In the Beginning there was Trend Following – A Primer – Part 6

Trend Following Primer Series – The Search for Sustainable Trading Models – Part 6

Primer Series Contents

The Search for Sustainable Trading Models

In our Primers so far, we have touched on some of the central arguments for why we need to pay respect to these amazing complex systems we call financial markets and adopt a very humble stance, as opposed to a controlling stance, in how we interact with them.

We are active participants in that system and not Gods looking from outside-in, who have no role in influencing outcomes. We actually shape the outcomes.

Each of us have our own knowledge cone that extends into the market domain and base our actions on what we interpret to be the reality. This knowledge cone is always limited in extent but it defines what we infer is ‘the reality’. Based on our limited access to this reality we impart our knowledge into the market and slightly expand this domain further.

From a trend followers viewpoint, we are philosophical relativists who are sceptical in assigning any form of objectivity to the ‘things’ we observe. We suspect there is more to it than the state of our knowledge.

We believe that our understanding is a two-way relationship between the observer and the observed and the extent of the domain (or context of this relationship) is what appears to us as cause-and-effect. This however is just a single perspective or symmetry of a much wider viewpoint taken by every participant. The way we interact with the system shapes our perceptions of it.

This tendency we like to have as humans to assign ‘objectivity’ to this narrow ‘knowledge’ domain makes us ignore or suppress the small things we deem immaterial whose relationships may extend out into a wider possible domain which in a wider nested emergent context, may have pivotal consequences to the illusory domain we think we understand. This can lead to catastrophic failure in our ‘predictive conclusions’.

While trend followers adopt a similar approach to the Efficient Market Hypothesis in the way we interpret information being ‘injected into an all-knowing market’. We drop the notion of ‘rational participants’ and replace that notion with ‘limited participants’ whose knowledge comprises simply what is ‘known’ about the system we interact in. Our limited knowledge results in us taking action which may only be a half truth about the state of the ultimate reality.  This has dramatic consequences to the conclusions made by the EMH. It means that there is arbitrage associated with the ‘error’ that exists in the information we inject into the market through our trade actions. This is where the edge resides for trend followers in this zero-sum game. The edge arising from simply adopting a rules-based process that ‘over-rides our desire to predict’.

This illusory reality we are forced to trade within therefore makes us very uncertain traders.  We assign our understanding of things to simply a limited viewpoint surrounding our propensity to like to classify and objectify stuff. We understand the reality of a complex system is far deeper than the constituent parts and relate to the way these apparent ‘things’ (which are really just emergent processes) are deeply connected.

How we Approach Risk

We adopt the viewpoint that conventional risk treatment and assessment adopted by industry is severely limited and does not truly express the total path of possible market states in which risk is known to lurk. As a result, we have the opinion that the subject of risk needs to be broken down into the risk that can be quantified through our ‘state of knowledge’ and the risk that cannot be quantified and relates to that broader domain for which our current state of knowledge is yet to expand into.….called uncertainty.

I remember when I was cutting my teeth as a ‘Fund Compliance Manager’ in the 1990’s and was presented with a risk matrix used to assign risk in quantifiable terms to those Investment Managers (IMs) seeking solace under our ‘Responsible Entity’ structure in Australia. The matrix was a template that encouraged the assessment of IM risk in quantifiable terms by weighting the ‘likelihood and consequence’ of risk events derived from reviewing their processes. It used to make me laugh. Was I a ‘God’ that had this amazing foresight and ability to quantify the unknown? Unfortunately, I was bound to the rules of Regulatory Compliance and was forced to complete the matrix….and while at least the process forced me to ‘consider’ possible risks it more frighteningly made me acutely aware of the industries inability to measure risk. I could not help but feel that lurking within this process was a ‘failure event’ waiting to happen.

By viewing risk in limited ‘quantifiable terms’ using proxy metrics such as Risk Matrices and the Sharpe ratio, or indeed any risk metric that is riddled frequently with Gaussian bias, trend followers feel that we are grossly understating the possible risk that lurks in a trading technique.

We do not assign blame to this viewpoint but rather treat it is an overly simplistic interpretation of a wider reality which is a natural consequence in the way we use a limited brain to understand complex systems,

We are swayed by the powerful inductive reasoning of mathematicians and philosophers who challenge conventional reasoning such as Mandelbrot and Taleb whose words deal in non-linear terms.

We need to pay heed to the risks of uncertainty and not simply sweep them under the carpet as being, too hard to fathom. These events are the real windfalls or catastrophic failures we see in the history of complex systems. These non-predictable punctuated events of a material nature, are the real stories of the history of complex systems. These fat tailed events change the emergent structure of the complex system permanently and are the major transitions we either need to worry about or have fantasies about. They are the real game changers that quickly decide who the losers and the winners are in this game.

As trend followers looking for the  ‘big prizes’, we believe that the change associated with ‘predictable’ events arising from an interpretation of what is ‘known’, are small pennies when compared to the possible massive change associated with events attributed to the unknown (or the fat tailed event). The small change arising from normal day to day price variation are an inevitable perturbation that we as ‘risk managers’ already have a firm grip on. We need to embrace this change as this is an inevitable consequence arising from striving to make opportunities in that domain of the unknown where big changes occur and where our fortunes await. If we worried about that inevitable volatility that resides in the ‘known’ and sought perfectly linear equity curves for each return stream in our portfolio, then we would never leave ourselves open to the massive windfall that can arise outside this known zone of perturbation in the unknown domain. That zone where the outliers reside.

In fact, our whole modus operandi is couched in terms of trading the risk events associated with uncertainty and avoiding those risk events associated within this narrow domain we ‘believe that we know’. We embrace the ‘volatility of the known’ and lie on the verge of the Gaussian envelope waiting to pounce on opportunities in the unknown domain.

We view the success of trading strategies in terms of the way they have responded to a myriad of large and small risk events and simply let profits arise from letting financial markets do what they do. We disregard the illusory stability of nice ascending linear equity curves and the future promises of high Sharpe ratios. You see, we believe that such narrow-minded treatment of risk is the fundamental issue that ‘biases’ the way we as humans select our preferred trading strategies or allocate capital to portfolios.

It’s All About Survival (Robustness)

We prefer to think that we, as humans, actually have it ‘mostly’ wrong so in evaluating the Managers who are less wrong than others, we use the long-term track record as our basis of distinction. There is no better way to assess the risk of a trading strategy than through the long-term track record itself. Being a survivor is the key metric we use as a basis to assess the relative strengths of a trader. Being a survivor is also a legitimate way to assess how a trader has been able to adapt to changing market conditions which are an inherent feature of any complex system.

‘Adapt or die’ you might hear being used by traders in these markets. Well surviving is all about the ability to manage known and unknown risk events and still be alive to tell the tale and we feel it is the only real method to assess the sustainability of a trading strategy. We do not need any fancy risk metric that is used as a proxy to assess the ‘riskiness’ of a trading technique and only assesses risk in Gaussian terms. We prefer to use the performance track record itself as our most valid risk management metric or in its absence, the long term back-test. It is the entire track record itself that exposes risk weaknesses that are not necessarily ‘seen’ by simple risk metrics. We pay more attention to ‘maximum single points of weakness’ such as the maximum drawdown than single holistic statistical risk measures such as the Sharpe ratio, Sortino ration etc. which give us a more subdued version of the possible risk weaknesses that lie in a return stream or a portfolio.

This track record and the long term backtest provides a ‘warts and all’ story to assess how a manager has fared against the known knowns, the known unknowns and the unknown unknowns. Thank you Mr Rumsfeld.

The secret to a long trading career is based on a notion of ‘survivability’. While many traders can experience periods of hedonistic bliss over a short time duration when markets are behaving according to their trading plan, no trader can prosper using a single technique across all possible market conditions.

There are inevitably those times when markets simply do not behave according to your plan and your success as a trader is defined by how you protect your hard-earned capital during these unfavourable market conditions.

Being a market survivor means that you can survive the unfavorable but are always able to participate in the market when conditions become favorable. The surest way to kill a trader’s prospects of generating wealth from the markets is to prevent them from being a participator. So, a key goal for any trader who enters this game is in learning how to manage risk and protect your finite trading capital. There are simply too many ways for you to lose your capital in these highly efficient, competitive, and non-stationery financial markets.

It is this principle of survivability, also referred to as robustness,  that allows you to stay in the game for the long haul and be able to capitalise on those opportunities that are favourable to your trading plan.

Markets are prone to change their nature and profiteering is simply a small part of the bigger problem when markets change their state. The true mastery of the markets lies in the way we manage all possible risks.

Now many readers might infer we are ‘scaredy cats’ who jump at shadows and should be concerned with everyday risk and not worry about ‘all possible’ risks as they are impossible to quantify, but we have a novel way of dealing with ‘all risks’ that ensures we are never left straggling in the adverse tail of the distribution of market returns. We always cut losses short. This simple technique is not a method to quantify risk, but rather a process that ensures we are never blind-sided by it.

Of course, the reality is that in our application we apply initial stops and trailing stops to all our divergent trading strategies and only apply small risk bets to each solution in our diversified portfolios, but this is not for the reason that most traders think. Such measures do not guarantee protection when the market gets angry and simply ignores these paltry tactics. During major tail events, liquidity becomes a major issue and frequently we find that our risk mitigation methods are simply ignored.

The actual reason we apply these measures is to ensure that at the global portfolio level, the warehoused risk that lies in every return stream is ‘released’. This means that no return stream is likely to bring down the whole portfolio due to some unforeseen risk event. By continuously ‘releasing risk’ from the portfolio through trade exits we don’t hang onto to risk. We let it go. This means that our portfolio is always ‘optimally configured for ‘Future risk events’ and is not holding onto risk from the past. This is what gives us robustness and allows us to fight the uncertain future with confidence. It is not the risk of the past that should worry us, it is the uncertainty of the future. We discuss this in a later Primer in terms of a Portfolios ‘Responsiveness to Change’ which is a key element of what it means to have a robust portfolio.

Having risk mitigation mechanisms does not guarantee that we can address all risk, but it certainly ensures that we are more robust than alternative methods that disregard these mechanisms. This is what survivability is all about.

Under uncertainty, it is not the profits we need to be concerned with as they are a natural consequence arising from how the markets behave. Rather, being a survivor is always about being able to participate in these ‘profitable events’. To achieve that, we need to be around to participate in them.

To have a long term track record is the way to choose between the ‘scams’ and the legitimate prospects. There are many ways that we as humans can conceal the underlying risk that lurks in all trading strategies.

We deploy devilish methods to conceal risk such as the use of averaging down into losers, avoiding mark to market valuations, showcasing equity curves during only favourable market conditions, providing curve fit backtests that respond to a single market condition and applying no protective risk stops or trailing stops to trades. All used to provide a false sense of security to investors or indeed ourselves that capital is being prudently managed and that we are ‘good traders’.

There are a myriad of clever ways to obfuscate the inherent risk that lies within all trading strategies and we refer to these techniques as methods to ‘warehouse risk’.

Unfortunately, you do not hear this term bandied about industry that much, as it implies that there is something about risk that we do not know about. Indeed, there is. There is always the risk of uncertainty.

Who are the long-term Survivors that we can learn from?

To save yourself from the classic trap that meets many novice traders, just like entering any profession, it is very wise to undertake extensive due diligence and learn from the successful traders with a validated long term track record. These are the ones who are around to tell the tales of the events surrounding past storms of uncertainty.

By undertaking this trading game from the start by first learning from the top traders in this game, you can save yourselves many years of wasted time and lost opportunity. Having an appreciation of the sustainable returns that are enjoyed by professional fund managers with a long-term track record will not only allow you to jump onto the shoulders of the giants in the industry but it will also  allow you to establish more realistic benchmarks that you can work within with your own trading endeavours.

It is very unlikely that a retail trader will outperform these top ranked long-standing funds in the world, so it provides a useful benchmark to establish ‘realistic’ expectations that a trader can work under without over-extending yourself and making yourself vulnerable to catastrophic risk of ruin.

For the vast majority of retail traders, most are very unlikely to survive more than a few years and even for those that manage to escape the lessons of the market with a track record greater than a few years, there is no guarantee that it was not luck that allowed them to survive the day. You see there is so much room for luck in an efficient market that it might take many years for a trader to realise that they never actually possessed any ‘real trading edge’ in the first place.

An examination of the successful Fund Managers with a long term track record allows us to identify trading methods that have a better chance of standing the test of time and provide much needed clues for a retail trader seeking a sustainable track record in trading these financial markets.

Now an examination of the literature is a bit deceptive as I simply could not find a listing of ‘the best long term hedge fund managers of the world’. There were a few listings of some solid performers over some time horizons, but a listing of the best long-term performers was peculiarly absent. I suspect that the reason for this absence in the literature lies partly in the ‘secrecy’ of these cherished institutions but also suspect that there are actually only a very small number of FM’s that can boast such a long-term track record.

There is no point considering those FM’s that simply seek to outperform an Index and do not focus on ‘absolute returns’. Evaluating these FM’s does not bring you any closer in understanding what survivability is about. It simply kicks the can down the road as you then need to compile these ‘Index Performing’ funds into a portfolio to see how it might be possible to generate ‘absolute returns’ from this amalgam.

I did find a useful Appendix in Greg Zuckerman’s excellent book “The Man who Solved the Markets” that has made a bold attempt of creating a listing of the best of the best in terms of absolute returns, but the information was limited.

Table 1: Absolute Return Comparison of some of the Most Successful Hedge Fund Managers in the World (after fees)

Source: Gregory Zuckerman: “The Man Who Solved the Market – How Jim Simons Launched the Quant Revolution” – Appendix 2

Now as limited as the information of Table 1 is, it should at least make you question the % returns that are bandied about in the retail world.

These top performers are not simply one-man bands. They have entire legions of quants, mathematicians, programmers, and physicists in their composition. Are we, as retail traders, seriously considering that we might out-perform them? Time to see your local psychologist if you think that is the case.

If the best in the world offers a net return (or Compound Annual Growth Rate) of 39.1% over a 30 year plus track record, then this should at least create the upper level of realistic expectations within which we as Retail Traders can work within. While chants of 100% per month or year can be heard in the retail trading forums of the world,  this may be possible, as nothing is impossible,  but reality makes us conclude that even if such returns are achieved, luck with excessive leverage forms the basis of them. They simply are not sustainable metrics and are more likely to crash and burn when conditions become unfavourable.

As traders rather than gamblers, some of us want a sustainable career for life. If that is your desire, then pay attention to the industry benchmarks, learn from the best in the world and work within realistic expectations.

Now I would like to go farther in my due diligence of the best FM’s in the world and in particular look at aspects of risk as opposed to mere performance returns. Even though this list boasts FM’s with a long-term track record, there is still a chance for chance and over-leverage to have a say in the matter.

What I would like to find is not simply a handful of ‘the best players’ who use different approaches to target alpha in the market, but rather a whole class of very successful long term traders who apply a similar trading philosophy and clearly can be seen to manage risk within my risk tolerances.

I found an article on my due diligence search by Daniels Trading in April 2010 that really caught my attention. It was titled “Beating Warren Buffett – Can your Investment Manager Beat Warren Buffett’s Berkshire Hathaway’s Stock Performance over the past 10 years?”

Now everybody knows Warren Buffett, and I thought to myself, what a great question? There is only one Warren Buffett, but imagine if we could find an entire class of FM’s that produce comparative performance who I could mimic in my trading endeavors. Isn’t that an easier path, jumping on the shoulders of giants, than trying to “reinvent the wheel”?

As I read on in this article I wasn’t disappointed. Table 2 below was presented in that research.

Table 2: Comparative Performance between Berkshire Hathaway versus Trend Following CTA’s

Have a close look at Table 2, You will not only see how Buffett over the 10 year period has been outclassed by a large number of CTA’s, but that these CTAs are trend following firms that apply traditional trend following methods that are the subject of this Primer series.

But there’s more. Have a look at the risk metrics that are included in Table 3. Not only were performance returns exceeded, but the drawdowns incurred to achieve those returns were far lower on average by the CTA’s.

Table 3: Comparative Performance and Risk Metrics between Berkshire Hathaway versus Trend Following CTA’s

Let’s now update this paper and undertake our own assessment since 2000 to the current day, using available data from Nilsson Hedge and Yahoo Finance to see if this performance track record continues to today.

Table 4: Comparative Performance Metrics between Buffett and the Trend Following CTAs 1st Jan 2000 to 31st March 2021

Chart 14: Comparative Equity Curves between Buffett and the Trend Following CTAs 1st Jan 2000 to 31st March 2021

Table 4 and Chart 14 continue to demonstrate that a large majority of the top performing trend following CTAs are comparable to and even outperform Berkshire Hathaway in terms of CAGR and more importantly continue to offer far better risk adjusted metrics using the MAR ratio. This ratio is a reflection of the annualised return versus the maximum drawdown experienced by the Fund over this time horizon. You can see from Table 4 that Berkshire Hathaway had a maximum drawdown of 44.5% over this time horizon whereas all CTA’s produced comparative returns with far  lower drawdowns.

But you want more don’t you? After all, there are a whole host of well-established long-term trend following firms to choose from that deliver superior risk adjusted returns to their clients without significant ulcers. How about some of our favourites that you may find on Twitter offering their sage advice such as remnants of the league of surviving “Turtle Traders” such as Jerry Parker’s Chesapeake Capital and also other Twitter favorites such as Niels Kaastrup-Laarsen of Dunn Capital fame. It really pays to listen to them diligently. They speak from years and years of experience surviving these markets. Unlike the more secretive ‘black box hedge funds’, these guys are more than willing to share their sage advice. Isn’t it just logical as aspiring retail traders that we should want to learn from them?

Table 5: Comparative Performance Metrics between Buffett and the Trend Following Favourites 1st Jan 2000 to 31st March 2021

Chart 15: Comparative Equity Curves between Buffett and the Trend Following Favourites 1st Jan 2000 to 31st March 2021

So what does this due diligence tell us?

It tells us that we do not need to be rocket scientists or have a legion of mathematicians and physicists at our disposal to build wealth building returns. We just need a diversified systematic trend following approach to trading these markets and enduring patience in this robust method.

We do not need to reinvent the wheel at all in our trading approach. We can learn from the best and simply mimic their techniques….but we do need realistic expectations and a firm grip on what it takes to be a survivor in these fickle markets.

When it comes to wealth building over the long-term, a long-term track record of performance success is perhaps your most reliable guide for an uncertain future. No-one knows what the future will bring…but at least we know from the validated track records of these long-standing managers that they are no strangers to taking uncertainty by the horns and delivering absolute investment returns for their clients.

Stay tuned for our next instalment in this Primer Series.

Trade well and prosper

The ATS mob

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