Saturday, November 03, 2012

Chasing absolute returns

Major CTA's and hedge fund managers are hamstrung to a degree in their desire for chasing absolute returns, by the demands of those individuals that have invested with them. The majority of investors desire smooth returns and will not tolerate periods of drawdowns. As a result, those funds have to ratchet down the risk parameters used. The funds are also potentially restricted to a degree in terms of position sizing and the effect on the markets they trade when they wish to open or close positions.

This is especially true of trend following systems, which are designed to catch the absolute returns available. The legendary trader Richard Dennis lamented this after one of his failed attempts at money management. Whereas he had the confidence to sit trough pronounced drawdowns, his investors were not. Given his track record over a prolonged period of time, this is somewhat surprising - had they done their research, and looked at the performance of Dennis or the the Turtle traders, they would have been able to see the performance peak and troughs. Investors wanted all the returns without being prepared to suffer the accompanying risk that goes with it. One of the Turtle traders, Jerry Parker, went the other way when he set up Chesapeake Capital and promoted it on the basis of reduced returns in exchange for reduced risks. His subsequent success proves that both trend following worked, even with the brakes being applied, and was acceptable to investors. Other Turtles kept  closer to the 'absolute returns' approach they were taught by Richard Dennis and William Eckhardt, on the basis that "if they seek me out to trade their money, based on my historical performance chasing absolute returns, then I should remain faithful to that approach".

This is not to say that trend followers have a disregard for risk - far from it. Risk control is an inherent part of the overall system parameters used. Some of the risk parameters used by the Turtles were major advances on risk control compared to what others were using at the time.

Where does this leave you, the individual trader? Well, this all comes back to the question of compatibility with your method, and your confidence in the method you use. Using proper risk control and a proven method, you CAN use such a system to generate returns of more than 100% per year - in a big trending year such as 2008, a return of over 1,000% is achievable. I know of one other UK based trend following system (longer term than what I use) that in 2008 achieved a return of over 1,500%. I have also recently read about a trader who used a very short term trend following method with a volatility component built in, and was able to turn $75,000 to over $1 million in a year. But with rewards, there is risk. The short term trader mentioned suffered a 50% drawdown in that period! Trend followers can go weeks, months or in the case of long-term system, even longer periods of no returns, but they know that over the long haul if they stay faithful to the system they will finish ahead.

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