Understanding Warehoused Risk and Why Stops are Critical Risk Management Tools for Classic Trend Followers

Understanding Warehoused Risk and Why Stops are Critical Risk Management Tools for Classic Trend Followers This blog explores the concept of warehoused risk and how effective portfolio management can enhance returns while mitigating risk. When trading, we often focus on individual strategies and their performance metrics, such as drawdown (DD) and compound annual growth rate (CAGR). However, the real power of trading lies in managing a portfolio of these strategies. This blog explores the concept of warehoused risk and how effective portfolio management can enhance returns while mitigating risk. Importantly, it demonstrates a curious conservation law in investing: “Risk cannot be eliminated from a portfolio; it can only be transferred within it.” The only way to release risk from a portfolio is by eliminating the risk contribution of an individual return stream by exiting that position. We will demonstrate why stops, though often criticized as inefficient for mitigating risk, are essential at the portfolio level. They provide risk release valves to mitigate current risk and allow the portfolio to absorb new risk in the future. Not having stops in place can detrimentally affect portfolio performance, especially when market conditions arise that have never been seen before in backtests. These new, unforeseen environments can expose the warehoused risk that exists in a portfolio, which may not have been previously observed. Single Strategy vs. Multiple Strategies Consider a single trading strategy on a single market. This strategy might produce a return profile with a 20% drawdown and a 7% CAGR. If we multiply this strategy five times, trading five identical systems on the same market with the same allocation, the drawdown increases to 100%. This happens because the drawdown in each system occurs simultaneously, resulting in a linear relationship between leverage and drawdowns. Multiplying the position size by 5x causes the drawdown to increase fivefold. However, the relationship with CAGR is not linear. While multiplying the strategy 5x might achieve a drawdown of 100%, the corresponding CAGR might only increase to around 30%. This is because CAGR is a path-dependent and nonlinear metric, where increased volatility suppresses compound growth. Now, what happens if we diversify our approach? Suppose we develop 10 different, uniquely configured trend-following (TF) strategies for the same market. Each of these strategies has a 7% CAGR and a 20% drawdown occurring at different points in time. The portfolio of these 10 strategies might then produce a CAGR of 40% but with a drawdown of only 40%. This is because the risks are spread out due to the lack of perfect correlation between the strategies. The drawdowns of each unique strategy do not coincide, and each return stream offers correlation offsets at different points in time across the entire time series. Furthermore, the CAGR is increased as the volatility drag associated with the drawdown of the entire ensemble at 40% is far less than the alternative of 100%. By diversifying, we distribute risk across various strategies, each contributing to the overall performance at different times. This risk spreading, due to the lack of perfect correlation, allows for a more stable and robust portfolio, enhancing returns while managing drawdowns more effectively. The Principle of Warehoused Risk Warehoused risk is a crucial concept in portfolio management. It represents the total risk present in all return streams, calculated as if each return stream went to zero at a specific point in time. By summing the potential risk contributions of each return stream, we arrive at the total risk summation, known as the warehoused risk of that portfolio at a given moment. This theoretical limit adheres to the conservation law that risk can never be eliminated, only transferred within the portfolio. Another term used to describe warehoused risk is “Portfolio Heat.” Many investors overlook this potential risk lurking in their portfolios—the risk of total collapse if all the risk held by a portfolio is suddenly released at once. Think of warehoused risk as akin to a “risk sponge.” The more we diversify and add new return streams to a portfolio, each with the same risk contribution, the more we pack warehoused risk into the portfolio. Despite the presence of warehoused risk, the risk investors typically pay attention to are measures such as the Sharpe ratio, Sortino Ratio, MAR (maximum drawdown), Ulcer Index, and other risk metrics. These measures are always far lower than the warehoused risk that actually resides in a portfolio. They reflect how individual risks within a portfolio offset each other and how risk events are dispersed across the time series of different return streams. However, these metrics often understate the actual risk potential within a portfolio. These risk measures typically assess the volatility of portfolio returns over time, a consequence of how discrete return streams interact. Some risks cancel each other out, resulting in a net portfolio variance measure, such as standard deviation or maximum drawdown, occurring at specific points in time. However, these proxy measures understate the possible risks if a new market regime emerges—one that has never been experienced in backtests and significantly alters these risk metrics, reflecting the higher warehoused risk inherent in the portfolio. Understanding warehoused risk helps investors recognize the potential hidden dangers within their portfolios. By acknowledging this risk and managing it through diversification and strategic use of stops, we can create more resilient portfolios that are better prepared for unexpected market conditions. The Role of Stops in Portfolio Management Trend followers often use stops as a critical tool for managing portfolio risk. Stops should be seen as risk release valves for the entire portfolio, preventing warehoused risk from becoming overwhelming due to any contributing return stream in unfavourable market conditions. While some traders argue that stops detract from performance compared to other exit measures, in portfolio management, stops are crucial for maintaining the positive skew of the entire collection of return streams and managing total portfolio heat. Consider this: in a portfolio comprising potentially thousands of return streams, there is always the possibility that many return streams could suddenly become positively correlated, potentially

Navigating the Complexities of Risk in Trend

Navigating the Complexities of Risk in Trend In a Non-Linear World View Straight Lines with Caution: Risk Management Principles for Trend Following The ability to adeptly navigate risk stands as a crucial skill for both investors and traders. The quest for robust investment strategies has traditionally leaned on a set of established risk metrics, with the Sharpe Ratio, Sortino Ratio, and Standard Deviation at the forefront. These metrics have provided a foundational framework for assessing the risk-adjusted performance of various investment approaches, offering a semblance of predictability and control in the inherently unpredictable nature of financial markets. The Sharpe Ratio, for instance, has been widely revered for its simplicity and effectiveness in conveying the amount of excess return per unit of risk, with risk quantified as the standard deviation of returns. Its appeal lies in its straightforwardness, allowing for a quick comparison of different investment opportunities under a common risk-return lens. Similarly, the Sortino Ratio refines this concept by focusing solely on downside risk, aligning more closely with the typical investor’s aversion to losses. Standard Deviation, on the other hand, offers a direct measure of volatility, serving as a proxy for the uncertainty inherent in investment returns. Despite their widespread adoption and inherent virtues, these traditional metrics are not without limitations, especially when applied to the intricate domain of trend-following strategies. Trend-following models, characterized by their reliance on capturing sustained directional market movements, embody a unique set of attributes that challenge the applicability of conventional risk assessments. The core of these strategies lies in their path-dependent nature, where the sequence and timing of market trends significantly influence their performance outcomes. The primary shortfall of metrics like the Sharpe and Sortino Ratios in this context is their inherent assumption of symmetry and normality in return distributions. These metrics do not distinguish between upward and downward volatility, treating all fluctuations around the mean as equal contributors to risk (Refer to Figure 1). This oversimplification glosses over the nuanced dynamics of trend-following strategies, where the asymmetry of returns—frequent small losses punctuated by occasional large gains—is a defining characteristic. Moreover, the path-dependent nature of trend-following strategies introduces a layer of complexity that traditional metrics are ill-equipped to handle. The success of these strategies hinges not just on the magnitude of market movements, but on the sequence in which these movements occur. A series of small gains followed by a significant upward trend can result in a vastly different outcome than the same trend occurring in reverse order. This aspect of path dependence is critical in understanding the risk and potential of trend-following models, yet it remains conspicuously absent from the risk assessment toolkit provided by traditional metrics. Figure 1: Three Different Strategies with Three distinct Paths of Returns with Identical Sharpe Ratios and Standard Deviations. Without seeing the NAV chart and only viewing the classic risk-return metrics, an investor would be indifferent: all three strategies would look equally good, however the impact of these paths on a return series have serious consequences for compounded wealth. In essence, while traditional risk metrics like the Sharpe Ratio, Sortino Ratio, and Standard Deviation have served as valuable tools in the arsenal of investors and traders, their application to trend-following models reveals inherent limitations. The dynamic and complex nature of these strategies, thriving on the ebbs and flows of market trends, demands a more nuanced approach to risk evaluation—one that considers the asymmetry of returns and the pivotal role of path dependence in shaping investment outcomes. The Limitations of Conventional Risk Metrics The limitations inherent in conventional risk metrics such as the Sharpe and Sortino Ratios extend beyond their mathematical formulations to the very core of how we perceive and measure investment risk. These metrics, while elegant in their simplicity, often fall short of providing a holistic view of an investment’s risk profile, especially in the context of specialized strategies like trend-following. The Sharpe Ratio, for instance, has been a linchpin in the arsenal of risk assessment tools, offering a succinct measure of risk-adjusted performance. By dividing the excess return of an investment by its volatility, it ostensibly provides a clear indicator of the return an investor can expect per unit of risk undertaken. However, this metric’s reliance on standard deviation as a proxy for risk introduces a critical blind spot: it does not differentiate between positive and negative volatility. In the realm of trend-following strategies, where profits often stem from “riding” prolonged market trends, this failure to distinguish between beneficial volatility (upside) and harmful volatility (downside) can lead to misleading interpretations of an investment’s true risk profile (Refer to Figure 2). Figure 2: The geometry, or the paths of returns, have significance for compounded returns. Contrary to popular opinion there are better geometries for compounded wealth apart from straight lines. Given that Sharpe ratios penalise beneficial volatility, we observe that Example 1 (the straighter line) has a far higher Sharpe than Example 2 but a far lower CAGR. The direction of the volatility is crucial for wealth generation which can be observed when comparing the terminal wealth of strategies with negative skew and positive skew. Moreover, the Sharpe Ratio’s implicit assumption of normally distributed returns does not hold water in the unpredictable seas of financial markets, where extreme events (often referred to as “black swan” events) are not as rare as traditional models would suggest. This discrepancy becomes even more pronounced in trend-following strategies, which, by design, aim to exploit these very outliers—large, sustained market moves—rendering the Sharpe Ratio’s insights less applicable, if not entirely moot, in evaluating such strategies. On the other hand, the Sortino Ratio, often touted as an improvement over the Sharpe Ratio, narrows its focus to downside volatility, ostensibly aligning more closely with investors’ natural aversion to losses. By considering only the negative deviations from the mean return, the Sortino Ratio aims to provide a more relevant measure of “bad” risk. While this adjustment marks a step towards a more nuanced understanding of risk, it, too, is not without its shortcomings. Specifically,

Announcing the Launch of the Classic Trend Index: The Rise of the Outlier Hunters

Announcing the Launch of the Classic Trend Index: The Rise of the Outlier Hunters The Aussie Turtles and Participating Programs are thrilled to announce the launch of the Classic Trend Index, a groundbreaking financial index that hones in on the essence of classic trend following programs. The Aussie Turtles and Participating Programs are thrilled to announce the launch of the Classic Trend Index, a groundbreaking financial index that hones in on the essence of classic trend following programs. This innovative Index distinguishes itself from others by exclusively focusing on traditional trend following methodologies, standing apart from indices that incorporate a broader spectrum of trend following styles. The Classic Trend Index is an equal-weighted blend of three prestigious Classic Trend Following Programs: The US-based Chesapeake Capital Diversified Plus Program The European-based Takahe Capital Systematic Trend Program The Asia Pacific-based ECCM Systematic Trend Program These programs are celebrated for their adherence to classic trend following principles, which emphasize straightforward, universally applicable breakout models. They eschew volatility control overlays in favour of a staunch commitment to extensive diversification across various asset classes. Classic trend following strategies are systematic in nature, focusing on small bets, medium to long-term breakouts, stop losses, and trailing exits. This methodology embodies the philosophy of “cutting losses short and letting profits run,” aiming to leverage time series momentum without setting price targets or adjusting positions dynamically during trades. This approach enables the capture of significant positive market shifts, known as Outliers. February 2024 marks a momentous milestone for the Classic Trend Following Index, as it not only achieved a new high watermark but also showcased its unique capability to outperform traditional markets significantly. This performance underlines the Index’s exceptional ability to harness returns from outliers in unpredictable market conditions, setting it apart from other trend following benchmarks like the SG Trend Index, SG CTA Index, and BTOP50 Index. As we celebrate this achievement, we remain cautiously optimistic about the continuation of these trending conditions throughout 2024. Our globally diversified strategy positions the Classic Trend Following Index as a potent instrument for navigating the intricacies of today’s financial markets. It offers investors a strategic advantage in securing superior risk-adjusted returns.For those keen on diving deeper into the dynamics of this distinctive trend following index, we invite you to explore further by watching our video supplements. These resources provide an in-depth look at the Managers behind the programs comprising the Classic Trend Index. An evening with Jerry Parker, Moritz Siebert, Moritz Heiden, Adam Havryliv and Richard Brennan…with special guest, Michael Covel.  The Sydney Special The New Turtle Traders ⦁ &⦁ The Genius of Classic Trend Following Are you intrigued by what the Classic Trend Index has to offer? Reach out to us at co*****@***************ex.com for a more comprehensive exploration of this dynamic trend following index. To stay updated on the Classic Trend Index’s performance and upcoming events hosted by Chesapeake Capital, Takahe Capital, and East Coast Capital Management, please subscribe to our newsletter at https://www.classictrendindex.com. And for those who are always eager to discuss trend following, the Aussie Turtles are just a click away at https://www.aussieturtles.au. Join us in this exciting journey as we navigate the future of trend following together.

Enhancing Trend Following Performance using System Diversification

Enhancing Trend Following Performance using System Diversification While it’s common to discuss diversification in terms of the wide range of markets trend followers engage in, diversifying the systems or models they use is equally crucial. While it is common to discuss diversification in terms of the wide range of markets trend followers engage in, diversifying the systems or models they use is equally crucial. This approach not only helps in lowering portfolio volatility but also enhances the potential to capitalize on exceptional market movements, often referred to as ‘Outliers’. Let’s delve into some key aspects of system diversification, specifically the practice of applying various trend-following models to the same market. By exploring this strategy, I aim to outline its advantages and disadvantages, especially when contrasted with the more traditional approach of applying a single system to a single market. This comparison will shed light on how different models can complement each other to capture diverse market dynamics, offering a broader perspective on effective diversification strategies. System Diversification Allows you to Reduce Portfolio Volatility System diversification in trend following involves deploying a variety of models within the same market to create a composite of strategies that can offset correlations and enhance the ability to tap into diverse market opportunities. This approach contrasts with dedicating 100% of capital to a single strategy within a single market, which typically results in a return stream characterized by the volatility and performance tied to how that specific system interacts with market trends over time. By allocating, for instance, 10% of capital to each of 10 distinct trend-following models within the same market, an investor generates multiple return streams. Each stream reflects the unique way its corresponding model engages with the market’s trending behaviours. This ensemble of models produces a set of results with inherent correlation offsets, leading to reduced overall volatility and potentially capturing a broader array of trending opportunities due to the reduced reliance on any single model’s selection bias. The traditional method of selecting a single trend-following model based on its historical performance introduces a risk of selection bias and curve fitting, as the chosen model is typically the one that performed best in backtesting. This can lead to overoptimization to past market conditions, reducing the model’s effectiveness in future, unforeseen market environments. In contrast, employing an ensemble of models mitigates this risk, as the collective approach is less likely to be overfitted to historical data and more adaptable to a range of market conditions. Each model within the ensemble adheres to the core principles of trend following—cutting losses quickly while allowing profits to run—but is uniquely configured to respond to different trend durations and patterns. This diversity within the ensemble equips it to handle a wide variety of trend scenarios, making it metaphorically the most ‘flexibly fitting’ approach in the trend following space. Using System Diversification to Have More Direct Control over Portfolio Correlations System diversification offers a strategic approach to managing correlations, distinct from the inherent correlations present between different markets. While market correlations are largely beyond our control, dictated by external market dynamics, system diversification allows for deliberate manipulation of correlations through the design and configuration of trading systems. An illustrative example of this control is the concept of a perfect hedge within a single market, where buying and selling a contract simultaneously can, theoretically, result in perfectly negative correlations, nullifying market risk aside from transaction costs. However, while a perfect hedge demonstrates the potential to neutralize market risk, it does not inherently generate long-term returns. To leverage system diversification for returns, the approach needs refinement. Systems must be designed with a persistent edge, and when combined, they should significantly dilute market correlations. Employing an ensemble of systems enables the strategic activation and deactivation of individual systems based on specific entry criteria, ensuring that they operate independently of one another at different times. This staggered activation contributes to a composite system with more uncorrelated characteristics, enhancing the ensemble’s ability to navigate diverse market conditions effectively. System Diversification Allows you to Expand in Terms of Market Diversification The effectiveness of capturing opportunities from market trends hinges on two pivotal elements: the inherent trends within the market and the capability of our trading systems to seize these opportunities. Utilizing an ensemble of trend following systems broadens our ability to identify and exploit Outliers across the market’s time series, enhancing the potential for significant returns. An Outlier trade is the product of the dynamic interplay between distinctive market trends, which may themselves be Outliers, and the specific design and responsiveness of our system’s architecture to these market conditions. Certain systems, by virtue of their design characteristics, are particularly adept at capitalizing on market trends, achieving exceptional reward-to-risk outcomes. Incorporating a variety of systems into an ensemble not only increases the likelihood of engaging with Outlier opportunities but also introduces a diverse range of responses to similar market conditions. Minor differences in system design can result in one system capturing an Outlier trade while another might not, underscoring the value of diversity within the ensemble. The real power of a system ensemble becomes evident when applied to highly correlated markets. For example, when an ensemble of Trend Following systems is employed across two markets with high correlation, such as Brent Oil and Crude Oil, the resulting return streams from the ensemble exhibit significantly lower correlation than the markets themselves. This reduction in correlation is a testament to the ensemble’s ability to diversify risk and enhance returns, even in markets that traditionally move in tandem. This unique attribute of system diversification allows for a significant expansion in market engagement within a portfolio context. By effectively dismantling the inherent market correlations through the use of system ensembles, traders can vastly increase the number of markets they participate in. System diversification, therefore, not only mitigates risk through broader market coverage but also amplifies the potential for capturing lucrative market movements, paving the way for a more robust and resilient trading strategy. Leveraging Trends with a Staggered

Aussie Turtles Launch

Aussie Turtles Launch An evening with Jerry Parker, Moritz Seibert, Moritz Heiden, Adam Havryliv and Richard Brennan… with special guest, Michael Covel… Charting a Course for Success in Trading Imagine, if you will, a gathering of some of the world’s most astute investors, united by a common thread in their investment approach. An approach that traces its roots back to the legendary Turtle Trading Experiment of the 1980s. Picture a scenario where these minds, steeped in the discipline and strategies of this iconic experiment, converge in one place. Well, imagine no more, for tonight, this vision becomes a reality. https://youtu.be/OA7OEQsO8Dc We find ourselves in Sydney, the vibrant heart of Australia’s financial world. Here, we’re not just attendees at an event; we’re part of a historical journey, revisiting and reviving the principles of the Turtle Traders. Our journey takes us back to an audacious venture by Richard Dennis and Bill Eckhardt, two pioneering Chicago pit traders. Their experiment, a blend of mentorship, discipline, and systematic trading, wasn’t just a financial venture; it was an exploration into the potential of the human spirit in the world of finance. This evening, we are graced by the presence of Michael Covel, the celebrated author of “The Complete Turtle Trader,” ready to unveil the intricate layers of this fascinating story. Joining him is Jerry Parker, an original Turtle Trader, bringing his first-hand experiences and insights from the front lines of this financial odyssey. Complementing them are the new generation Turtles, Moritz Seibert and Moritz Heiden from Takahe Capital based in Germany, along with Australia’s Adam Havryliv from East Coast Capital Management, each demonstrating how the Turtle principles continue to shape modern trading strategies. Tonight is not just a nod to history; it’s an enlightening exploration for the Australian investor into the power of the Turtle Trading method. This approach has shown remarkable resilience and success, adapting and thriving across varying market conditions. Our event is made possible by the generous support of our sponsors. Australian Fund Monitors brings their deep understanding of the hedge fund sector, Australian Patent & Trademark Services, led by the renowned Alex Ferrante, ensures the protection of our intellectual property, and VAssist Me who transform our operational efficiency, allowing us to focus on our strategic objectives.