation)
• Increase Market Breadth: If your strategy is limited to indices, you are trading an average, not a trend. Look for strategies that apply systematic rules to individual stocks or a wider array of global assets. (Over the next quarter)
• Abandon Smoothness Targets: Stop optimizing for Sharpe ratios. High Sharpe ratios often correlate with the elimination of the very outliers that drive long-term compound annual growth. (Immediate implementation)
• Stay the Course During Drawdowns: Understand that underperformance is the entry fee for capturing the next big trend. If you cannot hold through the fire, you will not be there for the recovery. (Ongoing investment discipline)