Chesapeake Capital: The evolution of managed futures from the eyes of a turtle
Managed futures is an evolving asset class, one that appears to be moving out of its wild youth phase into respectability. There may be no better example of this than Chesapeake Capital and its founder Jerry Parker.
Parker was an original turtle, a group of wannabe traders who answered an ad placed by C&D Commodities principals Richard Dennis and William Eckhardt. The legend goes that the two placed a nurture versus nature bet, à la the movie “Trading Places,” on whether their trading techniques could be taught. In subsequent interviews Eckhardt claims there was no bet, just an intellectual argument, and Dennis pointed out that he was someone who always sought real-world adjudication for such debates.
The turtle legend fits in well with the wild reputation of commodities traders from an era when commodity trading advisors weren’t ashamed to target 50% — or even 100% — returns and carried the volatility that goes along with such ambitions.
“It was the first time I ever had been in contact with people who were so smart and interesting — teaching us how to trade,
how to be disciplined and to understand how the markets work,” Parker says.
There were many lessons, one of the most important of which was to keep on learning and improving your system. So it should be no surprise that Chesapeake’s trading strategy probably looks quite different from the one Parker learned back in the 1980s. One thing that surely remained was the focus on trend following. “They were very big advocates of trend following, buying highs and selling lows,” Parker says. “Their view on how the world works and how people work was imbedded into the trend-following idea. We stuck to trend following more than most people, we haven’t changed much over the years other than adding more markets, which was encouraged.”
Chesapeake has done well in a unique way. “We are probably one of a few CTAs that have a material allocation to equities and with those equities we trade single stock futures,” he says. “It is a huge edge to not trade those indexes and trade the single stock futures where you can get more suited to trend following as far as having outlier trades and massive diversification. If you trade 100 stocks versus 20 indexes, the stock can act a lot different, the indexes tend to be correlated even if they are Asian, European and U.S. indexes.”
They also cut down on volatility. “It has been a slow evolution to lower leverage. We may have moved too slowly because some of the larger European CTAs in 2008 moved to really low leverage,” he says. “We sort of kept our leverage at the 20% volatility level and that was probably too high, especially in that period when the markets weren’t conducive to trend following. Mutual fund clients expect lower returns than what CTAs usually try to deliver.”
While volatility has been reduced, there is still a connection to the aggressive style that was part of the Turtle methodology, including “Not really caring about drawdown so much,” he says. “That is something really different about our approach. Most of the European CTAs and U.S. CTAs [for that matter] try and keep volatility at a constant level. We don’t; if the volatility of a certain trade doubles or triples we keep the same position. Most people scale back. That is a big difference. It’s more of a traditional trend following idea of letting your profits run.”
Parker says what he learned from being a Turtle was deeper than being taught trend following; it was more about the way the world works. “Other styles never made sense to me. Long-term trend following is where it is at.”
But long-term trend following is in a much different place than in the days of the Turtles.
“The business has sort of become a mutual business now,” Parker says. “Most of our assets are in liquid alternative 40-Act mutual funds. The volatility is 15% and we are trying to make 12%, so we are trying to compete with AQR and others in the space and be an alternative to traditional stocks and bond portfolios.”
Managed futures have always been marketed as an alternative to traditional portfolios but now it is one you can take home to mother.
New world order
“Everyone knows about mutual funds, the fees are low, so if you try and raise money for a fund of funds or an institution they want those same low fees. The management and incentive fees are pretty much gone for trend following. The fees are 100 basis points for institutions and 200 basis points for retail.”
Parker acknowledges that the end of the 2 and 20 fee model is pretty shocking for the managed futures space and although some managers implementing unique strategies outside of trend following can still command that fee structure, he sees it as a relic of the past.
While there does appear to be momentum, the number of 40-Act funds compared to the CTA universe is quite small (see “Baby steps,” below). “People are going to resist transition and giving up the incentive fees,” Parker says. “They want to resist registering with the [Securities and Exchange Commission] as [Registered Investment Advisors], and they want to resist regulations. In some respects it is less money and more work and people are hoping it goes away. They want to go back to managed accounts and the private placement funds that charge 2 and 20, but that game is over. If you want to get in the mutual fund business and be serious you are going to have to compete with best practices.”
Even the swaps used to allow CTAs such as Parker to claim a small incentive fee before the mutual fund fee is going away.
“AQR are right on fees,” Parker says. “Swaps are going away, the incentive fees are going away, it is going to get cheaper and cheaper and better and better; more markets, more risk controls, lower cost. The CTAs make less. This is going to be a great time to be an investor and people are going to have an appetite for this style of trading because it’s maximum diversification, maximum risk control [and is] uncorrelated.”
Not that Parker is complaining, he sees the transition as positive, and one that will take the strategy to places it has never been and challenge allocation models.
“[Managed futures] should outperform the stock markets over a 10-year period and the next time we have a big stock sell-off — if we ever have one — this space should just explode and the popularity will increase.”
No more kids’ table
While Parker has tough talk for the traditional CTA model, he says better things are on the horizon once that transition is complete. He doesn’t see futures programs as just a good diversifier, but as a main driver.
No more begging for a 5% or 10% allocation in a traditional 60/40 stock and bond portfolio. “We are much better than 60/40, we deserve to be the core allocation and over time I think we will be,” Parker says. “As leverage goes lower, as the fees go lower, as the CTA programs are accessible through mutual funds [and as] people get used to this idea, we are ready for a huge explosion like you have never seen before.”
He thinks it’s just logical. CTAs’ ability to trade more [diverse] markets, go short and do it in a systematic way is an advantage.
“Diversified CTAs should be 50% to 60% of your portfolio. Instead of adding 5% to 10% CTAs, you should start with CTAs and see what improves that. Perhaps some long S&P 500 [strategy], Parker says. “The truth of the matter is diversified CTAs have the highest risk-adjusted performance and should be the core.”
In fact, he would add some long-only allocations to a portfolio to improve the overall Sharpe ratio. It is an important distinction because the ascendency of the Sharpe ratio as a measure has hurt investing in general and CTAs in particular; strategies are judged on their individual Sharpe ratio instead of what the strategy does for the overall portfolio Sharpe ratio.
“It hurts is a couple of ways. They are hitting the CTAs like it is the only hedge fund strategy that is doing that. Trend-following CTAs feel a need to have these high Sharpe ratios,” Parker says. “It would be much better if they were just transparent and explained trend following and show that the clients portfolio will have a higher Sharpe ratio by [allocating to] trend following. The whole idea of trying to put [other elements] in a system and try to improve your own Sharpe ratio is not a good business idea. Client appreciate knowing exactly what they are going to get and trend following offers that. When market trend you are going to make money, when they don’t you won’t.”
He acknowledges that sometimes trend following doesn’t work — which is why he would add a diversifier — and that managed futures have a sordid history to live down.
“It is just a matter of time; when a better product goes on the market, its not adopted overnight. (However, we have a bad legacy to live down with high leverage, high fees [and] 5% trails — that needs to die. When I grew up in managed futures it was not a good situation for clients. Now it has turned around. It is a good atmosphere for clients, but bad for traders.”)