Trend Following Diversifies and Mitigates Risk

Jerry Parker, founder and CEO of Chesapeake Capital

EXTRACTS FROM THE TOP TRADERS UNPLUGGED PODCAST, EPISODE #065

Niels Kaastrup-Larsen in his podcast, Top Traders Unplugged, interviews some of the most successful hedge fund managers in the world. In the following extracts he speaks with Jerry Parker, chairman and chief executive officer of Chesapeake Capital, a CTA based in Richmond, Virginia. Parker started his trading career in 1983 as an exempt commodity trading advisor for Richard J. Dennis, in his “Turtle” training programme, and Parker has overseen Chesapeake’s operations and its trading since its inception in February 1988. The full interview can be found on the Top Traders Unplugged website.

Niels Kaastrup-Larsen: Welcome Jerry for this review of 2014, where we look at the big events from the point of view of your trading strategies. I want to explore the ups and the downs as well as the big takeaway from what only can be described as a great year for systematic trading strategies, in general. But as we know, just because you’re systematic, it doesn’t mean necessarily that your trading strategies deal with market events in a similar way. So I’ll be excited to hear how you fared. But let’s just jump right into it. Tell me about 2014 from your perspective: how did the year evolve both from a trading point of view, and maybe from your firm’s point of view?

Jerry Parker: Well 2014 was another nice year, and the trends were there and persisted in a lot of the different sectors. It’s always better to have a lot of nice small moves, or a lot of nice moves in lots of different markets, that allow us to make a profit from our trading strategy; that trades over 100 markets, and has relatively small positions on in lots of those markets – and we get the great diversification on the upside and the downside. A great year in the dollar again, where we were able to participate in a lot of the currency markets that better fitted our trend following. Our trend-following approach benefited from the good move in the dollar.

We were able to do decently in the stock market, trading a medium to long-term approach. We didn’t get knocked out of all our stocks in the middle of October, so that was a contributor. The single-stock futures added some diversification and some spice to the index trading as well. And, of course, the energy markets were fun to trade. It’s always fun to participate in markets where the popular press and the conventional wisdom are caught off guard, with rates continuing to go lower. Those trends kept going, and then short energies caught everyone by surprise. I suppose I sold that crude, heating oil, unleaded, etc., break-out many times over the past four or five years. I was as surprised as anyone to see this one break from 90 to 40-something – so that was good. And then just to show that we are very intent on our diversification, we’ve traded cattle for a long time. Feeder cattle were nice contributors to performance also.

NKL: Yeah, it’s important to see these different markets kicking in at different times. And I do agree, certainly the energy sectors have been difficult for a long time, and finally we got a break-out. I’m going to remind the audience that I believe that this is actually your 24th, out of 27, years of trading that was profitable, if my memory serves me right here – congratulations on that! For the benefit of investors, in general, do you happen to remember roughly where you started getting short crude oil, because it has been such a big theme? It would be interesting to share roughly where systems like yours and probablyall other trend-following systems actually started to detect that this could be the beginning of a move. Obviously we don’t know how big it was going to be, but certainly a beginning of a move to the downside.

JP: Yeah, well I’m just reminded of a Paul Jones quote about shorting the Japanese stock market or shorting the US stock market in 1987 – that it was a great trade but his fifth try. This is at least my fifth try over the past few years of getting the crude trade right. October 7th looked like a likely place to start really getting interested in crude – nothing special about that breakdown and those lows – but it just kept going, and unleaded, and gasoline and Brent, and gas oil. We traded as many of those energies as possible – a great trade, so far.

NKL: I guess it’s not something that we obviously look at. But obviously in the years that are profitable, I guess that it’s equally as important to look at things where you say, “Well you know, maybe we could have done a little bit better here.” So clearly there were a lot of trends that you captured well. Was there anything where you said, “Actually I’m surprised we didn’t do better in this particular market”?

JP: I would say that I understand, but I’m continually surprised at the failings of our methodology, our systematic approach we’ve decided to trade, which is the medium to longer term, basically a choice of hanging in there and trying not to get whipsawed around too much, and profit from the long-term trends. I would prefer to trade very short-term if I thought it was the right thing to do. I would absolutely do it, of course. But something like coffee had a 50% gain. That’s just the type of trade that I think trend followers in general are not going to be able to get close to – a 50% gain. Because 50% from that low of 13 October, and then the big crazy rally up that got volatility going, and then the choppiness – it really wasn’t a good trend trade for our systems.

Natural gas is another one with a big spike in early ‘14, and then a crash down. If you’re going to be longer-term, we’re going to look really poor on a trade like that, that had a nice amount of open trade equity but was really just chopping around, and not going to go anywhere. We’re looking at trends that are going to last over multiple years or a year at least. So the recent Swiss franc trade that had a big huge move in one day is difficult also.
 
NKL: I want to talk about that in a second, but I think it’s good that you explain the thing about the coffee and natural gas, because often people will say, “Hang on, coffee actually moved up.” And I think it actually moved up about 100% at some point, and then it fell down and was up 52% for the year, and natural gas also had a big move. But it’s nice to hear from someone like you explaining that just because it has a big move, it doesn’t necessarily mean that we’re able to capture it, and I appreciate that.

Now you did mention one of the themes that I wanted to just quickly ask you about. Although it’s a 2015 theme, obviously 2014 was certainly going to be remembered by many people for the problems in Ukraine and the big oil trade that we’ve already talked about. And, as often, investors will associate this with negative events, and I’m sure a lot of new stories will come out about the move in the Swiss franc. So, just from a trend-following perspective, can you share a little bit about how you fared and dealt with a situation like that in the Swiss franc, both from a specific Swiss franc point of view, but also from a portfolio point of view as a whole?

JP: Yes, well I think that that’s a very good topic. A couple things come to mind. I think on that particular trade, some people were saying that they didn’t trade the Swiss franc, and it was fairly obvious to them that with this intervention, this would be something that proper risk management would dictate not to trade. So, unfortunately that was a surprise to me, so I was short the Swiss franc against the dollar, but long the Swiss franc against the euro. So actually, I ended up making money net on that particular move. I do think that there are so many markets now from what I read – I’m supposed to not pay attention to fundamentals of course but…

NKL: You still need to read to keep informed.

JP: Yes, that’s right. I mean, which markets, which financial markets, are not subject to government intervention these days? Should I quit trading the interest rates and not taking those trends? When is that big sell-off going to occur? Well, if I just trade in fear, you know governments are always intervening. I know someone said it wasn’t a natural state of affairs; it wasn’t a pure market; government was involved. Well gosh, I’m not sure if I can objectively quantify which markets over my past 30 years have and have not had government intervention. And a lot of people think the stock market is just a pretend trend also. So I think that a lot of the trend follower profits over the years have been on pretend trends, bubbles or whatever. It’s a question of getting in and riding the trend, and then your trailing stop moves up, and you pocket some of the gains.

NKL: But it’s interesting as a theme, isn’t it? Last year systematic trend followers had a good year, but there were no disasters in other financial classes like in 2008 where we had a big disaster in the world economy. So last year, to me at least, was positive in that trend followers just proved they’re good at capturing trends regardless of why they occur. Also, it’s not just about making money when everything is falling apart. But then we go into 2015. We have this big Swiss franc event, and what it shows me, because of what I’m picking up from my guests (but also from reading and seeing the news stories coming out) is that it’s not the CTAs that seem to have any problems with dealing with what happened. It would have seemed to be certain hedge funds, it would have seemed to be certain brokers, and banks perhaps. So to me, it just goes to show, again, going back to risk management, I know, from having known you for many years, how much importance you put on risk management.

JP: Exactly, and I think it’s important to understand and to have this risk management baked into the cake before these things happen. There’s little that you can do sometimes, and in fact sometimes the risk management on a daily basis can really hurt. There have been times when reducing positions in the middle of a drawdown ensures that you have a big losing month. If you had just waited a little bit longer, the markets came back. I think of 2011, where we had a big swing intra-month due to the Japanese nuclear disaster, only to see us recover.

So it’s always important, and I think the lesson of the Swiss franc is, trade an appropriate amount of leverage in your portfolio. Your target rate of return needs to be reasonable. Trade as many markets as possible, trade the crosses. I know in research sometimes the crosses are not nearly as good as some of the other markets. I’ve had clients tell me over the years, “I just always appreciate when I open up the Chesapeake account statement on a daily basis and I see all these cross rates, and you’re never having this sort of extreme hit or extreme win from just trading the outright”… the currencies that are just based on the dollar.

You know you’ve heard all the CTAs will size their trades based on volatility, and we size our trades based on the average true range (ATR). And in the euro/Swiss, the average truerange got very low. When a market’s volatility gets too low we use a minimum ATR.

NKL: Right. That’s important.

JP: Yes. If the ATR is extremely small, you can lose more than you had hoped. The euro/Swiss moved about 60 ATR that day, the dollar/Swiss about 20 ATR. Now if we had used the actual ATR at the entry point in the euro/Swiss, we would have made 200 ATR in one day. And so you say, “Well that was bad,  you left 140 ATRs on the table.” And I’m like, “Yes we did.” But it’s not a healthy situation, and you’re going to get your comeuppance one of these days if you take those kinds of risks.

NKL: But that’s what I like about it, Jerry: people often look at what this industry is doing, saying, “Oh, but it’s all a black box, and it’s just a computer doing the thing.” But I think also what it says is, there is always common sense. There is always someone behind the system that says, “No, this is crazy, you would never want to do that, because this can kill you one day.” And actually what’s also very interesting, and correct me if I’m wrong here, because I can’t imagine the euro/Swiss has been a good trade for the last three years to have in the portfolio, but you kept it in. Then one day it paid off for you. And I think that’s another interesting lesson to learn. Just because you have a market that doesn’t profit or give you anything in return for a while, it doesn’t mean that it’s never going to produce for you.

JP: A couple of years ago, right before one of my clients fired me, I visited them, and they really gave me the business over this euro/Swiss trade. “Why do you have these trades? Why are you using margin? It’s not going to go anywhere; it’s just a waste of your time and energy.” I remember when I first started trading the currencies, the cross rates, many years ago. I would talk to the brokers at the banks and they would say, “Well there’s no use in trading some of these European crosses, because the governments have a band.” I said, “Well watch me.” I don’t believe in these bands. So I think that I have to take a more moderate approach to these, that, yes, eventually the free markets will explode to where they need to go. I think we need to be a little more concerned – or I do – about these moves. This is by far the worst thing that could possibly happen to trend followers, because there’s no way to defend yourself.

NKL: A lot of people have done their calculations of how big a move we actually saw. Some of them have come back and said, “This in theory should never have happened, even if you go back to when the world was founded, or you know, the Big Bang, it just can’t happen.” But it shows us that these things do happen, and unfortunately they happen more often than people are willing to believe.

JP: Another thing that was interesting is that I’ve heard some comments on the ruble. The ruble is, believe it or not, traded on an exchange, and we trade the ruble. We traded the ruble back in September. So that was a nice downtrend also. I know that there’s some skepticism on the liquidity of the ruble. From a long-term trend-following point of view, cattle, the ruble, cocoa, these are things that (dependent upon your asset size) we definitely can trade.

My slippage, entering and exiting the less liquid markets is going to be a bit more. Then all of a sudden, you take one of the most liquid markets in the world, and it does what it does. And I’ve seen this before where we say, “Let’s just stay with the liquid markets.” Oh, well sorry, sometimes they are going to become very illiquid also.

So that’s why I think at the end of the day, what trend following offers is the best type of risk control – as long as you use reasonable leverage, a reasonable 10%-15% targeted return. With massive diversification, long and short, the trailing stops and the stop losses, and determining your trades based upon the price only, this is the best way to go to battle in these markets and try to make a fair profit and limit the drawdowns.

NKL: I couldn’t agree more. That’s great, thanks for reminding everyone about that, Jerry. Now just jumping to another question, I wanted just to review with you: did you have any major changes last year in terms of research, in terms of new products?

JP: Well, we always do research and tinker with our systems a little bit every year. We made some minor changes basically to increase the diversification of our trading systems. I’m a huge believer in risk control, but you need to get this risk control embedded in on day one, through multiple entries, multiple exits, lots of different markets, long and short. So most of the time our research continues to tell us, be a trend follower, be the biggest trend follower you can be, pay attention only to price. We do that, and then we also change our methodology as much as we can to try to come up with different ways to basically just space the trades out, adding to winners all the time.

For instance, in October we had a very big sell-off in the stock market. When it recovered we had reduced our positions, and we ended up with about half the position when the markets went back to new highs. So it’s never supposed to be an all-or-nothing big bet. It’s hundreds and thousands of little bets if you take into consideration the markets and the multiple systems that ensure the fact that you’ll have different entries and different exits. So that’s something we’ll continue to do, and that sort of idea does not hurt performance, it just smoothes out the ups and downs.

NKL: Absolutely. Not that many managers yet have entered into the mutual fund space offering their strategies that way. Mutual funds, certainly my understanding is it’s more of a retail or private individual-type product. Are you seeing signs that the conversations are changing? Are people becoming more open to mutual funds now that you’ve packaged it in a way that they maybe understand better? Or is it still, you know you’re competing with an equity market that’s gone on for five years, and people are not really willing to listen just yet?

JP: I definitely see signs, and I talk to people, clients, potential clients, and at least on the retail side, the more the market goes up, the more nervous they get, and the more they’re interested in diversification. Especially in something like a managed futures mutual fund that has had competitive performance recently. I think stand-alone, all of our programmes need to have reasonably decent performance, and we just can’t keep selling vastly sub-par underperformance in the hope that people will just buy it due to the diversification.

It’s really nice, as you were saying earlier, to see the stock market do okay, and then the managed futures do okay; this can occur. I think that at least the retail people are very interested in diversification. The key component, as you mentioned, is being able to explain, and for them to understand, what it’s going to look like. The fees are good, the leverage is good, and people can open up the newspaper and probably figure out what my positions are.

I mean, I’m not going to tell you exactly how to do it, but we are going to not surprise you, and I think that’s the key to sort of a longer-term or medium-term trend following is that the one thing that we want to avoid is having some reasonably nice trends, that may be a little choppy, and not making some money in those trends by getting whipsawed in and out a lot. That’s why I favour a longer-term approach that keeps me in gear with the trend. At the very end, I might give back a little bit more, but at least I’ll have made some decent money.

NKL: Sure. Now, if we do see a warming up to our industry from not just the retail client base, but also from the institutional, which we saw last time in, I guess, 2009, 2010 with a big inflow of assets, and also of course subsequently we saw the big outflow, which many managers felt pretty hard, how do we as managers avoid a repeat of this? Do we need to become much more selective with the clients we take on? Or how do we better manage or educate investors so that the AUM becomes more stable, more sticky? Can it be done?

JP: Well, maybe. I think we have to do it, and do the best job we can, and just see what happens. I do think that once you’ve explained how you trade, and you’ve demonstrated that there is an appropriate amount of risk control, diversification, it’s really up to the clients to do the right thing and educate themselves. We can’t do it all for them. I do think that we changed our programme a few years ago to include 25% stocks. In our risk budget, it’s 25% each stocks, currencies, commodities, and interest rates. We went from a 50% allocation to commodities, and we’re going to increase our correlation to equities a little bit hopefully. Because once again, when equities are doing really well, we need to help the clients with a trading programme that has a better chance of making money at that time. The idea is to try to have a positive contribution from the equities when they are doing well – if equities are up 30, maybe we’re up 10. That would increase the chances that clients don’t give up on trend following even though it is underperforming the market.

But if you’re asking clients once again, to keep owning the diversifier that continues to materially underperform, I think that that is a tough sell. Every investment idea and strategy needs to stand on its own. And then I’m a big believer in education, and I think that it’s just difficult to educate people if you refuse to tell them exactly how you trade. And if you brag about the fact that you’re not trading a lot of trend following, where it’s not just trend following, it’s all these other strategies that are there to smooth out the equity curve – I wonder if we’re one of the few hedge fund categories that really concerns themselves with that.

Most hedge funds describe how they trade – macro or value, growth, etc – and clients decide to add it to their portfolio. I don’t really understand why we need to have this style drift idea as a permanent part of our trading. So that’s why we just try to stick with the trend following. It’s more of a purer, classic play on the medium to long-term trends, and it allows us to describe to people exactly what we do. They won’t be very surprised with the positions.

NKL: Sure, and that’s great – I mean that’s the way it should be. I want to check in with you and see if there’s anything else you want to bring up before we wrap up. Is there anything you feel is important to share from your point of view over the last 12 months that springs to mind? Or any other thing that you want to bring up?

JP: Well I think that the future is good for our business, and it doesn’t have a lot to do with the past couple of years. It’s sort of irrelevant. My opinion, or my happiness or dislike of the performance, is sort of irrelevant given the fact that, like I said, we’re trading so many markets, long and short, with our systematic approach, following these rules, keeping losses small, paying attention to price only and not taking small profits but letting the profits go. All of those things are indispensable; you can’t get rid of any of them. Theyare always the right things to do. I believe those traits are in some ways eternal virtues.

I don’t care what the research says, or what performance says. I’m going to keep doing those things because it’s the safest way to approach these markets. And I think inevitably as CTAs lower fees, lower leverage, and create good retail products, more and more assets will come to us. The importance of all of these elements of our trading will continue to come forth and be evident to most everyone. So I’m very bullish on diversification and risk control, which is what CTAs major in.

NKL: Sure. But I would also add one thing from a personal point of view, which is that I actually also hope that investors will start, not so much focusing on the fees, but actually look at the net returns, after fees. Because you know, with the kind of performance that is being delivered year in, year out, okay there’s going to be one or two years where we don’t deliver returns as an industry. People, I think, shouldn’t be so concerned about whether you’re charging 1% management fee or 1.5%. I would just focus on the after-fee return, and if you’re happy with that then that should be good enough. I mean we’re all, more or less, in the same range, and I think there has been a lot of focus on trying to reduce fees to next to nothing, but I really don’t think necessarily that that is fair either.

JP: True, I agree. I think from most retail people, that’s their opinion, and that’s why I think, I am very bullish on the mutual funds. It doesn’t have to be perfect; it just needs to be…

NKL: Well thought and easy to access.

JP: Yes, exactly.

NKL: Final question Jerry, if you could wish anything for 2015 what would that be?

JP: I don’t want to see another Swiss franc-like move. That was really disconcerting and not fun. That sort of move – and that’s one of intervention, or an unwinding of an intervention by government – should scare everyone. And it’s out there, and it could happen in any market in any sector at any time. So that, I’ll take my drawdowns historically like I’ve had them, that’s fine, but I think everyone should wish for less craziness. And I’d love to make 60 ATR, but I’d like that spread out over a year.

Listen to the interview at www.toptradersunplugged.com/065/