Backgrounder

Adam:00:02:27There you go. Well said. So, yeah, I’ve been really excited since Jerry agreed to come on the show. Jerry being, I think, one of the first traders in the trend following managed futures space. Jerry, when did you get started? That, was it back in the 80s?

Jerry:00:02:48That’s right. So, 1983, Richard Dennis, then that lasted four years and started Chesapeake in 1988, February ‘88. So, I’ve been getting a lot of well wishes from people on LinkedIn. You know how that goes, your anniversary. So, That’s been a long time. 39 years total, 40 years in the fall. So, it’s been fun, a fun 40 years.

Changes

Adam:00:03:16Astonishing. Yeah. Wow. And so, I mean, I’d love to know how you would characterize how things have changed since then.

Jerry:00:03:25Oh, wow. There’s been a lot of change, you know, slow change, and then you look back at all the slow, but it’s really materially been a lot of different changes. Obviously, we traded, when we were taught that diversification was a most important thing for trend followers, trade as many markets as possible, but we were only trading 25. And now we traded over 300. So, that’s been a big improvement to add those markets. We, unlike most CTAs, we trade single stocks instead of indexes. So, we have, you know, we can really make that number go high if we trade a lot of single stocks.

You know, I was there for the early managed futures years where the big wirehouses would have these public funds with really high fees. And thankfully, that gave way to mutual funds and now a few ETFs. So, that’s a big improvement. But I guess from a trading point of view, back in the 80s, we traded pretty short-term. And for those four years with Richard Dennis, we were making about 200% a year with huge, huge drawdowns. So, when I started Chesapeake in 1988, I kind of knew that I probably should not try to make 200% in order to start thinking about having a stable business that was going to last and have client investments. So, that was a no brainer. But, yeah, to sort of slow it down and try to add more markets.

But in the late 90s, another change happened for us. And I think a lot of CTAs picked up on this, which was the shorter term stuff was not that great. It was not working very well. The markets were experiencing trends, but they were very choppy. Short-term stop losses, you would get whipsawed. Short-term trailing stops, you would get out, the market would go back to the highs, come back down, you’d get out, it’d go back to the highs. So, you really got to make sure that you’re participating in these trends and not getting out too quickly because these long-term trends can last a long time.

Adam:00:05:52Yeah, absolutely. When did they start categorizing trend following futures as managed futures or CTAs? When did it become like a hedge fund category that the consultants started to catch on to and wanted to, you know, put you guys in a box or in a bucket and figure out how your category would be allocated to in institutional portfolios?

Jerry:00:06:20Well, good question. I mean, I’m pretty sure it started with a gentleman who ran the Merrill Lynch managed futures department. And he was just looking for a name to put on it versus CTAs, which was CTA centered. He wanted it to be, I think, more FCM and wirehouse centered, and they came up with managed futures and it kind of stuck. And I think the CTAs sort of took it literally. So, I think most managed futures programs, it’s still some trend following or mostly trend following, but it usually is just going to be futures. And so we’ve tried to expand that into trend following on stocks and ETFs, crypto futures, just anything, basically that was liquid that would add diversification.

But I’m sort of in a minority of almost one, not enjoying the term managed futures. I love CTAs. You know, CTA, the term CTA has the unique quality of a lot of good names. And it is that it doesn’t mean anything anymore, really. It’s just everyone knows what it means. And it’s like IBM. Most people may not even know what IBM really stands for more, but you really know what IBM, the company, is all about. And I think it’s a beautiful, wonderful name with a great heritage that I wish it would come back versus managed futures, but oh, well.

Mike:00:07:52I think this is the first time we’ve had some birds on the —  that’s a bit of fun, actually. We’ve got a few cats and dogs running through… and some kids, but I think this is the first…

Jerry:00:08:03Yeah. These birds are — they’re uncontrollable. The dogs are controllable and so they’re out of the way. But I used to feel really guilty about going on podcast and the spaces and Clubhouse and people would hear these birds and they come across so loud. And I’m like, to people, I’d say, no. They’re not that loud, really. So, the microphone just really picks them up. And so I would just come clean and say, sorry, the birds may be flying around. And then it got to where people were really worried if they didn’t hear the birds. They said, are they okay? How is … doing?

Mike:00:08:37We can confirm that the birds look okay today.

Jerry:00:08:40Yes.

Mike:00:08:41So, you have some dogs and birds?

Jerry:00:08:43Yeah. We have two labs and three shih tzus.

Mike:00:08:46Do the birds like, pick on the dogs at all? I would imagine they…

Jerry:00:08:50I try to keep the birds away from the dogs. They’re not trustworthy. You can’t trust the dogs.

Adam:00:08:59Or the birds. Really.

Jerry:00:09:01Honestly, I have seen one of the birds land on the back of one of the labs. And I didn’t think that was a safe move.

Mike:00:09:11Sorry for sidebar, but it was just —

Adam:00:09:12No. That’s good color. That’s good color.

Mike:00:09:14I missed that color.

Adam:00:09:17I was just going to ask you whether you found at least in the beginning maybe while the business was growing and this was more of a concern, whether the creation of a category of managed futures or CTAs changed how allocators wanted to treat you. You know? Did you find that that put you more in a box than you were comfortable with or than you were used to being before? And do you feel like that has continued to this day? Or do you think that there’s still sort of sufficient diversity and that allocators tolerate that diversity?

Jerry:00:09:58That’s a good question. I’m not happy with how we’re boxed in. I have so many things running through my mind when you mentioned that. Yeah. I mean, I remember silly stuff like we really were committed to getting more diversification from equities, just mainly replacing the indexes which we don’t think are going to have the type of outlier moves that maybe an individual stock might, and wanting to, like all the other sectors, choose the markets we like, based on liquidity and diversification and create a portfolio of crazy different stocks, long and short, and really enhance the trend following. And we went to our largest client once and we said, can we trade stocks and they said, no. You’re not a stock trader, you’re a futures trader. We’re like, okay.

So, then a few years later, single stock futures arrived and we said, can we trade single stock futures? They said, yes, because you’re a futures trader. So, silly things like that and that was very — and then I don’t know if managed futures per se is to be blamed, but it has evolved also into — managed futures is the servant of the traditional assets, long stocks, long bonds, your net worth, your worth what — your worth on this planet is totally due to how well you complement during crisis alpha convexity. A trade shorter term, because that’s better for us. You know, you’ll get short the S&P quicker. I mean, it’s not as good for your performance, the CTA performance, but it’s what we want. And so I don’t like that. I like, oh, my friend sent me an email once and the title of it was “Managed Futures, The Perfect Hedge”. And I called him up and I’m like, what’s wrong with you? Because I know, it’s — I had to do it. I’m forced to do it. That’s how I’m going to raise money.

And I said you know, it’s not the perfect hedge. It’s the perfect portfolio. He goes, yeah, I agree. So, that’s our idea is that we can make it. The CTAs with their knowledge and their experience with systems and markets, have the world’s markets in front of them. They can take those markets and do what they want to and create this amazingly diversified portfolio, longs and shorts, multiple trend systems, and other complementary ideas and just really produce the best chance at producing the perfect portfolio. And I think that it is somewhat not realistic to think that in a small allocation to a managed futures CTA is really going to do a lot for helping that portfolio. But if you liquidate some of your equities and invest in my fund, then I will trade quite a few single stocks in the fund with trend following, which is really going to give you some — it’s going to really prevent you from having as big a crisis because all these markets, including stocks, they really need some trend following wrapped around them, versus allocating 5% or 10% to CTAs?

Adam:00:13:34Yeah, I want to dig much more deeply into that. But before we do, just going back to your friend’s assertion that trend following or CTAs are the perfect hedge. Would you maybe buy into the idea that they’re the perfect diversifier for most kind of traditional portfolios?

Jerry:00:13:58I agree. I wouldn’t even try to make it the perfect hedge. I would just try to be as diversified and different as possible. They have a tendency to maybe be uncorrelated, and so they’re probably going to be your best shot at offering some good performance during a big stock sell off, but it can’t be guaranteed. Yeah. So, I agree. I’m not in for making these big claims. You know, we walk on the field with currencies, commodities, stocks, bonds, and shorts, a systematic price based strategy. I mean, we have so many big advantages that we’re likely to do really well and make people very happy when stocks do well, stocks do poorly. It doesn’t — should really matter. So, yeah, I agree. I would stay away from the hedge thing.

Sizing and Positioning

Mike:00:14:53When you’re thinking about the individual stock side, is it a purely price driven then for trend for you? You’re not looking at any sort of fundamental data? And then a follow on to that is how do you equate the gearing for the position sizing and those types of things? Is there some novelty there that you’re taking into account?

Jerry:00:15:18Well, we do the same thing I do with the currencies, commodities, and interest rates. I would choose the markets based on the liquidity and diversification, and try to trade them the same way with the same philosophy and not use fundamentals to choose them or to trade them. I remember coming up with this idea 20, 30 years ago, it was natural. I came out of that group and diversification was a big, big deal. And so, well where are you going to go? You know, you’re going to go — you’re going to add a couple currencies or commodities every year, but you really got to go to the stocks.

And then I would tell this to my turtle friends, and they would say, oh, okay. But you’re certainly not going to trade it using price only. And these were guys that were with me there, and we all drank the Koolaid. I was like, no, I am, price only. So, my best friends were skeptical, but I have not backed down. And so, yeah. Price only, the stocks trend really well. There have been periods as you well know, recent periods were not only did stocks trend well, nothing was trending except the stocks. So, and then Eric, our friend Eric Crittenden wrote the paper back in the day “Does trend following work on stocks?” and it works wonderful on stocks. So, it’s —

Mike:00:16:44That was Blackstar, I think, the paper, right back, in the — yeah.

Jerry:00:16:47That’s right.

Mike:00:16:48Yeah. If anyone wants to look it up.

Jerry:00:16:50Blackstar paper. Yeah. And it’s been duplicated by other organizations. So, yeah, it’s — one of these days, I think it’ll be mainstream, and it’ll really help — I think it’s hard to be taken as seriously as we want to be taken if we’re the one group — I mean, we trade an index, but we don’t want to really trade stocks. I really don’t know how we got there.

Mike:00:17:17I mean it’s interesting because you do get these very — and it’s like how do you — so, you have to have liquidity and then you’ve got to have difference, something that’s moving a little bit differently and giving you some trends. Do you ever run into problems sort of sorting through, hey, here’s a sort of a, I’ll say, a school of fish. They have a certain business that they’re arranged into. And underlying this school is trending up or whatever the case might be. How complex does it get when picking the fish within the school or do you just do that by liquidity perspective? Like sort of the different sub or these micro sectors that start to trend together. How do you think through that?

Jerry:00:18:04You know, I think it’s a daunting task. Sometimes we have a diff– if you can’t choose which currencies and commodities you’re going to trade, you’re just going to trade them all that’s liquid, there’s not that many. So, the decision is kind of made for you. I think with stocks, people can get paralyzed. There’s too many things to choose from. And then when I start looking into it deeply, I was like even more paralyzed because there’s so many great ones, you know. I like to trade the ones that are small cap, mid cap, maybe a company that has one product or one story basically. So, maybe it’ll be more easy to get an outlier.

Big companies with lots of divisions, they’re like an index. They’re diversifying themselves. And so the fundamentals that are going to drive an outlier may not make that much difference in a very large company. So, I think you try to tilt it that way a bit to where like I — we have a company that sells the biggest producer of french fries and then the biggest producer of eggs. So, those are nice too because we don’t really — There’s no french fry futures and there’s no egg futures. And so you can kind of get both. You have a company that’s — if something happens, it may really get a big trend, and then it’s kind of commodity related as well.

Mike:00:19:30Yeah. That’s interesting because it’s not just — it’s sort of as you were speaking, I’m thinking the outlier hunting is interesting. But it also kind of dovetails into the — I don’t know if you guys have — I can’t even remember the paper, but it talked about the diamonds in the index and how they carry –  a vast majority of returns for the index come from a very small number of these diamond-type stocks. And you’re in the diamond hunting business I guess too, right? It’s these outlier type businesses that don’t have an underlying connection to all the other things you’re trading. And Adam, you and I have had that discussion on innovation. Right? The idea of creating something from nothing or disaggregating a particular industry. And so if you’re not actually considering some of those types of potentialities, your kind of trend following can be somewhat blind to these areas of opportunity.

Jerry:00:20:31You’re never going to be able to get all the stocks you want to trade. You’re going to miss some trends and you’re going to miss some losses because you didn’t — you’re not trading some stocks. So, just do the best you can and at the end of the day, decide how many markets can you trade, do you think you should trade, and then be happy with that. I kind of believe in a fixed portfolio as much as possible. So, I’m not — once we build the portfolio, we trade it. We don’t get rid of wheat futures, we don’t get rid of the Swiss franc if it underperforms, and likewise with these stocks. We want to just simply replace the indexes with something that’s a bit more diversifying and a bit more outlier friendly and then we’re kind of done. There’s no reason to agonize over it. You’re not going to pick the perfect ones and you’re not going to be really bad and pick all the bad ones either.

So, it’s a simple replacement of indices because they really don’t have outlier capabilities like individual markets. You know, we just made a fortune on Tesla, you know. It just went — it was like the biggest trade ever. And so you’re not going to get that movement out of an index. So, that was really fun. I’ve got lucky. You know, we said Tesla’s — we ran these correlations and Tesla was like, it’s not really correlated to too much. It’s liquid, let’s put it in, a total luck. And hopefully we get lucky with some other ones one of these days. So, …

Mike:00:22:08How often do you do that process? How often do you sort of sit back and say — is this something that occurs to you while you’re in the shower, or is there repeatable process that you’re using with your team to sort of hunt for the potentiality of the outlier individual stock or markets, let’s call them in some way, shape, or form?

Jerry:00:22:31I mean, we just — we do some research on different sectors of companies in the group. So, we start defining the groups, you know, lumber, lithium, uranium, shipping, mining hundreds of groups. Right? And so then we try to find stocks, we do research on a stock. It’s totally subjective and fundamental, but it’s really just saying, hey, is this company doing something interesting that’s unusual and is it small enough, and it doesn’t have a lot of businesses going on. We don’t want you to diversify. We want something that’s totally undiversified. We’ll put it in with our other 299 markets, and that’s where we get our diversification. It’s really all about, can we kind of think in our mind that can it have a big outlier? It’s small, it has one business. If something happens to that business, maybe it’ll move.

And sometimes we made money in lumber, lumber futures, and then we had some lumber companies. And so that particular time, lumber futures kind of crashed eventually, but the lumber companies kept going up. So, it’s not the same. It’s a bit different. So, that’s good too. And sometimes it works the other way. The futures, the commodity futures do a lot better than the company, because the company is not going to be driven totally by what’s going on in that market. That’s what we’re used to, it’s what we like, we’re biased that way. But we just force ourselves to say, hey buy gold and buy a gold miner. And we just really want to look down the line and say, oh, we’ve got a lot of diversification. Some of these companies are very crazy.

Sometimes I just choose companies because they’re from my childhood. The names are crazy. They make me laugh like Tempurpedic, Crocs, Formula One. Some of them I’m like, yeah, I want to have, like, maybe 10 or 15 stocks that they’re my little buddies, they make me laugh, they make me think of my childhood.

Mike:00:24:46Well, you got to have fun. So, I suppose this helps with capacity too if you’re able to get involved with some stocks. You know, we run into CFTC limits at times. And if you can provide these other markets that are different, you also have the side benefit of having a bit more capacity.

Jerry:00:25:07That’s right. And hopefully smoother returns, more outliers. Adding – my idea is that adding markets is the only enhancement to your strategy that comes with no cost as far as adding a rule or adding more parameters. We all know that they can be problems. But adding these markets, it makes you more different and I can’t be replicated. You know, I think this replication thing, it’s kind of funny. I mean, I laugh about it because you have the 20 smartest and biggest CTAs, and this in one index, and this guy can replicate them. It’s mainly because they don’t make hunting the outliers their bottom line. They’re vol managed, they’re correlation managed, and so they kind of minimize the impact that some of these — a Tesla would have. Tesla’s too volatile. It’s too crazy. We need to scale it back because we have a portfolio overlay, money management portfolio overlay to keep a risk sort of the same or similar. And we’re just these crazy guys who get a hold of Tesla and Moderna and these outliers and our performance starts looking so much different than everyone else’s. And unless this replicated trades my 300 markets, is not going to be able to replicate me. So, I think it’s just interesting how that is all happening. I don’t — knock on wood I mean, because if I challenge him too much, he may try to replicate me.

Budgeting Risk Allocation

Adam:00:26:49Jerry, how do you budget the risk allocation to the individual equities? Do they get the same risk allocation as say, an individual commodity future or are they kind of grouped together and that group of equities get a certain risk budget or is it kind of a mix of both? How do you think about that?

Jerry:00:27:12Well, I trade each market the same size, I just trade more stocks than anything else. So, all the stocks will have the same risk and the same risk budget, but — each individual stock. But since I trade more stocks, I am more stock heavy than anything else. So, that I think the philosophy there should be that it’s only because they deserve it. You know, they deserve more allocation as a group because they offer more diversification. And we’re seeing that recently now, recently. We have not seen it in other times when we’ve all experienced big stock sell offs when all the correlations are one, But recently over the past year or so, we’ve seen that stocks were the only place we were getting diversification. We were long some, short some.

If you put together a portfolio and you’re like patting yourself on the back about how great you put it together and it’s really diversified, and all your stocks are long, you might have a problem. So, we don’t want to see that most of the time. Sometimes stocks just — every one of them go up. You know, are you happy or sad? You’re making money on all your stocks. You’re kind of happy, but you know you’re going to pay the price. So, the currencies, we’ve been short all the currencies, no diversification there last year. Interest rates, short them all, traded a lot of them. We think we have some diversification, short every single one of them, no diversification.

Commodities, you know, mostly in uptrends the past few years. Stocks, longs, and shorts, and as the market was even selling off hard earlier, we still had longs on and we’re doing pretty darn well. And when the market rallies, we have shorts on and they go down. So, sometimes you’re just not going to — you’re going to find — you’re going to get this diversification because we think there’s thousands of these stocks and you ought to be able to find some that act differently in the long-term. In the short-term, over the day or week basis, yeah, they’ll all go down or go up together. But the chart patterns and the positions with the trend following, it can look quite a bit different.

Then you have these periods like 2020 COVID, where everything was correlated. We were long, I was pretty much long everything; currencies, commodities, stocks, and bonds, and they all went down And so people bring that up as well, like, what about during COVID when stocks crashed? I’m like, well, so did currencies and so did commodities. And so I got really crushed during that period. So, you put it together, you do the back test, you know you’re going to see things maybe you’ve never seen before, you think you got the correlations pretty good and then all hell breaks loose and then you have to scramble to get your risk more under control. And that’s what we have to do every two or three years. We will get through a rough patch where we’re not seeing any diversification and we’ll have to make a kind of position cut back. That’s how we handle it.

Adam:00:30:29Can you go into that in more detail? So, you can use COVID as an example if it’s fresh or another one if it’s a better case study. But how do you think about this idea of cutting back risk? Or — I get the sense that you’re not sort of on a day to day basis using, for example, covariances or correlations to help with risk budgeting or sizing or what have you. But you’re observing that on occasion, obviously, that you’re in a crash scenario, right? And you do have this correlations crushed to one type of scenario. And it sounds like there’s some kind of, you know, discretion or intuition or experience that you bring to bear in order to manage those events. I’d love it if you could kind of go through the thinking there or the mechanics or —

Mike:00:31:24Mental model.

Adam:00:31:25Yeah. Yeah, framework. Yeah. I’d love to learn more about that.

Jerry:00:31:29Yeah. I mean, this is a Turtle Rule. That when you have a drawdown, you reduce your positions twice as fast as the drawdown. So, if you’re down 10% you should reduce your positions by 20% and so on. And that’s a different day when we were trading really large, very few markets, very short-term. But I think it still kind of applies that you want to have that one rule that always works. It’s always going to work. It’s going to keep you from losing too much. And that is just reduce your positions and live to play another day. And it also is very important in that one of the most important things is to always do the system trades. So, you don’t want to guess which trades to cut back. You know, you want to feel good. So, now, you know, it’s — you’ve gone through this really tough period. It’s a bit traumatic and you don’t want to get into a situation where you’re afraid to do — to follow the system and do the trades. And this cutback rule kind of helps you do that.

One of the secrets of the cutback rule is don’t have to implement it very often. So, I’ve seen people do research and they showed me their research and they said, and the research was, what happens if the turtles would have traded smaller? Would they have made more money by avoiding so many of these cutbacks? And the answer was, of course, yes. The cutback is a non-system rule. By definition if it’s non-system, it’s going to make less money. But you need to sacrifice and make less money sometimes in order to preserve capital. So, that’s the key. Trade small, don’t put yourself in a situation where you have to make these radical cutbacks, but don’t be afraid to do it because it is the perfect money management rule that tries its best to allow you to continue to trade the system and not do a lot of overrides.

But like you said earlier, it is somewhat discretionary because anything that doesn’t have a large sample size might — it’s going to be — even if it’s a rule, it’s kind of like not a rule based in good math or sample size. It’s just this rule you have. So, it’s okay to have a rule or to use some sort of feel or discretion. The whole key is you may not — you may use it once every five years or two years, but it’s not based on sample size because, thank God, you know, you don’t want to have to do this very often. It’s one of those rules where I’m happy that it doesn’t have a sample size. It means I’m not — my system is good and robust and doesn’t have these problems. So, yeah, it’s — I love whatever it takes, whatever the trader needs to encourage them to continue to do the trades the way that your model indicates you should do the trades is a really good thing.

Adam:00:34:37And so —

Mike:00:34:38I suppose it preserves gray matter too. I mean, if you got some ways to continue to keep your mind straight. I’m sorry, Adam. Go ahead.

Adam:00:34:47Yeah. No. I mean, it’s a discipline. Go ahead, Jerry. Sorry.

Jerry:00:34:49I used to trade a lot larger and less disciplined, so I was always running into these cutbacks. And the cut backs would always occur at the equity low. And so, and that’s inevitable. Right? It’s going to occur at the equity low. It’s –I’m really going to brag about how I stayed in the game and did this proper cutback and then the markets take off and it’s kind of a bummer, but it’s — a lot of trading is that way. You’re doing the right thing and you’re not necessarily going to be rewarded for it every time or the first time, but you just have to force yourself to do it.

Adam:00:35:39I love that candor about you, Jerry. It’s just so true. So, it’s not like every 10% drawdown, right? I mean, it would be more like a major crisis, a really fast drawdown that happens over a few days with some really big outlier moves in the total portfolio are kind of giving you an intuition as something is different that you just — you might want to just implement this rule. Is that kind of the way it works?

Jerry:00:35:56I think so. I’m very tolerant of 10% drawdowns and as long as it’s open trade profits and I’m still doing really well. You know, I think if I’m up 50 or 60% for the year and I draw down to plus 40% I’m going to be sort of tolerant of that. If I’m taking a lot of losses in a row and eating into my capital, I’m not going to be happy about that. If everything, like that COVID is a great example, everything’s going against me, everything seems to be correlated. The volatilities are out of control, then yeah, let’s reduce a bit. Let’s use a little bit of our experience and discretion to stay alive.

Adam:00:36:45And when do you put the full exposure back on? You don’t wait until you climb out of that drawdown I assume, right? You’d sort of wait for markets to sort of normalize in some qualitative way?

Jerry:00:36:57That’s right. I think you wait until they calm down a bit, the volatilities start coming down, the correlations start not all being — not every market is correlated with each other like they can be. And you sort of get back to a sort of a normal situation. These systems are great. They’re great guides of what we should do. You shouldn’t look at them as religion or something you believe in. I love my systems. They’re great. They’re fantastic. But I don’t believe in them to that degree. They can have these hiccups and problems. And one of the ironic things about CTAs is that we put all this emphasis on back-testing to kind of determine what works in the past. And I basically try to take as little from that back-test as possible because I know that the future it could have trends and my systems may do okay. But the fundamentals and the what’s driving these markets is going to change radically.

Trump was not in the back-test. COVID is not in the back- test. It doesn’t mean it’s going to, our way of trading, our style is not invalid. It’s very valid. Whatever the fundamentals throw at us, we’re going — they’re going to produce trends and our job is to stay in them and not get bounced out too quickly, but don’t stay in them too long to where we give back too much profit. But I expect different things to happen in the future. And CTAs in general are so — have a great reputation as when something happens, that’s never happened before, they’re right there. No one would have been as dumb as we were to continue being long interest rates when they were approaching zero. Buy stocks when they’re overvalued. You know, you’ve heard that. They’re overvalued. CTAs are just long and strong. Don’t even care. So, when something that’s never happened before happens, clients expect us to have good performance.

Adam:00:39:07Be there to participate with it. Yeah. I would think that your approach, I want to get into more of what you mean, hopefully, a little bit quantitatively by outlier hunting. But just in terms of your comments on kind of back-testing and we could probably have a four-hour conversation just on the nuances of how to think about back-testing. But I would think in the context of your type of approach of outlier hunting, that almost definitionally, you’re looking for types of moves that don’t happen very often. And therefore, like, you mentioned sample size, if you don’t have a sample, a very large sample of crisis periods where you needed to implement a cutback. Well, by definition, there’s just not a very large sample size of outliers in any one market, right? I guess kind of what you’re looking at in back-testing is because you trade a wide variety of markets and you trade them using basically the same set of rules, that when there are outlier events, wherever they happen and for whatever reason, over time they’ll accumulate P&L in generally a left, bottom left up to right direction, right? How do you think about back testing for outlier hunting type strategies versus maybe some of the more common trend following methodologies?

Jerry:00:40:32Good question. Well, like, I didn’t get the — I didn’t come up with any of this. So, if you like it or don’t like it, you can blame it on Richard Dennis, Bill Eckhart. And I don’t even know if they still, you know, I’m always wondering. I think I left there thinking that they were these big dedicated trend followers. And I think that’s obvious that they’re not. They weren’t. They were more systematic and they were dead set on systematic and then they were pretty easily able to abandon trend following, because making it more long term was just not going to be something that they were willing to do. So, I was the one who came out as the big trend follower.

But their idea was we’re going to trade all the markets the same. Each system would, you would trade each market the same with the system and the same parameters, the longs and the shorts. And so we’re going to assume that we can count all of those trades in the sample size because we are treating them the same. And some — and then we — so, we do the back-test, every market’s treated the same, the longs and the shorts, and we have this sample size of thousands of trades. And then, oh, we kind of notice over here that 5% of the trades made all the money. Isn’t that weird? So, we kind of pretend those 5% get caught up in the same net of the other 95% that didn’t make very much money.

And so that’s the philosophy. The theory is that we don’t look at the sample size of the 5%, the outliers. It’s the 90 — it’s the 100% and 5% of those are outliers. So, we can trick the numbers or we can do the sleight of hand and say, oh, yes, we have thousands of trades because we treated them all the same, long and short. And some of them, it just happens with this strategy that only five or 10% make all the money. You know, it’s similar to the other studies. I think maybe Eric did this. Yeah. Maybe part of Eric’s study was that 4% of stocks in these indices, they make all the money.

Adam:00:42:50That was Bessonbinder who did that. Yeah. The capitalist — The Capitalism Distribution. Absolutely.

Jerry:00:42:54Yeah. Yeah. Yeah. So, I find that pretty interesting. And with trend following, it’s the opposite. Every market makes money. It’s like Lazarus from the dead. Trend following rehabilitates every market. And so these people who they kind of sit around and they say, well, I’m going to include stocks and bonds, buy and hold. You can include gold. Gold is positive buy and hold. I think recently at some point, Bitcoin became able to be in the portfolio because buy and hold, it was great.

And then we come along and say, what these commodities and currencies do buy and hold, we don’t care. Trend following makes them all profitable. So, you have this diversification feature, wonderful. Shorts, oh, sometimes it’s the only thing that’s going to do well, is the shorts. And the trend following makes them all positive contributors. I mean, 90-some% of them. And the few percent that aren’t, haven’t contributed positively in the future, in the past, they may do pretty well in the future. You know, we just don’t know.

So, yeah, I got off subject there, but that’s how we handled the sample size. And so it’s really important in order to maximize that sample size to have systems with not too many parameters, not too many moving parts. I’m famous for coining this term, one entry, one exit and a stop-loss. And the reason — and we trade multiple systems like that. They all have one entry, one exit and a stop-loss because that’s the way to maximize the sample size. I used to tell people like if someone asks you a trading question, you don’t understand it, just guess that the answer is sample size. That’s what we were taught. You know, that’s what they were hammering into us. So, you’re right, in 40 years I haven’t really changed very much philosophically, you know. I’ve tried and I’ve made changes and regretted some of them, but yeah, I’m too old to change.

Regrets – I’ve Had a Few

Adam:00:45:04Are you open to sharing if you can remember any, some changes that you made that you ended up regretting?

Jerry:00:45:14Of course. I have a list of them, not in front of me. But, yeah, I’m like a masochist. You know, get down on myself, and I make a list of all my mistakes. I think one of the mistakes is, you know, you can make all kinds of mistakes. Treating shorts and longs differently, optimizing commodities versus currencies and things like that. But some of the ones I did is I did try to treat shorts differently and maybe try to eliminate some shorts. I think people are always saying, put in some negative skew between your trend following, or put in some things that are different.

I even heard Rich say, and I’m sure he believed this is, you can even trade things that don’t make money if it’s different enough. Combine that with your trend following, and then overall it should help. We just could never pull the trigger on that because we didn’t want to make less money. And so we just tried to diversify as much as possible and then trade more systems. But, yeah, so that’s how I handle that. I lost my train of thought. Get me back —

Adam:00:46:33Just was wondering, yeah, just if you had — were able to recall some major changes that you had made. And if you can’t recall any, that’s fair too. You know?

Jerry:00:46:42Yeah. I mean, we fell into the trap of vol management, things like that. I made — we got a good start because just trading these one entry, one exits, one stop-loss systems, we had, for our first, like, five or seven years, we made money every year. And people really love that. But then we got really big and we got — we just had to improve. We were just telling ourselves, look, we got to improve. And so we tried all kinds of things like vol management, profit objectives, things like that. And we did this great back-test and the performance was just amazing. And then the first few months of trading performance was really horrible. So, we were like, what are we doing? You know? We’re putting this pressure on ourselves to be something that we’re not, and to improve something that’s made money like seven years in a row. I think that’s kind of good enough.

But you just get into this competitive environment and you hear what other people are doing and you’re like, hell, I want to be like those guys. You know, and we should have a big research crew. And I think my destiny was just always to be more of a good classic trend follower and that was where my talent was and my love was and passion and I — but I deviated from that quite a bit. But I got back on the right track. I wasn’t off for too long.

Adam:00:48:14Right. I wonder if —

Mike:00:48:15Course correct.

Adam:00:48:16          Exactly

Jerry:00:48:17You can fall in love with these back-tests. I mean, I used to go into research meetings with the research staff and it was just such a high. You leave there going, man, we are good. I mean, we are really good. I sort of came to the conclusion, you know, there’s not an idea in my head that’s going to even come close to approaching being long Tesla. I got long that market, I diversified, I added some stocks. The markets are the heroes. They are the ones that are going to take us home and make us heroes. And these systems just need to kind of get out of the way, don’t screw it up, don’t get out too quickly, take your small losses and let these markets do the work for you. Because honestly, I’m not going to do very much if I don’t grab some of these outliers.

Contrasting Outlier Hunting and Trend Following

Adam:00:49:10So, say more about these outliers. And how would you — and I know you’ve talked at length about these mechanics on Top Traders Unplugged and on your Spaces and stuff. But maybe just contrast for me how you would characterize the mechanics of a trend strategy that really tries to focus on outlier hunting versus maybe the more common trend strategies that are deployed in a lot of the funds in the CTA index nowadays.

Jerry:00:49:51Right. I mean, I think you know, I know maybe six traders who really would say that they are obsessed with the outlier hunting. I think it’s — hunting is not the perfect word. I think it’s easy to find — it’s easy to get on these outliers. You just buy the breakouts and 60% of those are going to be losing trades. So, if you make your bottom line, don’t miss a big trade, that’s pretty easy. So, we don’t really miss the trades. And I think it all boils down to we let the trade — we don’t change the size of the trade. We don’t liquidate for instance, any of the position if the correlations increase or if the volatility increases. So, that’s pretty much it in a nutshell. Certainly it relates to your specific question of the difference between — I think a lot of traders and CTAs are longer term they kind of — they’re not too prescriptive of the type of trend they’re going — the loose pants. They’re going to allow the markets to have some fluctuation, they’re not too prescriptive of what the trend needs to look like. They’re not using too many parameters.

But what’s crept into managed futures is trend plus smoothness and Sharpe and correlation and kind of — I was learning a lot to the extent that it’s sort of gone this way is the traders, the managers on the Top Traders Unplugged CTA section saying it’s like, every day we’re kind of balancing and it’s a soup of markets and we’re making sure that everything’s kind of level. And we are adding and subtracting pretty continuously to keep that smoothness going. And if an outlier, a good characteristic of an outlier, is to volatility to dramatically increase, then we’re going to cut that back. We’re going to make sure that — that’s getting out of control. That’s a problem for us. The Yen short and the British pound short got way too profitable, way too correlated, way too volatile, that those things needed to be cut back. Because it was impacting the overall portfolio and we’re going to call that risk, volatility is risk.

And so we need to be proper risk managers and cut that back. And we’re like, oh, no. No, no, no. Risk is these small losses we take. We’re bifurcating the equity. The very definition of trend following indicates this is what we should do. We’re going to separate profits from losses. The losses they’re going to be small. By the mere fact it’s a loss, we’re going to handle it different. We’re going to cut that thing off pretty quickly. If it’s a winning trade, we’re going to let the profit run, much more liberal much more flexibility in allowing the market to have pretty significant drawdowns, versus the losses.

So, we just say, okay, let’s sum those up. We’ve got the closed trades, we’re going to — that’s our capital. We’re going to try to preserve that. The small losses are very important to us. The volatility of the open trades we’re going to let those go. We could have hundreds and thousands of basis point drawdown and we don’t really care because the trailing stop has not been hit yet, and so we’re going to just let that go. And so the client just sees all this crazy volatility and has no idea really and can’t really prove that we’re really good money managers. And we think being a proper money manager is to maximize these trends and let them get totally out of control as far as their impact on the whole portfolio, because the back-test really loves that. The back-test says you’re going to make so much money if you let those profits just go unrestrained, and that’s what we try to do.

Mike:00:53:55It’s such a different mindset and experience from an investor’s perspective. I mean, it’s funny because I understand precisely what you’re saying. But I’m not sure that most people do. The idea that you’re tracking these entries and the small losses and then you have these huge gains, and part of that probably becomes more relevant with institutional money management, whether that’s funds or institutional funds and fund flows that are hitting the accounts at different times. If you’ve got initial capital that you put in and you’re sitting there and you’re riding it, you can sort of, as you said, bifurcate these two groups.

But now you’re a money manager with flows coming at you at all different times and those flows have different cost bases and they’re experiencing different things and often they’re coming in at inopportune times rather than opportune times. And their experience is not quite the same, especially their mental experience. I don’t know if there’s — I don’t know how we can add to that or help people kind of understand that or investors understand that because it is a really tricky concept.

Jerry:00:55:12It really is.

Mike:00:55:12… those profits is a different thing. And as you said, I’m up 40 or 50% and I lose 10, I’m not concerned about that, house’s money if you will, but a lot of the money came in maybe when you were up 40. It seems to be the way…

Jerry:00:55:27You’ve introduced a different problem, but that is another problem. We usually try to tell clients, potential clients, hey, spread it out over the next six months. Don’t give it all to us at once. We’ve got to give you pro rata positions, but we want you to have a good initial experience. But I am going to tell you, you’re going to — if we have a 20% drawdown, a lot of times, our clients are so — they’re so happy because they’re up 30. But the new clients, they’re like, I’m down 20. Talk to me all you want, but I’m not happy. And you can have just imagined me going into institutions who deal with managed futures CTAs and say, okay, I got two things. One is, I don’t care about open trade volatility and I trade stocks.

Mike:00:56:20Yeah. But I’ve been in the game for 40 years. So, it’ll buy you some cred.

Jerry:00:56:25They’re like, I am never giving you money. I am never giving money. And so why do we do this to ourselves? And we just say, well, is what we believe in. This is how we’re passionate. We really think that this is far superior. But it is — yeah. It’s just one of those things where if we can get back to the old days where when we would go in in the 90s and do presentations, our presentation was essentially — it was also this thing where here’s the biggest stock drawdowns and here’s how we did. And of course, that looked pretty good. But it was even better. It was, here’s our performance over the last 10 or 15 years. It was better than stocks and of course it was less volatile. So, then you go through this 10 year period where we didn’t do as well, and so you know, we have to find other ways to entice clients.

But I think we’re going to get back to that. We just have the odds stacked in our favor, all of us, not just me, but everyone, stocks or not, we’re just going to be able to get back on track of offering a product that with so much diversification and trading with rules, we’re going to be able to beat almost everyone, make more money than stocks. Stocks are not superior trenders. They’re not better markets than the currencies or the commodities. They have been, but they won’t be, and they’re not inherently better. And we’ll be able to say again, and appeal to people’s greed basically, that’s part of the way I raised money was people were greedy and would throw money at you if you made money. So, we need to get back to that. Trying to explain all of this to them, especially what I have to explain, is probably not ever going to work. I need them to say, yeah, be quiet, be quiet. I don’t care. You’re making money, here’s your money.

Adam:00:58:22Jerry, how much of the — how much of your P&L do you think since you started trading individual stocks has come from the individual stocks, versus the other components of the portfolio? Do you have a general ballpark? Is it more than a half? Is it…

Jerry:00:58:41Oh, no. I wouldn’t say it’s more than half. I wouldn’t say — I’d say it’s around 25%, you know. So, nothing outrageous, but it’s doing its fair share. I mean, these things are really difficult to sit with sometimes. I don’t know — we may have had a 10 year, 15 year losing streak in commodities. Once again, that’s this a kind of a CTA thing. What are you going to do if you have a 10 or 15-year losing streak in a particular sector? Nothing. We’re going to keep it right there. So, as soon as November 2020 rolls around, we’re buying those breakouts in soybeans, corn, and wheat like they’re our favorite markets. And that’s what you have to do. You have to close your eyes and really tell yourself, look, they’re all one market. There’s nothing particular about them. They have good diversification characteristics, but historical performance, recent historical performance means nothing.

Stocks were great and they may go through a period where they don’t trend very much, but you’re still going to make them a good part of your portfolio and you just don’t know how to predict — there’s no way to predict certainly based on historical performance. The only thing that I found that you can add to trend, and you can systematically, you can figure it out. But you can add to trend that makes trend a little bit better than just, and I mean the breakouts, is get in quicker if the market has been really bad. So, the opposite.

If the market has been very choppy, false breakouts, losing trades in a row, get ready to hit that breakout sooner. If you have a market that’s had a really good trend recently and hasn’t had much time to consolidate and vol to go down and people kind of want to get, you know, they made it on the upside, they want to make it on the downside. We made a lot of money on the long side, so let’s just get short and make it all the way down. As it goes all the way down, that kind of wishful thinking, kind of want to delay entering that, the next trade. So, it’s quite the opposite. The best trades are the ones that have been the worst recently, worst markets, kind of the most pain and suffering, people are discouraged. They don’t like it anymore. They’re thinking about kicking it out of the portfolio.

Adam:01:01:07We’ve been more hesitant to take that next trade too. Right?

Jerry:01:01:10Yeah. And I think, yeah, counter intuitiveness and just this perversion exactly what — the opposite of what human beings want. I think that’s a good guide for all your research projects.

Adam:01:01:23Totally.

Jerry:01:01:24Yeah.

Mike:01:01:26Well, I think that kind of complements that sell the losers quick and beat the hell out of the winners. I mean, that’s just typically the exact opposite of human behavior. Let me take that small gain and I’ll wait till I get back to breakeven on whatever it is that I hold.

Jerry:01:01:44Oh, Rich used to — Rich used to say humans just get a charge out of a profit. It’s just a reaffirmation. It doesn’t matter how small it is. You hear people saying, don’t let it turn into a loss. Leave your stop up to where at least it doesn’t turn into a loss. And of course, if you do the back- test, letting it turn into a loss is absolutely the best thing to do. We don’t like it, so more than likely it’s going to be correct. I used to say, when you have a loss, you’re thinking, I’m hopeful that it’s going to come back and turn into a winner, but that’s when you should be fearful that the loss is going to get bigger. And then the biggest mistake is when we have big profits, we’re very fearful. We’re fearful it’s going to turn into a smaller profit, but that’s when we should be very hopeful that it’s going to be a big huge winner.

So, I think that, you know, we’re always going against the way we’re wired And I think that is going to help with the longevity of trend following. And I try to maximize that and be an extremist in those areas. Smoothness, no, I want the bumpiest, most volatile, yeah. I want the hardest to implement strategy possible. I think it might have some benefits of working longer.

Adam:01:03:07I mean, you should look a lot more beat up and older, Jerry, given how much contrarian grief you’ve inflicted on yourself over the years.

Jerry:01:03:16I know. I know. But most of that has come from, honestly, from over-trading and not following my systems to a T, as a 100%, as much as I could have. Yeah. So, most of that was all self-induced anxiety. The markets I can kind of get over, I can turn it into a game, I love the game. I love playing and I love competing. But, yeah, that’s the two most important things. And I got that from Rich. I asked him, like, one day, what’s the two biggest mistakes we make? Or what are the biggest mistakes we’re going to make? And he’s like, oh, over trading and not following your system. And that kind of connected to some — in some ways as well.

Adam:01:03:58All right. I’m wondering if you’ve got any theories or whether you care about whether there was anything — whether there’s any sort of cause and effect going on with that, let’s call it kind of the trend following winter or whatever that we saw in kind of the mid-teens a few years ago. Any thoughts on whether there was particular macro environment that was unfavorable or whether… I don’t know. Anyways, just — I’m curious whether you have any thoughts on what happened there and the likelihood of it playing out again in the near future.

Jerry:01:04:03I mean, yeah, anything can happen, I wouldn’t be surprised. I wouldn’t rely — if I was worried about that happening again I would try to do something about it. I wouldn’t rely upon well, you know, this idea that it’s probably unlikely. Well, obviously, I think I’ve said before already that I think it has to do with stocks. You know, we don’t — CTAs need to trade the single stocks. They need to have a material allocation to single stocks for their own benefit and preservation, track record, legacy. You had the one trending — the best trending sector, possibly the only trending sector overall. And we’re probably under-invested in that, and probably very important to have a single, single name so you can maximize the benefits of trend following, which is the outliers.

People who use vol management and correlation management, they still get outliers. They just don’t get as much as people like us. They don’t get the volatility like we do either. I think another thing obviously, the Fed was — a lot of calmness. I like the AQR paper. I think there were more than one, but I think the AQR paper where they kind of lay out, hey, look, your strategy relies upon outliers, we counted them. There weren’t that many, not nearly as many as there were. So, you’re fine, you have a strategy. You didn’t mishandle it. You didn’t miss trends. You didn’t get out of them too quickly. You didn’t mishandle them. You didn’t have trends that crashed on you, not a system failure, just the characteristic of that period was there wasn’t that many trends. But I think, I’m sure AQR wasn’t totaling up the type of typical trends you may have gotten from trading single stocks.

So, yeah, I mean, I — so, that’s another reason I’ve tried to emphasize more stocks and being aggressive with the single stocks because I’m not going to allow that to happen to me again without putting up a big fight. I love that people want to invest in trend following and it makes their portfolio better. I think that’s fantastic, but also I have my own money invested in the fund, and family and friends and clients who love trend following, and they just want to make some darn money. And so they don’t want to look at it as well, it was a good hedge or it offered some volatility reduction. That’s not good enough. So, we got to go out as — and uncover better ways to make ourselves less susceptible to those periods.

Mike:01:07:32It’s challenging within the context of whether it’s the zeitgeist, the current zeitgeist of low fee and harness beta, close your eyes, don’t worry about it. And it’s been a compelling decade on that. And then how do you get away with that? How do you navigate the compliance departments of sort of your average or your more typical portfolio manager or wealth management shops in order to get exposure that’s even enough to make a meaningful difference in the overwhelming portfolio of 90% stocks and bonds, and then you’re going to add this diversifier that’s 5% or 10%. To some degree, it’s got to be a larger position than that anyway just to make the difference happen.

Jerry:01:08:21I mean, I think for a lot of us and a lot – for me and for a lot of people, not the top 20, but I think for a lot of people, there’s only one path. And that is have a material allocation to stocks, trend follow those stocks, and at some point, people are going to love you for it. They’re going to understand, miraculously. They never understood. You told them that when they lose a ton of money on their long indexes, they’re going to all of a sudden have this Come to Jesus Moment where it all makes sense. Yes. Of course, you have to have a trailing stop. Of course, you have to have a stop loss on everything, nothing is going to replace that. Eventually, you will get got if you do not come in every day with a serious attitude towards risk, primarily.

And then the great thing about trend following is you can have a very serious strategy about risk, but it doesn’t take away from the potential profit either. And I think it will happen. But for most people, this idea that it’s a complement to stocks and bonds, when the stocks and bonds are sitting there. The bond market oh, my. Can you imagine comparing the bond portfolios of some of these people with how we did in bonds last year — this year? It’s getting more nasty now. So, we’re inevitably going to win. You just got to be there, when people understand. And they’re going to be driven by money and losses, unfortunately, not by education as much.

Adam:01:10:11Yeah. No, I think the education component is vastly overstated in its persuasive power for most individuals. And in the end, you kind of have to, you know, you take a path, you are rewarded or you’re, or you experience pain. And the different path of rewards and pain are typically what end up motivating change and decisions in one direction or another. I think we’re all old enough to concede that point.

I want to talk a little bit about convexity, Jerry, if you’ve got a few more minutes. A lot of people bandy this word about — I’m convinced there’s no standard definition of convexity. I’m just curious, how do you think about this idea of convexity? And do you actively seek to maximize that in the portfolio? Do you think you do that or is it your objective to do that with the breakouts and preserving your original risk budget without reducing it as volatility expands? Or are there other dimensions to your strategy or even maybe to other strategies that seek to maximize convexity? How do you think about that?

Jerry:01:11:37Honestly, I don’t really think about it too much. The way I understand it, it’s the idea that CTAs should be — when the stock market sells off that CTA should be likely to step in and really help out. So, I don’t really think about that at all. I don’t — I want to create this perfect portfolio that doesn’t have any — that doesn’t pay any attention to what long only passive index people are doing. It’s a standalone product, the perfect portfolio. It’s not always going to work. As sometimes these V bottoms and these really crash and sell off, you know, the trend following really fails, especially in the stock market. But I am just maximizing what I do and making it as good as possible. I’ve even branched out into interest rate ETFs, ones where there’s no futures markets like TIPS and corporate bonds, muni bonds, high yield, all kinds of things.

You know, I love this ETF world. It’s another great source for more markets for me and especially in the interest rate sector. So, I’m just totally absorbed with myself without trying to help people with any of their other problems. Your problem can be solved by investing in traditional trend following in 300 markets, maximum diversification, shorting, everything we do. That’s the solution and not how I — my relationship with other markets.

Adam:01:13:33Great. Well, I honestly think that’s a fantastic place to put a pin in it, with that statement. So, Mike, I don’t know if you have anywhere else he wanted to go or Jerry if you had anything else you wanted to talk about. But if not, then it seems like a natural bookend and leaves some other things open for us to have you back on and dig a little deeper on a few dimensions.

Jerry:01:13:59Well, I’ve really enjoyed it. Thank you for having me. You’re a perfect host and you got me going. Good questions. Congratulations.

Adam:01:14:08That’s great. Well, you’re an old hat at this as we discussed. Right? So, we wanted to cover at least a little bit of new ground. Jerry, just on the off chance that people have been hiding under a rock and don’t know where to find you, where can they find you and what do you do for a day job and where can people go to learn more about you?

Jerry:01:14:30Oh, definitely chesapeakecapital.com, Twitter, RJ Parker JR09. I’m big on Twitter. Spaces, Friday mornings at 08:00 AM. So, yeah. It’s hard to miss me. I’m on some podcasts and maybe I’ll do my own podcast one of these days. Who knows?

Mike:01:14:54Nice.

Adam:01:14:54Yeah. That’s — you are omnipresent, Jerry. Fighting the good fight.

Jerry:01:15:01Yes. Exactly.

Adam:01:15:03Well, listen, thank you so much for being such a gracious, candid guest. And we’ll definitely look forward to having you on at some point in the future. So, otherwise, have a great weekend.

Jerry:01:15:14I look forward to it. Thank you, guys.

Mike:01:15:16Thanks, Jerry.

Adam:01:15:16Thank you.