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ISBN 978-1-118-41085-1 (hbk) ISBN 978-1-118-41082-0 (ebk) ISBN 978-1-118-41083-7 (ebk) ISBN 978-1-118-41084-4 (ebk) To my wonderful wife Eng Cheng and my son Brandon for their love and patience - 1 - Table of Contents Foreword.........................................................................................................................................................3 Preface............................................................................................................................................................4 Acknowledgements........................................................................................................................................6 1......................................................................................................................................................................6 Cross-Asset Trend Following with Futures....................................................................................................6 2....................................................................................................................................................................18 Futures Data and Tools.................................................................................................................................18 3....................................................................................................................................................................41 Constructing Diversified Futures Trading Strategies...................................................................................41 4....................................................................................................................................................................53 Two Basic Trend-Following Strategies........................................................................................................53 5....................................................................................................................................................................76 In-Depth Analysis of Trend-Following Performance...................................................................................76 6....................................................................................................................................................................92 Year by Year Review...................................................................................................................................92 7..................................................................................................................................................................198 Reverse Engineering the Competition........................................................................................................198 8..................................................................................................................................................................215 Tweaks and Improvements.........................................................................................................................215 9..................................................................................................................................................................224 Practicalities of Futures Trading.................................................................................................................224 10................................................................................................................................................................229 Final Words of Caution..............................................................................................................................229 Bibliography...............................................................................................................................................233 BOOKS.......................................................................................................................................................234 Index...........................................................................................................................................................234 - 2 - Foreword This book is an excellent training manual for anyone interested in learning how to make money as a trend follower. I know a bit about trend following because I was part of the famous Turtle experiment in the 1980s when Richard Dennis, the Prince of the Pits, showed the world that trading could be taught and that people with the right sort of training and perspective could make consistent returns that far exceeded normal investments. Ultimately, that ordinary people could learn to trade like the most successful hedge funds. I started as a 19-year-old kid and by the time I was 24 in 1987, I took home $8 million, which was my cut of the $31.5 million I earned for Richard Dennis as a trend follower. I even wrote a book about it, Way of the Turtle. It became a bestseller because many traders wanted to know the secrets of our success and to hear about the story first-hand which had been kept secret because of confidentiality agreements and our loyalty to Richard Dennis, a great man and a trading legend. I’d thought about writing a follow-on book a few times in the intervening years; something meatier and with more detail. My book was part-story and part-trading manual and I thought about writing a book that was all trading manual. In Following the Trend, Andreas Clenow has written a trend-following trading manual I would be proud to put my own name on. I’m very picky too, so I don’t say this lightly. Very few trading books are worthy of an endorsement of any sort. Too many are filled with tips and tricks that don’t stand the test of the markets, let alone the test of time. Too many are written by those who are trying to sell you something like a course, or their seminars. Too many want your money more than they want to create an excellent book. That’s why I don’t often speak at conferences and you won’t see me endorsing many books. There is too much self-serving propaganda in the trading industry that makes its money by fleecing the unsuspecting newcomers; too many lies designed to rope in the neophytes with promises of easy profits and quick money that will never pan out. Following the Trend is different. It is solid, clearly written, covers all the basics, and it doesn’t promise you anything that you can’t actually get as a trend follower. If you want to be a trend follower, first, read Reminiscences of a Stock Operator to learn from Jesse Livermore. Then, buy Jack Schwager’s Market Wizards books to learn about the great traders who have been trend followers, like Richard Dennis my trading mentor, Ed Seykota, Bill Dunn, John W. Henry, and Richard Donchian. They will get you excited about the possibilities but leave you wondering how; how can you too learn to be a trend follower? Then, when you are ready to move from desire to reality. When you are ready to do it yourself. To make your own mark. Read Following the Trend. Curtis Faith Savannah, GA U.S.A. - 3 - Preface This book is in essence about a single trading strategy based on a concept that has been publically known for at least two decades. It is a strategy that has worked remarkably well for over 30 years with a large number of hedge funds employing it. This strategy has been given much attention over the past few years and in particular after the dramatically positive returns it generated in 2008, but it seems nevertheless to be constantly misunderstood, misinterpreted and misused. Even worse, various flawed and overly complicated iterations of it are all too often sold for large amounts of money by people who have never even traded them in a professional environment. The strategy I am alluding to goes by many names but it is in essence the same strategy that most trend-following futures managers (or CTAs for Commodity Trading Advisors if you prefer) have been trading for many years. This book differs in many ways from the more traditional way in which trading literature tends to approach the subject of trend-following strategies. My primary reason for writing this book is to fill a gap in that literature and to make publicly available analyses and information that is already known by successful diversified trend followers, but understood by few not already in this very specialised part of the business. It is my belief that most books and therefore most people aspiring to get into this business are focusing on the wrong things, such as entry and exit rules, and missing the important aspects. This is likely related to the fact that many authors don’t actually design or trade these strategies for a living. There have been many famous star traders in this particular part of the industry and some of them have been raised to almost mythical status and seen as kinds of deities in the business. These people have my highest respect for their success and pioneer work in our field, but this book is not about hero worship and it does not dwell on strategies that worked in the 1970s but might be financial suicide to run in the same shape today. The market has changed and even more so the hedge-fund industry and I intend to focus on what I see as viable strategies in the current financial marketplace. This is not a text book where every possible strategy and indicator is explored in depth with comparisons of the pros and cons of exponential moving average to simple moving average, to adaptive moving average and so on. I don’t describe every trading indicator I can think of or invent new ones and name them after myself. You don’t need a whole bag of technical indicators to construct a solid trend-following strategy and it certainly does not add anything to the field if I change a few details of some formula and call the new one by my own name, although I have to admit that ‘The Clenow Oscillator’ does have a certain ring to it. Indicators are not important and focusing on these details is likely to be the easiest way to miss the whole plot and get stuck in nonsense curve fitting and over-optimisations. I intend to do the absolute opposite and use only the most basic methods and indicators to show how you can construct strategies good enough to use in professional hedge funds without having unnecessary complexity. The buy and sell rules are the least important part of a strategy and focusing on them would serve only to distract from where the real value comes. Also, this is not a get-rich-quick book. If you are looking for a quick and easy way to get rich you need to look elsewhere. One of my main points in this book is that it is not terribly difficult to create a trading strategy that can rival many large futures hedge funds but that absolutely does not mean that this is an easy business. Creating a trading strategy is only one step out of many and I even provide trading rules in this book that perform very well over time and have return profiles that are marketable to seasoned institutional investors. That is only part of the work though and if you don’t do your homework properly you will most likely end up either not getting any investments in the first place or blowing up your own and your investors’ money at the first sign of market trouble. - 4 - To be able to use the knowledge I pass on here, you need to put in some really hard work. Don’t take anyone’s word when it comes to trading strategies, not even mine. You need to invest in a good market data infrastructure including effective simulation software and study a proper programming language if you don’t already know one. Then you can start replicating the strategies I describe here and make up your own mind about their usefulness, and I hope find ways to improve them and adapt to your own desired level of risk and return. Using someone else’s method out of the box is rarely a good idea and you need to make the strategies your own in order to really know and trust them. Even after you reach that stage, you have most of the work ahead of you. Trading these strategies on a daily basis is a lot tougher than most people expect, not least from a psychological point of view. Add the task of finding investors, launching a fund or managed accounts setup, running the business side, reporting, mid office and so on, and you soon realise that this is not a get-rich-quick scheme. It is certainly a highly rewarding business to be in if you are good at what you do, but that does not mean it is either easy or quick. So despite the stated fact that this book is essentially about a single strategy, I will demonstrate that this one strategy is sufficient to replicate the top trend-following hedge funds of the world, when you fully understand it. WHY WRITE A BOOK? Practically no managed futures funds will reveal their trading rules and they tend to treat their proprietary strategy as if they were blueprints for nuclear weapons. They do so for good reason but not necessarily for the reason most people would assume. The most important rationale for the whole secrecy business is likely tied to marketing, and the perception of a fund manager possessing the secret formula to make gold out of stone will certainly help to sell the fund as a unique opportunity. The fact of the matter is that although most professional trend followers have their proprietary tweaks, the core strategies used don’t differ very much in this business. That might sound like an odd statement, since I have obviously not been privy to the source code of all the managed futures funds out there and because they sometimes show quite different return profiles it would seem as if they are doing very different things. However, by using very simplistic methods one can replicate very closely the returns of many CTA funds and by tweaking the time horizons, risk factor and investment universe one can replicate most of them. This is not to say that these funds are not good or that they don’t have their own valuable proprietary algorithms. The point is merely that the specific tweaks used by each shop are only a small factor and that the bulk of the returns come from fairly simple models. Early on in this book I show two basic strategies and how even these highly simplistic models are able to explain a large part of CTA returns, and I then go on to refine these two strategies into one strategy that can compete well with the big established futures funds. I show all the details of how this is done, enabling the reader to replicate the same strategies. These strategies are tradable with quite attractive return profiles just as they are and I show in subsequent chapters how to improve upon them further. I intend to show not just simple examples but complete strategies that can be used straight away for institutional money management. And why would I go and tell you all of this? Wouldn’t the spread of this knowledge cause all trend- following strategies to cease functioning; free money would be given to the unwashed masses instead of the secret guild of hedge-fund managers and make the earth suddenly stop revolving and fling us all out into space? Well, there are many reasons quantitative traders give to justify their secrecy and keep the mystique up and a few of them are even valid, but in the case of trend-following futures I don’t see too much of a downside in letting others in on the game. The trend-following game is currently dominated by a group of massive funds with assets in the order of US$5–25 billion, which they leverage many times over to play futures all over the world. These fund managers know everything I write in this book and plenty more. The idea that me writing this book may cause so many people to go into the trend-following futures business that their trades would somehow overshadow the big players and destroy the investment - 5 - opportunities is a nice one for my ego, but not a very probable one. What I describe here is already done on a massive scale and if a few of my readers decide to go into this field, good for them and I wish them the best of luck. What we are talking about here are simply methods to locate medium- to long-term trends typically caused by real economic developments and to systematically make money from them over time. Having more people doing the same will hardly change the real economic behaviour of humankind that is ultimately behind the price action. One could of course argue that a significant increase in assets in this game could make the exact entries and exits more of a problem, causing big moves when the crowd enters or exits at the same time. That is a concern for sure, but not a major one. Overcoming these kinds of problems resides in the small details of the strategies and will have little impact over the long run. There are other types of quantitative strategies that neither I nor anyone else trading them would write books about. These are usually very short-term strategies or strategies with low capacity that would suffer or cease to be profitable if more capital comes into the same game. Medium- to long-term trend following however has massive liquidity and is very scalable, so it is not subject to these concerns. Then there is another reason for me to write about these strategies. I am not a believer in the black-box approach in which you ask your clients for blind trust without giving any meaningful information about how you achieve your returns. Even if you know everything that this book aims to teach, it is still hard work to run a trend-following futures business and most people will not go out and start their own hedge fund simply because they now understand how the mechanics work. Some probably will and if you end up being one of them, please drop me an email to let me know how it all works out. Either way, I would like to think that I can add value with my own investment vehicles and that this book will not in any way hurt my business. Acknowledgements I had plenty of help in writing this book, both in terms of inspiration and support, and in reviewing and correcting my mistakes. I would especially like to thank the following people who provided invaluable feedback and advice: Thomas Hackl, Erk Subasi, PhD, Max Wong, Werner Trabesinger, PhD, Tony Ugrina, Raphael Rutz, Frederick Barnard and Nitin Gupta. 1 Cross-Asset Trend Following with Futures There is a group of hedge funds and professional asset managers who have shown a remarkable performance for over 30 years, consistently outperforming conventional strategies in both bull and bear markets, and during the 2008 credit crunch crisis showing truly spectacular returns. These traders are highly secretive about what they do and how they do it. They often employ large quant teams staffed with top-level PhDs from the best schools in the world, adding to the mystique surrounding their seemingly - 6 - amazing long-term track records. Yet, as this book shows, it is possible to replicate their returns by using fairly simple systematic trading models, revealing that not only are they essentially doing the same thing, but also that it is not terribly complex and within the reach of most of us to replicate. This group of funds and traders goes by several names and they are often referred to as CTAs (for Commodity Trading Advisors), trend followers or managed futures traders. It matters little which term you prefer because there really are no standardised rules or definitions involved. What they all have in common is that their primary trading strategy is to capture lasting price moves in either direction in global markets across many asset classes, attempting to ride positions as long as possible when they start moving. In practice most futures managers do the same thing they have been doing since the 1970s: trend following. Conceptually the core idea is very simple. Use computer software to identify trends in a large set of different futures markets and attempt to enter into trends and follow them for as long as they last. By following a large number of markets covering all asset classes, both long and short, you can make money in both bull and bear markets and be sure to capture any lasting trend in the financial markets, regardless of asset class. This book shows all the details about what this group does in reality and how the members do it. The truth is that almost all of these funds are just following trends and there are not a whole lot of ways that this can be done. They all have their own proprietary tweaks, bells and whistles, but in the end the difference achieved by these is marginal in the grand scheme of things. This book sheds some light on what the large institutional trend-following futures traders do and how the results are created. The strategies as such are relatively simple and not terribly difficult to replicate in theory, but that in no way means that it is easy to replicate them in reality and to follow through. The difficulty of managed futures trading is largely misunderstood and those trying to replicate what we do usually spend too much time looking at the wrong things and not even realising the actual difficulties until it is too late. Strategies are easy. Sticking with them in reality is a whole different ball game. That may sound clichéd but come back to that statement after you finish reading this book and see if you still believe it is just a cliché. There are many names given to the strategies and the business that this book is about and, although they are often used interchangeably, in practice they can sometimes mean slightly different things and cause all kinds of confusion. The most commonly-used term by industry professionals is simply CTA (Commodity Trading Advisor) and though I admit that I tend to use this term myself it is in fact a misnomer in this case. CTA is a US regulatory term defined by the National Futures Association (NFA) and it has little to do with most so-called CTA funds or CTA managers today. This label is a legacy from the days when those running these types of strategies were US-based individuals or small companies regulated onshore by the NFA, which is not necessarily the case today. If you live in the UK and have your advisory company in London, set up an asset-management company in the British Virgin Islands and a hedge fund in the Caymans (which is in fact a more common setup than one would think) you are in no way affected by the NFA and therefore not a CTA from their point of view, even if you manage futures in large scale. DIVERSIFIED TREND FOLLOWING IN A NUTSHELL The very concept of trend following means that you will never buy at the bottom and you will never sell at the top. This is not about buying low and selling high, but rather about buying high and selling higher or shorting low and covering lower. These strategies will always arrive late at the party and overstay their welcome, but they always enjoy the fun in-between. All trend-following strategies are the same in concept and the underlying core idea is that the financial markets tend to move in trends, up, down or sideways, for extended periods of time. Perhaps not all the time and perhaps not even most of the time, but the critical assumption is that there will always be periods where markets continue to move in the same direction for - 7 - long enough periods of time to pay for the losing trades and have money left over. It is in these periods and only in these periods that trend-following strategies will make money. When the market is moving sideways, which is the case more often than one might think, these strategies are just not profitable. Figure 1.1 shows the type of trades we are looking for, which all boils down to waiting until the market has made a significant move in one direction, putting on a bet that the price will continue in the same direction and holding that position until the trend has seized. Note the two phases in the figure separated by a vertical line. Up until April there was no money to be made in following the trends of the NZ Dollar, simply because there were no trends around. Many trend followers would have attempted entries both on the long and short side and lost money, but the emerging trend from April onwards should have paid for it and then some. Figure 1.1 Phases of trend following If you look at a single market at any given time, there is a very high likelihood that no trend exists at the moment. That not only means that there are no profits for the trend-following strategies, but can also mean that loss after loss is realised as the strategy enters position after position only to see prices fall back into the old range. Trend-following trading on a single instrument is not terribly difficult but quite often a futile exercise, not to mention a very expensive one. Any single instrument or even asset class can have very long periods where this approach simply does not work and to keep losing over and over again, watching the portfolio value shrinking each time can be a horrible experience as well as financially disastrous. Those who trade only a single or a few markets also have a higher tendency of taking too large bets to make sure the bottom line of the portfolio will get a significant impact of each trade and that is also an excellent method of going bankrupt. With a diversified futures strategy you have a large basket of instruments to trade covering all major asset classes, making each single bet by itself almost insignificant to the overall performance. Most trend- following futures strategies do in fact lose on over half of all trades entered and sometimes as much as 70%, but the trick is to gain much more on the good ones than you lose on the bad and to do enough trades for the law of big numbers to start kicking in. For a truly diversified futures manager it really does not matter if we trade the S&P 500 Index, rough rice, bonds, gold or even live hogs. They are all just futures which can be treated in exactly the same way. Using historical data for long enough time periods we can analyse the behaviour of each market and have - 8 -