As Chesapeake Capital founder, Jerry Parker, reflects on 35 years of systematic trading, his approach remains faithful to the lessons taught by “Turtles” Bill Eckhardt (interviewed by THFJ for issue 136) and Richard Dennis. As part of Eckhardt and Dennis’s famous Turtle Trading experiment, the erstwhile accountant (and 19 other successful applicants who passed the Turtle training programme) received $1 million to trade in January 1984. At the age of 25, Parker moved from Virginia to Chicago to take part, and recalls most of the Turtles making 150% per year, four years in a row, with big risk, volatility and drawdowns.
“The great training, experience, and encouragement made this the most amazing job ever,” he recalls. “Your client was your mentor, and you did what you were taught, when you made money and when you lost money. These guys were geniuses using computers to back-test models”. He left with a track record that allowed Parker to set up Chesapeake Capital in 1988, with $3 million from the first client. “All I needed was a telephone and a quote machine, and we were fortunate to make money ten years in a row. The markets were better and more trending.”
Chesapeake never dialled down its risk to the same extent as some CTAs, including some in Europe, which reduced their volatility in two main ways, diversifying into non-trend strategies, and starting to target volatility. Parker has eschewed both.
He has always espoused the purity and objectivity of his trend-following strategy, summed up pithily as “trend following plus nothing – forever”. He declares, “I do not want to get distracted by short term trading, carry trading, pattern recognition or mean reversion”.
Parker recognises that targeting volatility is popular with some investor groups – and has helped European CTAs to eclipse US CTAs in terms of assets (contrary to the rest of the hedge fund industry where US managers account for around 70% of assets). But he argues that the practice is not consistent with the principles promulgated by the Turtles. Parker perceives volatility targeting as a way of taking lots of small profits, which enforces premature profit taking in cases where trends continue – the diametric opposite of how Turtle trend followers let winners run. Chesapeake has averaged a standard deviation of around 15%, but this has moved around, and a cap would cramp the firm’s style. The typically “long volatility” profile of trend-following means that volatility tends to be higher during profitable periods.
Conversely, during a losing period, Chesapeake’s exposure to the markets can decrease since positions likely are getting stopped out which is expected by following the system. The firm has limits on leverage and uses a market’s volatility to define a trade. “We are upfront about being very negative on volatility targeting given our trend-following beliefs.” Some clients prefer a lower risk profile, and Chesapeake does offer a programme for those that desire this.
Parker even argues that volatility targeting can, perhaps paradoxically, lead to increased risk. “Volatility targeting reduces the profit per trade,” he suggests. “If the average profit per trade falls, position sizes need to grow, increasing risk.”
Parker further contends that, “volatility targeting causes crashes and instability in markets”. Indeed, targeting constant volatility or Value at Risk (VaR) can be viewed as a form of “pro-cyclical” behaviour that amplifies market cycles by encouraging traders to ramp up leverage in calm markets, and then forces them to deleverage when storms come.
Trend following plus nothing – forever. I do not want to get distracted by short term trading, carry trading, pattern recognition or mean reversion.
Some CTAs also employ a discretionary risk management overlay. Parker has stayed close to 100% systematic but concedes “if something happens that is really crazy in a high volatility period, you can take some positions off”. Still, he reflects, “one reason for my success has been sticking to the rules as much as humanly possible. When I overrode the models to reduce risk, it rarely worked out in the long run. Most of what we were taught was absolutely brilliant in terms of the basic framework. The Turtle trading rules provided the foundation for an amazing career in trading, and I did not find anything better”.
The overriding theme of the methodology used by Chesapeake has not changed since the 1980s. “We use a classic trend following model without too many moving parts, or optimisation parameters,” he says. “We do not try to extrapolate too much from the past. This is the opposite of Big Data, which takes in as much data as possible and tries to be very accurate. Trend following is very inaccurate in most trades lose money”. Parker is wary of “data-mining” and “over-fitting” as those can be pitfalls of some more complicated approaches.
The optimal periodicity for trend following trades has changed. Argues Parker, “the biggest change was that we needed to become longer term to succeed as short-term trend following stopped working in the late 1990s. It is difficult to compete in the short-term space with slippage costs, so our average holding period has extended to an average of one year. Therefore, the way in which moving averages and breakouts were measured has also changed.”
The underlying reason for moving to slower models was, “overcrowding and computer trading, leading to choppy markets that resulted in us getting whipsawed. We would get out of a long, which would then go back up, requiring us to get back in. There is a cost of short-term trend following that prevents you from participating meaningfully in a long-term trend,” explains Parker, who has stayed in some trades for as long as three, four or five years, if market trends persist in the right way. “Over the years we have refined it so much that the systems attempt to stay in the long-term trends and do a good job of not staying in too long,” he continues.
These longer-term holding periods reduce trading costs, namely, transactions costs and slippage. “We have a big edge from not trading frequently. At the same time, we could enter in the morning and get stopped out in the afternoon if the markets became very volatile,” he says. Parker himself finds it easy to access good liquidity and execution in today’s mainly electronic markets – a far cry from the open outcry pit markets in Chicago where Dennis and Eckhardt cut their trading teeth.
Parker’s approach to trend following has also evolved in terms of its investment universe as he has started trading single stock futures over 15 years ago. Chesapeake has selected a universe of around 40 stocks diversified across sectors. “Money management is used to size positions to give as much diversification as possible, not based on market capitalisation weighting, so we get more diversification,” he declares.
On a personal level, Parker has also traded trend following strategies focused purely on equities. The same systems apply to the equities as the other strategies.
Like everything else Chesapeake trades, the stocks can be traded from the long or the short sides, though in certain years, such as 2013, most all stock positions were long. These long single stock exposures explain a large part of why Chesapeake markedly outperformed the wider industry in 2013; Chesapeake also had a strong 2014, in common with most trend-following CTAs. Chesapeake is the sub-advisor to the Equinox Chesapeake Strategy Fund, EQCHX, which has an overall five-star rating from Morningstar Rating, based on its three- and five-year performance as of September 2018, in the managed futures category.
But equities have become less important over the last two years as the US equity market rally has had rather narrow market leadership, with the technology complex driving the market higher. Parker admits that his single stock positions – which now include some flat positions (ie no position) and shorts – have not kept pace with the S&P 500, but he wanted to stay diversified. By October 2018, the strategy had exited, and taken profits on some long stock positions after price retracements, and thereby reduced the weighting in individual stocks.
But the long run rationale for trading single stocks remains clear. “Most CTAs trade equity indices. We trade single equities, which have the best trends and offer more chances for large moves. Individual stocks can rise hundreds of percent, just as commodities did in the 1980s. Currencies, commodities and interest rates have not recently had the same trends as single stocks,” he says.
Chesapeake has selected a universe of around 40 stocks diversified across sectors.
This is important, because trend following is a “convex” strategy where the win loss ratio is much higher than the hit ratio. Chesapeake has an average hit ratio of 40:60, losing money on the majority of trades, and a win loss ratio of 3:1, but these winners’ profits are heavily skewed towards a minority of trades. Typically, 10% of trades not only make most of the profits, but also pay for many small losses.
This – combined with the wild gyrations in the above statistics – is why most humans find it so difficult to adhere to the discipline of following trends. “This is where behavioural finance comes in. It is painful to lose most of the time and waiting and waiting for big winners. This is the most frustrating thing possible, so most traders would prefer a strategy that reliably makes 1% per month,” says Parker. “Traders can miss big profit if they are too quick with their exits. Long term trend works well because it goes against human nature” he adds. Behavioural finance also teaches us that loss-averse investors find it hard to cut losses, and also fail to run winners.
The simplest rationale for trend-following is that, “I have said the same thing for many years. The world is a crazy place. All the time we see things we have never seen before driving markets. The world in general shows non-normal distributions, with large positive and negative outliers. We are happy to take small losses that attempt to eliminate the big negative outliers and hang onto the positive outliers – through both long and short trades. Our methodology is to eliminate the negative returns, and allow the positive returns to go as far as possible, without any preconceived idea of how far a market can go. CTAs are probably going to make good money in markets when things occur that have never happened before”.
This means that trend-followers do expect to profit from asset class and market “bubbles” and “busts” alike, although long positions have contributed more over time. “Historically a long trade is better than a short one, but every now and then we will hit one like crude oil in 2014 that dropped from 90 to 20. But usually the shorts are just about diversification,” says Parker.
I have spent a life time trying to make my trend following approach better... If the market says I do not get an incentive fee, then I am fine with that.
The historical propensity of trend-following CTAs to profit during crises has contributed to the term “crisis alpha”. Parker expects that, “CTAs should do well in an extended bear market, such as 2008, but clients should not count on CTAs to perform well during shorter term corrections, such as those seen in February and October 2018. We may be short stocks in the next crash but it’s just not something that is reliable”.
Indeed, most CTAs, including Chesapeake, trade multiple asset classes. Chesapeake typically has 25% of its risk in each of equities, currencies, commodities, and bonds/interest rates, so clearly trends – or the lack thereof – in the latter three asset classes, typically making up 75% of risk, can matter more than price action in equities. In October 2018, Chesapeake’s largest asset class exposure was in currencies, where the US Dollar has demonstrated pronounced uptrends versus other currencies like the Swedish Krona and Chinese Renminbi.
Even so, for long term investors, what counts for more than performance during equity market pullbacks is the multi-decade pedigree of the strategy. “Historically, we have made more money than the stock-market, but with less risk, and we expect to do so in future,” says Parker.
Though Chesapeake has outperformed the average CTA over the past five years, the industry has generally seen returns decline as Parker observes liquid futures markets not trending as well as they used to. We know of no CTA that has recently come close to the types of returns generated in the 1980s, or even the 1990s. Parker is often dubbed as being the most successful Turtle and thinks this is probably true in terms of asset-raising, which peaked at $2.5 billion.
Chesapeake currently trades only futures. Parker acknowledges that some CTAs have ferreted out stronger trends by trading less well followed, non-futures, over the counter (OTC) markets. Yet he worries that, “liquidity may be the biggest issue with these markets. I am all for adding markets so long as they have enough liquidity”. Chesapeake has expanded its investment universe over the decades, from around 20 markets in the 1980s to around 120 today, including somewhat less liquid commodities such as feeder cattle, palladium and cotton.
The extra markets have added to liquidity and scalability but not all of them have provided meaningful diversification. “There is a lot of overlap in correlations, so there are probably only about 50 unique drivers of returns” says Parker, who is on the lookout for new markets: “For example, I am fairly sure that some of the Chinese futures markets could add further diversification to the portfolio”.
Though more markets are traded, Parker’s style of trading has had minimal changes and the team has been very stable. The core people, Head of Research, Mike Ivie, and Head Trader and President of the Company, Anil Ladde, have both been with the firm for over 25 years.
Parker has seen his client base shift dramatically. Having started with managed accounts charging classic hedge fund fees of two and 20, for minimum tickets of tens of millions, he now sub-advises on a CTA trend following US ’40 Act mutual fund, which charges only management fees and no incentive fees. Individuals with low to medium net worth as well as high net worth are now the client base. “We trade in exactly the same way as we would for a large SMA or LP,” confirms Parker.
The aforementioned CTA trend following US’ 40 Act fund is called the Equinox Chesapeake Strategy Fund. The fund’s advisor is Equinox Funds, and since the fund’s inception (September 2012) it has been a consistent top performer among its Morningstar peers.
Parker actively discusses CTAs, financial markets, investment research and academic research on social media, where his twitter handle is @rjparkerjr09. Most twitter accounts abbreviate views, but with Parker, the readers may find his twitter feed further elaborates on some of the points mentioned in this article.
As the interview draws to a close, he declares, “I have spent a life time trying to make my trend following approach better. I would much rather refine the trend following and be an expert in it. If the market says I do not get an incentive fee, then I am fine with that. Regardless, I will always manage my own money in the manner described”.