One of the great Investment books of all time is Reminiscences of a Stock Operator, which is the fictionalized biography of perhaps the most famous Financial Speculator of all time: Jesse Livermore. There is no doubt that even today, 100 years later, we can all learn from of the experiences of successful Investors.
In this Best of Top Traders Unplugged, which I have appropriately titled Reminiscences of 3 Trend Followers, Michael Adam, David Harding and Marty Lueck, also known as the founders of AHL, finally shed light on one of the best kept secrets of modern finance. I sat down with them in Abbey Road Studios in London, on the 30-year anniversary of when they founded AHL. The conversation turned out to be witty, inspiring, and far more entertaining than it had any right to be. So, enjoy these truly unique takeaways from my conversation with Michael, David and Marty, and if you would like to listen to the conversation in full, just go to Top Traders Round Table Episode 11.
Sugarcoating The Medicine Of Trend Following
Niels: Now, rightly or wrongly my understanding of Winton and Aspect, in the early years, was that both firms had an emphasis on Trend Following within your strategies. From what I've observed, over the years, this seems still to be the case for you, Marty, at Aspect, but perhaps less so for you David. So let me come to you first on this one, David. If my observation is right, when did you begin to move away from the classical trend following approach, if I can call it that? Also, what was your motivation for doing so?
David: It's a question of degree. There's still a fair amount of Trend Following in what we do but when we were doing our research in the early 90s we did a literature review and looked at what else, what other opportunities there were and we scoured the literature. Time and time again we came across academic papers referring to what is now called carry - the phenomenon of carry. So we focused a lot of our research on that. We developed a bunch of trading systems which used that and we even got as far as implementing those trading systems. They all went a bit wrong in the ERM - when Sterling exited the ERM. At that stage, we had quite a bureaucratic board process and it had become hard to take risks and so all those systems were taken out. The significance is that they went on and worked very, very well for the next 20 years - as well as Trend Following, actually.
So, we didn't use that until maybe 2005 or 2006 or 2007 but it worked extremely well. There were other things that we were developing back then, which also worked, subsequently. They're not in the form that we were developing. There are some things that we developed back then which we still use today.
To really fully exploit the potential of this kind of research you have to move into equity markets and it took me a long, long, long time to develop all the infrastructure and expertise to deal with thousands of equities, databases, corporate actions, and so on and so forth. By the time we'd done that the easy money in Convertible Arb was long gone, that was long gone - after 2008 really, with a number of other strategies, the easy money was long gone. My own pitch is I just don't think the markets... There will never be no opportunities for people to do more research in science. Some people think that we're on the verge of a grand unified field theory of everything, and a grand unified field theory of efficient markets, and I just don't believe that. I know people who say, "Well, what it is then? What is the next big thing then?" Well, I don't know, that's why you have to do research.
Niels: Very true. You've stayed true to your roots to a large extent
Marty: To degrees, to degrees, Aspect was predicated on this trend following approach being an important utility that was begin overlooked by the investment community. It really did deserve a place in people's portfolios. The irony, I think (and this is all with the benefit of hindsight), the irony is that we spent a lot of time doing a lot of research in order to ameliorate some of the characteristics of trend following. Trend following can be quite a challenging utility, return profile, for investors to hold on to.
Equities tend to go up, up, up, up, up and then kick you in the teeth and then recover and then go up, up, up.
'If you take Trend Following or you take Deep Value Investing, you could argue the reason they actually work is that they're so difficult to hold psychologically.'
Managed futures have an opposite profile where they tend to make consecutive losses then have a very strong run that makes money. That's intrinsically quite challenging for investors to hold onto, but it's really valuable in the portfolio. So, the irony was that a lot of the research we were doing was motivated by desire, if you will, to sugar coat the medicine. We put all these other features like carry, that David refers to, and other component pieces in small doses, as you didn't want to take away the characteristics of trend following. It was very much still focused on trend following as the core of the business.
These days we've gone on to do a range of other things because clients want a range of other solutions. I think the industry - we can talk about that - but I think the industry has matured, or the investors have matured that it's not (I don't know if David would agree with this observation) but it's not now as much a world of, "I'm the investment manager, let me tell you what's good for you," and just plonking the product on the table. I think it's much more of a consultative exercise where, within reason, investors know what's in their portfolio. They know what they're looking for, and firms like ours have the component pieces that can put together solutions or products that provide a lot of different utilities. So, it's no longer just one thing.
Niels: Sure. I can't help asking you if you think the decision to maybe stay true to trend following for at least awhile longer is kind of the reason that Winton has leaped the whole industry when it comes to size. It really is... There is a difference now.
I want to circle back to you David, on the question of size, actually. If my memory serves me right, and correct me if I'm wrong here, at some point you decide to lower the volatility of your program a bit. So, if that is correct, what was your thinking behind doing so? What was the benefit that it had for your business and for your clients?
David: Well, I think I'm always driven by the memory of October 19th, 1987. I remember that night very, very vividly and the next day. On that day the stock market was down 21% and the futures were down 30% because the carry broke free. So, as you're double leverage long in the stock market with futures on, and if that happens again you'll be down 60%.
Mike: You'll be called for margin.
David: I don't want to be down... I don't want my investors to ever be down 60% over an evening. That only happened one day in my life, but I don't ever want that to happen. So there's now what they fashionably call a "hard stop" on how much exposure I'm willing to put investors... I'm willing to undertake on behalf of investors. That's my way of dramatizing the fact I'm concerned about... I won't say the fat tails because that implies something that happens once a year. I'm talking about something that happens about once every 20 years.
Niels: Also, could you say that losing less when you do lose is the way you win in investing overall? Is there something to that?
Mike: This remains an area of interest for me but in a completely bizarrely... I'm still in the investment management business but in a completely different field-
Deep Value Investing, which is also challenging for investors. Deep Value Investing consists of most of the time doing absolutely nothing, which most investors find extremely difficult. Investment managers find it even more difficult, I would point out. So, last year the fund I think only did two trades, essentially, the entire year. That was it. So, I think the profile of what you do and the way it's perceived by investors, matching those two things together it remains...
I would slightly disagree with Marty. I think it's as psychologically difficult as it has always been for investors to do the things that they should do just because of human nature. If you take trend following or you take Deep Value Investing you could argue the reason they actually work is that they're so difficult to hold. They're so difficult to hold psychologically.
David: That's the contrarian view of investing. They have to be a contrarian to succeed.
Mike: So, managed futures and trend following are not the only contrarian investment approaches. It doesn't matter if intellectually they get that it's in their interest, truly, to diversify. Diversification is the hardest thing to do psychologically for an investor.
David: Sometimes I say to people, "Do you want to be happy or rich?" In other words when you're out of step with social pressure you are unhappy, but that is the right thing to do.
Mike: Yes, it's very, very hard to do. So I think that remains a challenge.
David: So my next life the answer will be, "Happy." I'm joking, but maybe rich makes you happy. It's a tough road to hoe as Michael said.
Mike: There are all sorts of reasons why. So I got back involved with Aspect, and one of the key events for me that led me to the conclusion that I should definitively stop, is actually, at Aspect, we had a market neutral equity program which was very successful. It had the opposite profile. It had produced a mediocre return with really quite high probability and was going extremely well. Luckily we were scared enough of leverage not to have leveraged as much as some of our competitors.
I thought, we thought, that it was safe. It was so unlikely to be taken apart by our counterparts because in order to break the back of the strategy would require a whole bunch of closely correlated stocks to be driven apart to the extent that surely liquidity would come in on the other side. We were completely wrong, completely wrong. At a low liquidity point in equity markets our counterparties did a classic squeeze on market neutral funds and wiped all of them out, interestingly. Pretty much except...
Mike: That's pretty much the event that led me to think, "I've got to stop doing this." Yes, I feel we were lucky enough. I feel we found two or three things back in the day. I thought if that strategy can be taken apart then I'm no longer confident...
Marty: It was time to be happy...
Mike: It was time to get out and be happy, but it was not a happy experience to watch, that market neutral fund being taken apart by our counterparts. I shouldn't go into detail as to who those counterparts are, and I won't go into detail as to how we escaped by the skin of our teeth. Let's just say if I needed a reminder of the challenge of doing this it's mostly psychological, both for the people doing it and for the investors in it. I think it's a constant and remaining challenge and one I could really do without, frankly. (Laughter)