The track record of most succesful hedge funds suggests that systematic trading out performs discretionary trading over the long run. The difficulty with discretionary trading as we have discussed in prior articles is that it’s hard to repeat the trading process consistently.

Traders who have tried to implement a trading system will confirm it takes a lot of disicipline to implement a trading system. It’s especially difficult to implement a single market trading model. All trading models will at some stage go into a drawdown phase, even if you are trading 2 or 3 models on 2 to 3 instruments. At some stage these models will go into the kindom of drawdown land and you may lose confidence in your models.

There will always be drawdowns, in fact most hedge manager including oursleves at Solas Financial spend quite a lot of time in drawdowns i.e. we do not make higher highs on our equity every day or every week.

Good systematic hedge funds strive to drive alpha but keeping drawdowns to a mininium. In our view the real measure of a money manager it to define risk as function of drawdown vs returns. Lets look at hedge fund manager A who delivers a 12% year with a drawdown of less than 3% and manager B who delivers a 20% return but suffered a drawdown of 20% during the same year.

Manager A is a far better hedge fund manager when measured on a risk adjusted basis. Manager B delivered a higher return but how did Manager B’s clients feel when they were 20% down. Manager A’s clients experienced a much more pleasant journey. The same process should be applied to your own trading – design your trading plan to never deliver a drawdown that causes sleepless nights or put you in an emotional place which causes you to question your trading stretegty.

How do good managers deliver good risk adjusted returns? In our view the magic sauce is a portfolio based approach using multi strategies, multi instruments trading with very small allocations of risk to each trade.

Often you will see capital allocations adjusted to the style of trading that is most likely to produce results in the current trading climate. For example in the 3 months to the end of 2011 – trend following or volatility models performed poorly whereas mean reversion models performed very well. A hedge fund who was running all 3 trading styles probably made profits during this difficult period.

More on portfolio trading in future articles.