Once a Turtle, Always a Turtle

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This summary is written by Rich based on a conversation in our CTA series between Jerry Parker, Founder of Chesapeake Capital, and the podcast hosts, Niels and Alan.

About Chesapeake Capital

In this episode, Niels and Alan are joined by Jerry Parker, Founder of Chesapeake Capital. The discussion focused on trend following in managed futures, the investment strategy that outperformed others in 2022. 

Founded in 1988 after Jerry participated in the Richard Dennis Turtle Program, Chesapeake Capital initially had a stellar track record. Jerry mentioned that being a 'Turtle' opened doors for him on Wall Street, including opportunities like managing money for Kidder Peabody, courtesy of Paul Saunders. He attributes much of his foundational learning and career kickstart to Richard Dennis.

Mike Ivie and Anil Ladde have been with Chesapeake for over three decades, making significant contributions to research and compliance, respectively. Jerry values the long-term collaboration with them and considers them key to the company's successes.

Chesapeake attracted substantial investments from big financial houses and had a significant commitment from a client in Abu Dhabi. However, they also faced challenges with high-fee loads that could go up to 10-12%. The firm had to adapt drastically when mutual funds began taking over the market, impacting their asset base.

Jerry reflected on his strict adherence to trend following, a principle taught by Richard Dennis. He stated that while others felt freedom to deviate from the philosophy, he took it very seriously. Jerry views these teachings as 'eternal truths' that have guided his trading strategy.

Despite his dedication to trend following, Jerry admited to making deviations in 2006-07 to try and improve the system. He experimented with profit objectives, smoothing, and dynamic position sizing. However, when the performance did not meet expectations, Chesapeake returned to its classic one entry, one exit, and a stop loss type trading.

Investment Philosophy

The discussion then turned towards understanding Jerry’s philosophy to Chesapeake’s investment approach, how it was shaped, how it evolved and how Jerry strikes a balance between sticking to core principles and adapting to new information and opportunities. 

Alan asked Jerry about the philosophical underpinnings of his trading strategy. Alan is interested in what convinced Jerry to adopt trend-following strategies in the markets. Jerry explained that he leans towards trend following because he appreciates its built-in risk management and profitability. From his mentors, he learned the importance of "doing the hard thing" and following rules. Jerry emphasized the importance of sample size in trading decisions. Over the years, he says, he's been mentored by very smart people who even supplied more money when they lost, creating a unique learning environment.

He talked about how the principles he was taught, such as taking small losses, letting profits run, and viewing volatility as not equivalent to risk, have proven to be effective. Jerry mentioned that his strategy has evolved from focusing on short-term lookbacks to employing very long-term lookbacks now. He also noted how his trading has expanded into various types of markets and instruments, from commodities and currencies to different types of bonds and equities.

Alan then asked how Jerry balances the need for strategy evolution with the risk of straying too far from his core philosophy. Jerry stated that while they've had the temptation to tinker due to having smart people and fast computers, his role has been to keep the team aligned with the fundamental principles. He said the most significant change they made was shifting from a short-term to a long-term outlook. This was partly in response to poor performance in the late '90s and also because backtesting confirmed that long-term trend-following strategies were generally more profitable.

Alan ended by querying what would prompt Jerry to change his trading strategy again. Jerry responded that a shift in approach was driven by poor performance and in-depth backtesting, emphasizing that they focus on a risk-to-reward ratio where you risk $1 to make $3.

The Importance of Discipline, Trading Size and Consistency

Jerry emphasized that one of the most critical mistakes traders make is "trading too large." According to him, the size of your trade should be calculated to ensure you remain "in the game" over the long term. Trading too large not only puts you at the risk of significant losses, but it also impinges upon your discipline to follow your trading system's rules.

Speaking of rules, Jerry ardently believes in strict adherence to whatever trading system you use. He suggested that even an average system, if followed diligently, could outperform a superior but inconsistently applied system. The discipline to follow rules and execute trades accordingly often trumps the quality of the trading system itself.

Alan chimed in with the investor perspective, pointing out that for a trading program to attract investor capital, it has to operate at a "meaningful level of volatility." Both Alan and Jerry agreed that the level of volatility that a trader is comfortable with is often a personal decision, dictated by one's risk tolerance.

Jerry acknowledged that while personal preferences do matter, they should largely influence your trade size, not your overall approach to trading. In other words, your comfort level should not dictate your strategy, especially since successful trading usually requires walking the fine line between risk and reward. In Jerry's words, "Trading should be hard, it should be painful, it should be very annoying," and if you find that your system pushes you out of your comfort zone, you're probably on the right track.

Niels brought up an interesting point about parameter selection, questioning whether traders should continuously update their system parameters. Jerry stood firm in his belief that constant recalibration may not be necessary. He suggested focusing instead on establishing a "sweet spot" of parameters that have historically proven to be profitable. Jerry also emphasized the importance of using all available data for backtesting, rather than just the most recent data.

At the end of the day, Jerry encapsulated his philosophy into a desire to "stay in the trade" without giving back too much of the profit. He believes that it's a constant tug-of-war between entering a trade at the right moment and exiting it without losing the accumulated gains. Despite the myriad of tools and tactics available to traders, Jerry underlined that discipline, sensible trading size, and a well-tested set of rules are the key components of a successful trading career.

The Issues with the Sharpe Ratio 

Niels began by referencing a 2022 paper by Cliff Asness, which questioned whether investment managers, particularly Commodity Trading Advisors (CTAs), were focusing too much on the Sharpe ratio. Jerry agreed that the ratio wasn't the best yardstick for trend-following strategies, as it tends to penalize outliers and ignores the 'real risk,' which for trend-followers is about safeguarding capital.

Jerry criticized the obsession with the Sharpe ratio and its focus on volatility. He argued that the metric distracts from the essence of trend following, which is to let profits run while keeping losses at bay. According to him, using the Sharpe ratio can hinder the freedom to follow trends without micromanagement.

Jerry also addressed Niels' question about what constitutes an 'improvement' in a trading strategy. He admitted that while clients and investors often seek smoother, less volatile returns, what they actually need is consistency. He stressed the importance of educating clients about this difference, even if it means pushing them to "eat their broccoli" by tolerating higher short-term volatility for long-term gain.

The conversation then shifted to the role of volatility in trading decisions. Niels floated the idea that volatility tends to increase around market turning points, which could be a valuable signal. Jerry, however, was sceptical. He uses volatility only to size positions at the time of entry and relies on trend-following breakouts for the rest of the trade. He cautioned that though volatility does spike near turning points, it can also produce false signals, echoing sentiments made by Rich in 1983. He also voiced concerns about the limited sample size when dissecting large trends, emphasizing that the backtesting he relies on wouldn't support any drastic shifts away from classic trend-following strategies.

In summary, the nuanced conversation highlighted a dissonance between traditional financial metrics like the Sharpe ratio and the realities of trend-following strategies. Both Niels and Jerry advocated for a focus on consistency over a futile chase for lower volatility. Moreover, while they agreed that volatility is a complex beast, Jerry’s stance leans towards its cautious use and stresses sticking with proven, backtested strategies.

Meeting Investor Expectations

Alan then discussed with Jerry about the challenges and nuances of trend following in the investment management industry, Alan brought up the complexities of meeting investor expectations while adhering to a particular investment philosophy. He questioned whether there will always be tension between these objectives, especially since many investors and Commodity Trading Advisors (CTAs) view diversification as a route to more consistent returns. Alan wondered if this is at odds with the practice of purely following trends.

Jerry acknowledged that there is indeed inherent conflict in managing investment money, especially when compared to just running one's own individual portfolio. Unlike investment icons like Warren Buffett, whose advice is seen as gold, Jerry admited that CTAs like him have to consider investor sentiments more closely. However, he believes that CTAs essentially offer trend following, and his own philosophy is firmly rooted in it.

Referencing a quote from another podcast featuring CFM, a top research firm in the CTA space, Jerry agreed that 90-95% of returns in this field come from trend following. He is resistant to incorporating strategies that might diversify but ultimately dilute the performance. He’s looking for people who are as passionate about trend following as he is, considering them outliers who are instantly captivated by the philosophy and are willing to live with the associated volatility and drawdowns.

Both Alan and Jerry agreed that there is a tension between investor expectations and the fundamental philosophy of trend following. Jerry suggested that while it's necessary to consider investor sentiment, it should not divert from the core principles of his preferred investment strategy, which has provided the majority of returns for CTAs. He believes that those who are truly committed to trend following are willing to endure the volatility and drawdowns that come with it.

The Challenges of Strictly Adhering to Trend Following Principles

Alan and Jerry continued to explore the challenges and opportunities of adhering strictly to trend following. Alan noted that Jerry's approach, encapsulated in an ETF called "Trend Following Plus Nothing," seems unorthodox. Most people don't exclusively rely on trend following, and Alan wonders if the strategy would still work if everyone adopted it.

Jerry acknowledged the limitation, agreeing that if too many people used strict trend following, it could cause market instability. However, he sees this as a self-preserving mechanism for the approach, suggesting it will never become mainstream, thus leaving room for those who do embrace it. Jerry also clarified that while he is dismissive of some investment approaches, he isn't against equities; rather, he supports trend following equities.

Alan and Jerry also discussed the diversification of portfolios and conclude that both trend following and equities have had their periods of strong and weak performance. Alan brought up the topic of using stops in trading as a risk management tool. Jerry asserted that whether one uses stops or not, the key is to keep losses small. He explained that backtesting showed no significant difference in performance with or without stops, so he chooses to use them.

Jerry concluded by admitting that trend following involves more complexities than people often realize, especially when it comes to things like dynamic position sizing, correlations, and volatility management. However, he remains committed to his philosophy of keeping it simple with one entry, one exit, and a stop loss, stating that additional complexities haven't shown significant benefits in his case.

Overall, the conversation suggested that while trend following might not be universally adopted, it holds a niche yet valuable position in investment strategy, and its limitations could very well be its strengths. Jerry embodies this in his approach, emphasizing the value of sticking to a philosophy, yet recognizing the complexities involved in this seemingly simple strategy.

The Role of Correlations and Dynamically Adjusting Position Size in Portfolios

Niels brought up a topic that he considers controversial: the role of correlations in asset management. Specifically, he questioned Jerry's somewhat black-and-white approach to investment, where Jerry suggests that his own strategies are best and dismisses others.

Jerry defended his approach by saying he prefers simple systems with fewer parameters and rules. For him, the rules are in place to ensure consistency across different trading scenarios, whether one is long in both stocks and bonds or long in one while being short in another. He argued that too many parameters can create complications and that his system has proved successful over a long term.

Niels countered by pointing out that those who use correlations in their dynamic positioning would view the risk differently depending on whether they are long or short in different asset classes. Jerry acknowledged the point but maintains that his strategy aims for long-term consistency, ignoring short-term fluctuations. He also criticized the commonly used practice of adjusting trade size based on current assets under management (AUM), stating that doing so can distort risk assessments and lead to mistakes.

According to Jerry, the key is to measure risk against a set "bankroll," adjust it slowly and methodically, and always have an eye on protecting capital rather than open trade profits. He contends that his style of money management inherently incorporates this disciplined approach. In closing, Jerry argued that traditional metrics like Sharpe ratio, volatility, and correlation don't necessarily correlate with risk to capital in the way he trades.

Overall, while Niels was cautious about declaring one approach superior to others and emphasizes the complexity of the investment landscape, Jerry was firm in his belief that simpler, rule-based systems, when applied consistently, yield better long-term results.

The Misconceptions of Trend Following

In the concluding part of the discussion Niels acknowledged the diversity of strategies in the industry and appreciates that various firms have succeeded over long periods using different methods. He then asked Jerry what misconception about trend following he most disagrees with.

Jerry responds emphatically, stating that he fundamentally disagrees with criticisms aimed at 100% trend following. He believes in its superiority and doesn't see logic or evidence to the contrary. Jerry admitted that incorporating insights from other successful trading strategies could be beneficial but holds his ground on the efficacy of trend following, especially when applied to a diversified portfolio.

Jerry also addressed a point made by Florin Court about market diversification. While he's impressed by Florin Court's extensive portfolio, he doesn't agree with the notion that some markets are intrinsically superior to others. Jerry also defended the practice of trading both single stocks and indices, contradicting Florin Court's stance on this issue.

In sum, Jerry's core argument remains steadfast: a well-diversified portfolio focused on trend following, coupled with a disciplined approach, doesn't require anything else. He considers it risky to include assets that lack built-in risk mitigation strategies like trailing stops and stop losses. The conversation underscores the nuances and complexities in the world of investing but leaves Jerry as a resolute advocate for his preferred method: trend following.

Outlook for the Future

In concluding the discussion Niels asked Jerry what excites him about the future of their industry, aside from his own new ETF launch. Jerry expressed his optimism about the resurgence of trend-following strategies. He believes that the years 2020, 2021, and 2022 mark the beginning of a return to a period where trend-following programs will outperform equities with lower drawdowns, similar to when they both started in the business.

Jerry's goal is to see trend-following strategies recognized for their proper position in the investment world. He pointed out that while other famous hedge funds have faced challenging periods, trend-following remains resilient. Jerry agreed with Niels' assertion that people often underestimate the volatility and risks present in the world, emphasizing that trend-following strategies can serve as one of the best solutions to navigate these uncertainties. Overall, Jerry is excited about the future potential for trend-following to prove its mettle, especially given the unpredictability of global markets.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.