Trend Following. Ritholtz Barry

Table 2.1):

TABLE 2.1: Monthly Performance Data for Winton Futures Fund (%)

      I have had the opportunity to talk with Harding on multiple occasions. He always comes across as down-to-earth, a hard worker, but also highly competitive. He wants to win. Harding did not start out with the silver spoon. He worked. To hear him describe it, he engaged in the sort of deliberate practice that Anders Ericsson researched:

      I worked for a company [early on], and the people who ran that took a very old-fashioned approach to trading. About 10 people and I spent the first half of every day drawing about 400 charts by hand. It was very tedious. I did this for about two years. The act of laboriously updating these charts forces you to focus in much more minute detail on data than you normally would, and over a period of time, I became completely convinced the market was not efficient, contrary to the theory at the time.83 I became convinced that markets weren’t efficient and absolutely trended… We trade everything using trend following systems, and it works. By simulation, you come up with ideas and hypotheses, and you test those. Over the years, what we’ve done, essentially, is conduct experiments. But instead of using a microscope or a telescope, the computer is our laboratory instrument. And instead of looking at the stars, we’re looking at data and simulation languages.. it’s counterintuitive to think in terms of statistics and probability. It takes discipline and training; it tortures the machinery. People are much better, for instance, at judging whether another person is cheating in a human relationship. We’re hugely social creatures. We’re keen on our intuition. But when our intuition is wrong, we’ll still be very resistant to being corrected. What are traders’ biggest failures about understanding risk? There’s a human desire to seek spurious certainty. We try to come to a yes-no answer, one that’s absolute, when the right answer might be neither yes nor no. People see things in black and white when often they need to be comfortable with shades of gray.84

      Shades of gray are tough medicine to swallow, a tough philosophy to believe down in your core. No one wants to think that hardcore when it comes to money. You might want to imagine uniform precision as possible, but if the guys who make the most money think like Harding, it’s smart to try and think that way, too. At the end of the day, perhaps the best lessons I took from Harding came from his original internally published book, The Winton Papers. His decision-making philosophy should be absorbed before anyone ever puts a dollar to work in the markets:

      The aggregate effect of shared mental biases and imitation results in patterns of behavior, which while they are nonconsistent with Mr. Spock-like, rational decision-making or with informational efficiency, are demonstrably systematic. The market equivalent of these behavioral patterns is trending, whereby prices tend to move persistently in one direction or another in response to information. The widespread adoption of investing fashions, like indexation, introduces market mechanisms, which magnify herding behavior on a large scale.85

      Although Harding’s words were written before the events of 2008, his insights explain the crash that followed. To those who want to learn how to trade, to those who don’t want to affix blame for down performance, Harding offers a way out. But he knows his agnostic approach has critics: “Most people believe it doesn’t work or if it did it soon won’t work. We almost never do anything based on our opinions. If we do it’s based on opinions about mathematical phenomenon and statistical distribution, not opinions about Fed policy.”

      Summary Food for Thought

      ● David Harding on EMT: “Economists, academics, modelers, gurus and geeks need to recognize that though a grand and beautifully simple theory applying across financial markets may be desirable, it is most likely impossible.”

      ● Harding: “… the essence of trend following has been effective beyond my wildest dreams and, for me it has been more risky to diversify away from it …”

      ● Harding: “As the years have unfolded and I have had experience of the seemingly magical phenomenon of trends, my prejudice in favor of this unloved and unheralded investment approach has hardened. To a statistician this is called a Bayesian Philosophy.”

      ● Harding: “Humans are prone to unpredictable behavior, to overreaction or slumbering inaction, to mania and panic.”

      Bill Dunn

      Bill Dunn’s firm made 50 percent in 2002 when the majority of investors were losing big from the Dot-com blowout. The firm made 21 percent in the one month of October 2008 when most of Wall Street was melting down. And into 2017 the firm’s track record exceeds 40+ years. Dunn Capital performance data is a clear, consistent, and dramatic demonstration of trend following.

      Dunn was the original founder and chairman of Dunn Capital Management, Inc. By his original design the firm has always traded for above average returns. Dunn has no defined target for return (other than positive). There is nothing in their risk management that precludes annual returns approaching 100 percent. There is no policy, for example, if a Dunn portfolio was up 50 percent by mid-year, they would rest, and dial back for the rest of the year. Further, since 1984 their track record shows 10 drawdowns in excess of 25 percent (Did you know Warren Buffet has drawdowns too?). But whatever the level of volatility, this independent, self-disciplined, and long-term trend follower never deviates from the core strategy:

      We have a risk budgeting scheme that certainly was ahead of its time in 1974 and is still – in our opinion – state of the art in [2017].86

      It is easy to believe that Dunn Capital adheres to core rules set forth 40 years ago if you understand sound business principles: “Essentially, whatever you find will be as true 10 years from now, 20 years from now, 30 or 50 years from now as it is today and as it was 50 years ago. And if you can put your finger on those truths, then you’ve made a contribution.”87

      Dunn Capital has always believed in order to make money you must live with volatility. Clients who invest must have absolute no-questions-asked trust in the firm’s decision making. This trend follower has no patience for questions about their ability to take and accept losses. This “full throttle” approach has proven itself for 40 years, making everyone involved, owners and clients, rich.

      The Dunn risk-budgeting scheme or money management is based on objective decision making. “Caution is costly” could be the motto. At a certain point if they enter a market and if the market goes down to a point, they exit. To Dunn, trading without a predefined exit strategy is a recipe for disaster.

      Dunn Capital’s risk management system enables the firm to balance overall portfolio volatility – something the average or even professional investor ignores. The more volatile a market, the less they trade. The less volatile a market, the more they trade. For Dunn, if risk-taking is a necessary means to potential profit, then position sizing should always be titrated to maintain the targeted risk constraint, which in turn should be set at the maximum level acceptable.

      The Dunn system of risk management ensures discipline:

      One of our areas of expertise in the risk-budgeting process is how risk is going to be allocated to say a yen trade and how much risk is going to be allocated to an S&P trade and what is the optimal balance of that for a full 22 market portfolio. The risk parameters are really defined by their buy and sell signals so it is just a matter of how much you are going to commit to that trade so that if it goes against you, you are going to lose only x percent.88

Extreme Performance Numbers

Like Dunn Capital’s philosophy this chart (Figure 2.1) assumes an in-your-face attitude and that is not negative. That performance data compares returns if you had hypothetically invested $1,000 with Dunn and $1,000 with the S&P. It demands a choice – either put your money

84

Ibid.

85

David Harding, The Winton Papers, Winton Capital Management, www .wintoncapital.com.

86

Daniel P. Collins, “Seeding Tomorrow’s Top Traders; Managed Money; Dunn Capital Management Provides Help to Commodity Trading Advisor Start-ups,” Futures 32, no. 6 (May 1, 2003): 67.

87

Jim Collins, Good to Great (New York: Harper Business, 2001).

88

Collins, “Seeding Tomorrow’s Top Traders.”