Diversification of Trading Strategies | Robert Carver

you know my own personal training system because I'm running a fully automated system I spend very little time doing it because I'm just using Christ's data I automatic filters in place to catch bad prices I spend about maybe five minutes per month per market so you know if I had a thousand markets then it would become a full-time job and I did quite a boring full-time job as well I wouldn't be being interested in doing that but I could easily trade in a hundred futures markets or Ahuh there's probably about 150 really liquid futures markets out there in the world and if I had enough money I'd quite happily trade all of them because even if the last market I had only adds a few basis points is that worth five minutes of my time a month yes it is that's my own personal trade on stone before we find out who's on today's show I want to mention that today's podcast is brought to you by Urich's and in today's conversation I actually learn about a brand new contract from my guest that Eurex have just launched which my guest finds to be very useful for many investors and which you can find out much more about by visiting the Eurex website today I'm talking to Robert kava who's both an author and a trader and who spent a good chunk of his career at one of the biggest European systemic trading firms named the AHL before leaving in 2013 to write his newly released book imagine spending an hour with the world's greatest traders imagine learning from their experiences their successes and their failures imagine no more welcome to top traders unplugged the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level before we begin today's conversation remember to keep two things in mind all the discussion will have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance also understand that there's a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions here's your host veteran hedge fund manager niels castro Larson [Music] these things have something in common yet they seem to be received very differently um yes it is an interesting problem because you're right people have a strong preference for trading systems that that generally make money every month yeah but every now and then lose lose a lot of money which is the exact opposite to trend following and I think I can have a lot of them a lot of emotional kind of bonding with these people I feel like you know I really understand their pain because from one you know when I look at the returns from my own system inevitably if I'm in a drawdown I feel more unhappy than if if it's doing well and if I've had a day when I've lost money even though I know upon an intellectual perspective that this is just a random number from some unknown distribution of returns that I hope has a positive mean you know when I have a down day I feel slightly less happy than if I have an up day and if I had an up day every day for six months then I'd be much happier for that point of view I think the the Reed there's sort of reason for their dichotomy between this emotional response and the emotional response to buying lottery tickets is to do with the the the size of the pain and the size of the payoff right so when you know if you've invested all of your money into a tram following the bond and you know you lose money for two-thirds let's take an extreme example you know two out of every three days you're losing money right you could be losing you know maybe half a percent of your net worth two out of three days whereas no one's probably going to buy that many lottery tickets if I was to buy enough lottery tickets the represent half percent of my net worth actually you know quite a few lottery tickets so the size of the loss that we get when we buy a lottery ticket is sufficiently small and it doesn't bother us now you know if I've got this trend-following system it might be that if I have an exceptional month I might make twenty that yeah so you could look at say September 2008 and you know the big CTAs we're making a that kind of say 20 or 40 percent normal Yvonne target sure now 20% of my wealth is is good don't get me wrong if you yeah I checked with that tomorrow I'd be happy but it's also a lot less than I get it I won the lottery yeah which would be you know depending on the payout many many times my health so we're I think that's the reason the the size of the the gain and the size of the loss fine excuse our perception um makes one thing seem more attractive than the other yeah that makes perfect sin risk and as doddle wrongful said the the known unknowns and the unknown unknowns what do we need to know about predictable and unpredictable risk in your opinion so the the main thing to bear in mind is that the the risk has these two components two predictable and predictable and the the problem starts if you start to assume that there is no unpredictable risk or at least you ignore it or you forget about it and you know nothing tal never spent the last 30 years writing books to to make sure that we don't forget about it but you know the most of the time when we're trading we have some model of how we think returns appear you know as this is and which can be usually pretty simple and you usually say okay I think returns are going to have the following standard deviation and they're going to have the following correlation structure and that implies that you know you'll get returns coming day after day you know you can have a certain chance of a loss of such magnitude and certain chance of again as such a magnitude and so on now that is fine and you you can't really run a trading system unless you do have some way of modeling what your returns are going to be and you can make that more sophisticated and more realistic so you can add in you know what what's the the quantity guys would call higher moments so you could add in skew and kurtosis which means you know you you instead of having a classic bell-shaped curve of returns you have a more funky returns which do more realistic for real asset markets and you can also do things in the correlation space so you can have things like coast kunis and all these you know plants and things now that's fine the problem is the more of these the more fantasy you make your risk model the more calibration you need to do and I think you you mentally then assume that you must be capturing more of the expected risk that the amount of unexpected risk left is smaller which i think is what happened really in the financial crisis when you know we had these models of CDO prices which were fairly sophisticated certainly much more complicated than than anything I could understand but because they were sophisticated enough that people kind of assumed that they must be encapsulating the real world risk entirely when of course they weren't there was this huge charge of unintended put this huge charge of risk out there which wasn't captured in the model so my approach is to use that you know they're really the most simple risk model you can which it has no you know no prior moments just standard deviation just correlation and then to know mentally know that I am exposed to getting these things wrong right and then what I do my own trading system is I do relatively simple things like say well you know what if my model for correlations is completely wrong and actually all correlations are going to be either 1 or minus 1 whichever is worse for the position I have on at the moment and on that basis how much am I likely to lose and then I kind of kept that exposure and if you know my exposure goes beyond that but I will actually automatically cut my positions so you know generally speaking is hopefully your understanding I like things that are simple that I surely understand but also robust yeah and another way that I modeled handled whisky is exactly that way so I do think you've got a simple risk model then you're never going to forget that it is a simple risk model and you're never going to put too much confidence into the assumptions that it's making sure I have a few more questions relating to to the book and then I'm gonna try and and sort of seem seamlessly transition into some of my usual questions so we'll see how that goes but you touch very early on in our conversation you touched upon the importance of the alikom remember the words you use but it's essentially the management of your position so it's partly the position sizing but it's also how that position size stays whether it's constant or whether it's changing along with the trade talk to me about why this framework is so important and because you were actually saying that if you get this part right then the actual entry point is not so important Anna and and and for me at least I would say that I think a lot of these systemic trading strategies to a large extent certainly if their longer-term trend following strategies they tend to get into the same traits at the same time give a give a you know plus minus a few days or whatever but what sets one manager apart from the other is really one to your point how they manage the risk along the trend and and the other thing is of course the exit but let's take one want one at a time let's talk about so the the the the sizing and the management of the position because I think again this is something a lot of people may not see as as as important as as you rightly put it so the thing the problem is that people wrap up a number of different things together at the same time so you know if you read a lot of trading systems that are out there they they often say the example you know you should never bet more than a certain percentage you look at on particular trade and you know they then say or you should always you know then you should own never buy more than a certain number of futures contracts assuming you have a certain amount of money like and this is kind of confounding different things that should be separated so let's take stop losses because it's something the most pure on I'm sure and so the kind of big question is how should you say your stop-loss so if you actually follow the logic of the way that these systems are written what you should your stop-loss will be different depending on how much money in that because if you're if you're a small trader you'll only be able for with a very tight stop if you've got more money then you know two or three percent legal capital will be a much larger amount of money and you have a bigger stop the the market doesn't actually know how much money you have and doesn't care the the the price is going to move around the way it moves around and in practice what that will mean is that the smaller trader will get stopped out earlier and me the bigger trader will get stopped out later and what that means then is that the the smaller trader will tend to have to trade more frequently than the bigger trader but the point I make my book is that the amount of volatility in the market and the correct holding period in the market are absolutely nothing to do with how much capital you have so these two guys shouldn't should actually be trading the market in exactly the same way and what that means in practice is you should calculate your stop-loss based on how well the tar the market is so if the market is more volatile and you need a wider stop and secondly on on how long you want to hold that position for because you know the YV or stop is the the longer you'll spend in that position and you know the market is expensive to trade than that you know you probably want to have a wider stop and if it's cheap to trade and you you can afford to hold positions for less time in which case you can have a tighter stop the point is that at no time in that calculation are you considering how much money here and then the the next step then is so we'll have big she's my positions should my positions be in it's at this point you then bringing in how much much capital you've actually got and how much risk you want to take on that capital and then you know how injurious you should take on that capital is actually yeah you know it's not a cynical question there's actually about I think I list about eight different things you should consider when deciding you know how much risk you should you should have in your capital is not just or your f-type or risk is it's also how profitably expect your system to be so if it depends on what kind of system you're running so divergent system can be run at a higher risk than a convergent system for example because of the the properties of the the skew of the returns so good the point about these this sort of the way I like to do things is it's very much about kind of taking separately what we're components of the trading system should be and then individually saying well you know what should we consider when making this decision and then kind of moving on to the next step and saying well now we know how big our stop loss is you know what how should we then decide how big our position should be so you've got to separate these things out and calculate them correctly and that's something that's usually done in an institutional set ups pretty well although maybe not in the same way or as explicitly but you know if you're talking about a retail traders then very few of them will be using systems that have been set up in this way sure and in your experience I mean do you look at a trades on a trade by trade basing meaning that you have specific stop losses for for each trade or do you combine because you also talk about combining you know signals together and in order to get different you know strength of off a signal and so in some cases obviously the other way of doing it is to say well actually we we can either manage the risk by having a stop that takes us out a particular point but we could also manage the risk of having so different entry points and exit points that incense you changes to the signal you know from long to short or short to long and that's gonna be how we get out of a trade do you have a do you have an opinion or a favorite of those two kind of ways of doing it so in my own system I use the latter so I call this I like to call this a continuous trading system so yeah you never have it a discrete position and if anyone ever says to me or you know what's your target stop-loss on this trade I get confused because I don't really know how to answer that question is that the concept of a trade doesn't really exist I just have a target position which is implied from the forecasts I have for the price trip and then if the if the target position changes then I trade and that at some point will take me from from being long to being flat to being short and then you know that implicit trade is closed but that's not how I think at all but I do discuss under the heading of the semi-automatic trader the alternative approach which is what I would call the discrete position management where essentially you have discrete trades and you you kind of put them on and then you don't take them off until you've hit the stop-loss right and this approach is better in circumstances where you don't have systematic trading rules because by by saying to the trader right once you put a trade on it's not coming off unless you hit the stop-loss you're kind of binding them into that a contract and thereby forcing them to to manage the risk and the profitability of a position in a way that's that's correct if you said to them well you know you you can you can take the trade off when you feel like it then you know there's a risk that they'll don't do the wrong thing and trade it away that's essentially going to break the the kind of very carefully set up systematic framework that they put themselves into the other circumstances in which that makes more sense are for example if you're trading a system where you're mostly buying options because you know you're probably going to just want to buy the option and if you're going to buy out of the money options then you you pay your premium and that's your maximum loss so you don't really have a stop-loss exactly but you do have a discrete position where you even though the abortion option you hose your face off you've got a maximum loss you don't need to worry about trading out of it and the other reason why discrete positions work better if you've got a non systematic way of looking at trades is it's just easier you know if you've got a look at a hundred positions every day and evaluate whether you should be in or out of them manually you know by looking at charts or fundamental data or whatever is you're doing and then that's obviously you know quite a lot of work and it's much much easier if you you've got this very simple binary concept whether you're into trader you're out of the trade so you mentioned earlier on that a lot of professional managers in this space they would often have a volatility target of their portfolio say 15% or could be 20% does really matter and they will target that honor on a kind of a daily basis adjusting their portfolio accordingly but I just wonder isn't that like driving a hundred miles an hour regardless of whether you're on a motorway or in the mountains or in a city so to speak always having the same target of volatility of your portfolio wouldn't it be better if you could kind of adjust the target depending on the condition so if we're back to the racing analogy you know whether you're driving in you know on on a track or whether you're driving in a city so to speak and so I must have explained myself badly because that's not what most of these managers do at all okay they do the the target let's say that the target is 50 miles an hour together with your own allergy that's a target they expect to achieve on average over a period of potentially years okay you know they wouldn't expect to achieve it every day or perhaps even assuming you know they're trading reasonably slowly or even every month and they might not even achieve it over any given year and the speed the amount of risk you actually run is going to be driven by how much confidence you have in your your forecast so if your forecasts aren't very strong then you perhaps just drive at ten miles an hour drop and if but on the other hand if all you know all the lights the flashing green and they're saying you know this is a really strong forecast this mark is going to the moon or to the ground depending on which side you're on then you drive at 100 miles an hour and you would normally have a speed limit in place then so in my own system my my speaking is a hundred miles an hour in the sense that I will never take I never have an expected known risk of more than twice my long-run average target but you know I I could go down potentially to ten or fifteen percent okay and that's on the whole portfolio which obviously is made up of a number of different instruments and on any given instrument you know you may well have almost no risk when I risk at all if there's literally no no information out there telling you what your position should be sure sure sure absolutely now there are there are managers in different parts of the quantitative space who do have biggest risk targets so it's it's more common in the lively equity long-short space for example right and so those guys generally are always trade driving at 50 miles an hour okay and the the problem with that is if you get into a situation where potential returns are compressed so the classic case would be going in 2007 you cast your minds back and there's a situation in which a lot of quantitative equity long-short managers all had essentially the same positions on yeah and the amount of juice in those positions was seriously reduced and you know they were making just a few basis points in quite high leverage and then there was a couple of bad days in August 2007 winds you know everything went against them at the same time and that is that that is the danger of running over fixed risk target [Music] now let's let's try and make that transition a little bit and jump into something that I would normally ask my guests about let's start with organization and I just want to ask you this I mean you've obviously spent a lot of time doing research and you've worked in in in in teams you know at large institutions if you today were charged with the challenge of putting together a research team for a systemic fund manager what would that look like you know and and and do you need 50 PhDs or two PhDs how how does that how does that all go together so there are three three considerations I would say the first is the size of the team okay the second is the as you touched on me the kind of educational attainment or general level of intelligence if you like material and the third is the the diversity of opinions and backgrounds so team size I I do have to say that I think that the large numbers of researchers employed by many institutions are unnecessary and indeed could be potentially damaging okay so generally speaking you know if you if you were designing a systematic training system and not one that's gonna need to be adapted regularly as which we already discussed you know it's like building a building you know you hire a bunch of people to design the system and then really wants to building is up you're just gonna need a few a few building maintenance guys to you know to make sure the lift is working in there and similarly you probably not gonna need once the system is designed and working you're probably not going to need 50 people depending on the size of the fund the complexity of what you're doing I mean if we're talking about say a CTA with say hi hundred million dollar a short room yeah then I would say it kind of half a dozen people is probably sufficient sure second is on on intellect and educational attainments om so I should stay up front first night I have no PhD I didn't deny that ROI I try not to let it influence my thinking it may well be that I have an unconscious bias against people with PhDs okay but what I will say is I have worked with some incredibly smart people yeah people who are you know many many times smarter than I and it's I think it's fair to say that we've got six people if we have six kind of super genius people in a team there's probably going to be quite dysfunctional hmm for a number of reasons so I think you know you do want smart people but but you don't I don't think there's necessarily a positive correlation between how smart people are or how many degrees they've got beyond a certain point I mean you don't want some guy who's maybe very bright but has no doesn't have the right kind of you know mathematical background to cope with the sort of stuff we have to deal with that understand that doesn't mean that everyone has to have a PhD in statistics or economics or or physics or whatever so when you know I think you know sort of people who were clever but not you know not necessarily a team of geniuses because Jimmy's has a quite hard to manage and you know if everyone on the team is a genius then you know who's gonna do the dirty work I seem to remember firm back in 1998 there was probably a team of geniuses and and a few Nobel Prize winners as well management right yeah yeah yeah so that's that's an interesting example perhaps sure and finally in terms of the kind of backgrounds of the people so when if I look at a shell for example you know if you go back to the the early 90s I think pretty much everyone I hired had a degree in physics from Oxford or Cambridge right okay and and so you have a lot of people who really thought in exactly the same way and you know there are probably a lot of hedge funds out there start exclusively with people who've been to the University of Chicago and I with the kind of Eugene the farmer writer in having into their heads and the problem with having a lot of people who all think in exactly the same ways you know you kind of you've got the old story is if you've got six people in the room and six that we've got the same opinion then five of them are a waste of space I do think you need a diversity of backgrounds and one of the interesting things about the business of systematic trading is it does bring together a lot of different skills and you know you need people who know about the IT in computing you need people who know about economics need people who know about how financial markets actually work and who ideally have had some trading experience and you know you need people who have got that kind of statistical ability so when you do need people with a range of backgrounds and it's unusual to find people who do combine those and I've already said I'm a rare exception but I just means in practice that I'm I'm sort of not too bad at a number of things rather than being brilliant in any of them but I think in this business if it's better to have a team of people from those different backgrounds who are going to think differently and not just follow the same train of thought and and be exactly the same there's been a lot written about you know things like herding behavior and you don't want hurting behave you in your team you don't have anyone coalescing around the same opinion no I mean see I mean I agree with what you say but but it is interesting that there is still a preference I think from many institutional investors to go with the firm's with the larger teams although there is nothing to suggest in the performance data that you know 50 PhDs is better than than one so to speak but obviously there are some other things that you do when when you have large teams usually also have to accommodate managing and executing large amount of money and and and that takes research as well so for now I want to ask you a little bit about track records you know how investors should read them because not everyone has a 20 30 or 40 year track record and and and and even if you have a 30 or 40 year track record this system will have changed over time people make changes that's why they have research teams and and on one side investors want you to be innovative but on the other hand if you say you make changes hmm they don't necessarily like that either so how do we how do we put all of that together and and how should investors deal with historical track records so the biggest problem we have when looking at historical track records is this issue of statistical uncertainty so it's exactly the same problem that we have as researchers when looking at a backtest right we don't know whether this parenting really good bad test or really bad back test it's just an you know just bad luck of good luck and it's the same problem that investors have and one of the things I like to do is actually plot the evolution of the estimates of portfolio means and correlations over time and you know even with 10 20 30 years of data you know you never really in a situation where you have a significant difference between two portfolios which actually are quite in you know long-run would be quite different and so then that really hammers home to me that the difficulty of this at this job so I would look at it personally you know if I was running a fund of funds per jobs sure then you know I would look at track records but I probably wouldn't put a huge amount of effort in so analyzing them to death I mean I do think you know if you're in a funder funds business and you employ a smart researcher that's the first thing the smart researcher will do is is you know taking their twenty years of 12-month returns and do all kinds of amazing statistical analysis within which no can be yeah yeah yeah I think you can go over the top with these things and I think I remember seeing once a presentation by someone I mean funds business who'd analyzed track record of three managers over ten years and there were actually more slides than data points which you know is probably going a bit far but the basic things to do I mean look at the track record and it should be similar to to the track record of people who were supposedly doing the same thing so you know if you if you go for guys trend-following and he lost money last year then you you should kind of have a big question mark right that might mean that he's really bad or it might mean that he's not trapping pulling at all and he's doing something else you know if the guy did really well between 2011 and 2013 when Trent Pauling did badly then then again you you should be saying well he's he he is that due to exceptional skill or is that because he's doing something quite different from from all the other trend pours and maybe he's actually exposed to to some kind of risk hmm you know I would if someone's performance was like really really bad or really really good so you know well outside that the distribution of what I'd expect and I'd probably dismissed them both both being really good and really about so you know if someone comes to me and they've got a twenty year track record and they're doing and trying to falling in futures of an average holding period of a month and that ratio is three and say you know you you you you might be that you're a genius but to be honest is more likely you're the next Bernie Madoff so I'm really sorry but you know we're not going invest in you sure and then I would spend much more of my know I've hired this smart research going to fund a fun business I then sent him to talk to the the smart researchers in in that business and ask them questions and and you know make sure that they listened to give anything away but make sure that they could explain you know what they were doing and what risks they felt they were exposed to and it would be much more of a qualitative judgment for me rather than just looking purely at the track record sure so I remember from an e-book you helped me put together recently you have something called explain your strategy in terms my grandmother would understand it yeah now speaking about performance a little while longer in system at in the systematic trading world obviously we have the very short-term strategies we have the longer-term strategies and and and we have all sorts of other strategies that can be systematized often people will you know I I hear the point about all but there's too many people doing trend followers too many people doing short term or high frequency that's gonna be dead because this that and the other I mean did you have an opinion about these concerns that people might have will with these systematized strategies the main considerations are the the kind of size of the the systematic traders in that business versus you know everybody else the the style of how they're trading and whether their conditions are likely to change in the future so let's take high frequency trading zone high frequency trading is is basically as far as I can tell 100% systematized right there is no human being who can click with with some exceptions I mean you know there's some people who are being prosecuted for spoofing right yes oh yeah apparently they've been doing it manually which is quite interesting and have actually been able to take money off the high frequency traders you know unfortunately the cost of doing something that is alleged to be illegal but but generally speaking our high frequency n is a hundred percent computers because humans just can't compete well the things that humans are good at a completely irrelevant when wing the only thing that matters is that the latency in the speed at which the you're training you know these things aren't doing highly sophisticated calculations they can't be because their their main job is to turn around as fast as possible and update the orders they have in the market as new information comes in so you know will will that go away well no I think that business will remain under a systematized but as to who will make money in that business I mean at the moment if you believe the media then basically the you know it's the high frequency shots that are making the money and the people who are going into that market to execute who who were getting who were paying effectively attacks right you know and they're obviously the third part of my early statement was will that market change well you have things like obviously a lot of fuss in the US about this Hillary Clinton's high life that is a problem you've got IEX which is the you know the exchange set up literally to frustrate h15 you know the market will probably change but my opinion is that there will always be high-frequency firms out there they will have to adapt sure and they probably will it out you know the size of the profits they make may go down a bit may go up a bit but I believe that that will always be a you know a business which is profitable that doesn't mean to say that any individual firm doing it will always be profitable or that any strategy that's working now will still work in a year's time that's almost certainly not true now if we go to the other end of the scale well sure let's go into somewhere in the middle of a scale that's okay about kind of medium speed relative value trending right now so when let's suppose that you know you were doing I don't know long short equity trading sugar so you've got a bunch of equity factors and you know you let's just make it simple assume you've just got one factor which is Book value mm-hmm obviously the world is much more complicated than that but you know that doesn't change the argument so you've got a lot of firms that are cheap they've got you know high Book value and lot of phone's expensive got low book value so you do a long story short strategy on those and you do that in a systematic way now if only five percent of the people the market are using that strategy then that's great you'll continue making money hmm but if 50 or 75 or 90 percent of the people in that market are using that strategy then you know pretty soon the opportunities are going to disappear mmm you know the prices of the the firm's that a cheap will be bit up your prices are firmly expensive push down until they're you know in the extreme situation they'll all be the same price so in those areas the the profitability of those systems and it's not even it's not even since tonight training per se it's it's more the profitability of that kind of investment factor right is cyclical so there are times when you can make a lot of money of that kind of training and it's normally actually after a market crash so it depends on the kind of crack being over-the-top the dot-com crash back in 2000 after that actually value stopped swearing that cheap because they hadn't gone up that much in attack then they've been all the you know the growth stops that have gone up true whereas after the moment in the more recent crash you know in 2009 you you know you could pick up a lot of value stocks really cheaply because they were the business system they're things like house builders sure that have really been hammered and therefore value investing from yeah would have done extremely well in the two or three years out of that period yeah so that's the cyclical business so it won't ever go away because it's just that it might go away over the next few years but then something will happen it will come back again and you can either take the view that you'll just always be in that strategy over a very long period of time or you can try me a little bit smarter in saying well I'll put more money and when there's this more value a bit like driving faster than 50 miles an hour right you know when you when the road is clear because of the MU energy children now let's take something like a slow edge strategy like trend-following mmm-hmm so the the thing about trend forming is unlike a relative value strategy is that if more people follow it it actually becomes self reinforcing mmm-hmm sure so if when markets go up there are trend followers in the market who will buy it then the market will continue to go on so from that point of view having more people in the markets may actually improve your returns rather than harming them the issue then comes around execution because if you have a lot of people training more market who are all running the same model and then the price moves against you they're all going to want to rush for the episodes at the same time yeah and you know there were probably futures markets out there which have quite high percentages of people in them who are running at CTA time strategies and no we we had a shell we always made sure we were less than a certain percentage of the open interest shop yeah look bigger figure I can disclose and it's probably changed anyway but let's just say it was 10% sure it wasn't the same us yeah that's fine but if you've got you say you less than 10% if you then have 10 large CTAs all of whom saying oh let me up to 10 some of the open interest all of a sudden you've got a market that is a hundred percent CTA sure you know and they're all gonna rush for the exits on a correction and exactly the same way so that you know the the underlying returns of a trend following CTA type strategy because it's pretty slow because it's based on human behavior but I think that they shouldn't change yeah we'll probably still be around for a long time to come but there may well be periods when there are too many people in that strategy it gets crowded and then you know and that will mean and that so there'll be these unexpected and liquidity problems at times but you know in the long run it probably be okay sure which is kind of why I certainly also feel that in some ways I think the exit however you do it but I think the exit is another important factor in in these strategies at least in order to avoid being caught up in in in when maybe a large part of the the same strategies is is going to to get out at the same time now I want to ask you a question that I never asked to anyone really because they may not be as in the you know the details as you clearly are and and I just wanna you know when you look at all of these things is there any one statistics that you really like you think this is this is just a great one too you know some people talk about shops and people talk about Sortino ratio or make a ratio all sorts of different things I don't know is there something when you do your analysis that you feel yeah you know this is important and I'm gonna so put a lot of emphasis on there I generally look mostly at shot ratio okay and that's because it's relatively simple to calculate trouble well and then because because I generally looked at Sharpe ratio for you know the best part of ten years I have a very strong intuition as to one is a good shot ratio you know what is a bad shot ratio and and you know now the disadvantage of shot ratio is obviously it assumes a symmetric sure returns and that reason the other thing I will look at is skewed okay so positive skew means that generally speaking you have more losing days than winning days but you're winning days are biggest that are very much like a trend following strategy a negative skew means that you're making money more days than not but when you you have a loss it's a big loss and that would be something like a relative value strategy or perhaps a carry strategy so the the problem with with skew is that without getting into technicalities that the the higher up you go in the distribution and more moments you calculate the more unreliable the statistics are and the more they can be distorted by just one or two data points and one thing I'm very aware of is with a lot of negatives few strategies is that they may not have had their big down day in the backtest like which you know economists call the peso problem I came back to Mexican peasant crisis in the other 1980s so I'm very suspicious of a strategy that has a high sharp makes money more days than that doesn't they are money yeah but then it has never had a big loss because I I'm always thinking well this thing must be exposed to a risk which is out there and you know if I was in this hypothetical situation where I were working for a fund of funds organization I would go to the manager to say right you know what keeps you awake at night what's what's the big risk you exposed to what can go wrong and if the guys just kind of shrug their shoulders and say oh nothing it's wonderful and I I won't invest in them because you know they they clearly you know that you know if they can but if they can articulate and say well yes this looks amazing and the backtest looks amazing but we know for a fact that we are exposed to this particular risk but we've quantified it and we only think that we might have a 20% down year if it happens and you know then I might actually be happy enough to invest in in their strategy [Music] I'm gonna give you a challenge Rob because I have so many more questions and I know we can't get to all of them so the whole next section which is where I wanted to talk about your own trading strategy I'm gonna formulate it or at least I'm gonna try to two into one question okay and that is taking everything you've done the research you're writing and and all of that how have you ended up from a sort of 30,000 feet point of view and maybe a little bit lower than that how have you ended up with your own trading system what does it look like today okay so I trade about 40 futures markets mate rate they're spread over the all the main asset classes as I said earlier you have to be diversified in this game diversification diversification really is the only free lunch in finance so I've got a good spread of assets and geographies so if I had more capital I'd have more markets you know it's as simple as that but how many but just on that point but how many more because I think that's a big discussion as well because I find that certainly in some of the strategies that I've seen and been part of there is a number of where you don't really get any more diversification benefit and and so people who trade 200 markets they do it because they need capacity they don't do it because they need more diversification but I don't know what that number is whether it's 60 markets or whether it's 70 or 80 I don't know what what is you bought where would you like to go in terms of number of markets well theoretically there is always a benefit adding another market 100% correlators sure now the question is what is the cost of having that market yeah so if I go back to my institutional experience today a child one of the things I did while I was there has had a lot more markets to their system mostly OTC interest rate swaps and credit derivatives and you know one day the the CIO called me into his office and said you know you value all these markets you know what's the you know is this really necessary and I said well you can tell me what the cost is in each of these markets then I can say you know whether I think it's worth it or not because it might be the last market we had it and there's a tiny tiny fraction of the portfolio and added only you know one basis points for our performance one basis point Mon you know ten billion dollars is still it's took I can't work it out in my head that looks and now but if their cost aveling that market in terms of operational costs or back office costs or whatever you know exceeds that one basis point mean yes I agree that bad trade and we discussed it and decided that I was right but you know if I think my own personal training system if I had a mark it's because I'm running a fully automated system I spend very little time doing it because I'm just using Christ's data I automatic filters in place to catch bad prices I spend about maybe five minutes per month per market so you know if I had a thousand markets then it would become a full-time job and I wouldn't it be quite a boring full-time job I wouldn't be being interested in in doing that but I could easily trade you know a hundred futures markets or Ahuh there's probably about 150 really liquid futures markets out there in the world look and if I had enough money I'd quite happily trade all of them because even if the last market I had only adds a few basis points he's worth five minutes of my time a month yes that's my own personal trade on so sure so you've got 40 month 40 market at the moment tell me about sort of the number of different strategies and models that you decided upon in your own and and and and and what kind of style did you end up become you know what kind of style trader did you end up becoming so everyone listen to this so far is probably concluded that I'm obsessed with trembling in my system would be a hundred percent from falling so I'll now disappoint you and tell them you my system is only forward of Center and the and it's it's also an you know I'm not just doing me I'm doing a few different ways of doing that trend following which will fairly highly collimated correlate with each other but just adds a bit of variety so a chunk of carry the carry system mm-hmm so that's going to be looking at the slope of the yield curve and looking at the roll arm and the the contango and they said both in in yields and and they're all commodities or mainly in commodities where there seems to be it's it's across the board so one one thing I concluded is there's not really enough evidence to say that different systems work much better in different asset classes than others I mean there are some exceptions so it does seem for example that trader trading trend following relatively quickly doesn't seem to work as well in equity indices as in other markets and the same and that then finding follows through down into the individual equities as well and actually under Americas are nice so he's on his blog about this yeah absolutely I saw that and you know but but on the other hand if I actually look and be really statistically rigorous and say he's do enough statistical evidence the backtest to say I should run a different system with S&P 500 futures as with US 10-year bonds I don't see that so I take the the the simple approach of running exactly the same system and every market with a caveat that I do adjust for the respected trading cost of the market and therefore you know on a really cheap market like like Nasdaq or S&P 500 I will be trading more quickly than on something like Australian interest rate futures which is relatively expensive market I have a systematic short bias on on the two volatility index Markinson trades just the VIX and the European equivalent the v2x and that's because you know I believe that's being short the the you know the implied versus realizable premium is a it is a kind of source of return and ideally I have a you know the system's you can build a capture that more efficiently but the my current trading space the simplest way of doing that is just to have this little short bias and those two markets how much wood of the audible risk would you allocate to that kind of strategy it's I think it is about 5% 5 and 10% I gotta go but exactly it's not a lot because that obviously is pretty that that's the dark real-die side when it kind of mr. Pappas is you know these things have four times the skewer of the the equity Marcus they track and if something like 2000 and they happened again in Italy would be pretty dangerous but because I'm also running a trend following and the carries is right it's not sure if things really went badly I'd be out of the position so it's not too much of a concern no no in in trend following at least my experience is that there is a disproportionate part of the profits in in long term trend following that is being made from the long side of the trend of the trades have you looked at that and and if so do you adjust for that fact I mean again it comes down to statistics so part of the problem is especially in the financial markets so you know the the bonds the equities the interest rate futures the there has been this massive long secular trend class 30 years which he touched on agile which means there isn't really that many times when when you know the markets going down so it's really hard to know if we have a less unbiased data set where there were roughly the same map bear and bull markets then we could probably be able to make that decision a bit a bit more and a bit more easily in and you can try quite clever things like trying to adjust the history of the past to remove this circular trend and then refitting your system and and you know you kind of get this this result coming through but but again I've become a lot more rigorous in my old age so when I was younger I I used it if I saw it as something that looks good in a backtest I'd immediately put it in but but now my my bias is towards doing nothing so I'm keeping things as simple as possible and the same across the board and so I need really strong evidence to suggest that what you said was true to actually pour them into my system and there's definitely something there but it you know unfortunately because we've got this bias sure it's rare that you'll see a statistically significant difference between those two environments so I have a little bit of a cheeky question hope you don't mind you've been running your system for four for a while now no no PhD how are you comparing to your old friends at AHL so I review my performance annually okay so after the first year the first year I was running this from April 2014 so April 2015 and you know I'm looking at Sharpe ratio I think they had better show ratio for it's just goes to show you what an incredible year it was at Redmond and I had a show at ratio of 2.8 okay which probably somewhere in the middle of the pack in terms of the CTA so there were some other CTAs I was doing better than this year I have done I haven't looked at the numbers in formal sense but I know about performed them okay but and I can do a little more analysis when I get around soon but my intuition is that is because I do have this higher allocation to non trend following strategies so it's probably not a fair comparison from that point of view sure I would expect over a long period of time that they would outperform me mainly because they do have many more markets and that is a key you know a key difference between a small retail investor in a large investor base the main advantage a large investor faster sure sure sure let's jump to another topic just touch upon that briefly and that's a drawdowns we've spoken about it a little bit I have a couple of question what is what's the best way of getting a gauge on a system's potential drawdown have you found any rule of thumb or can it only be done through you know hours of testing how do you find out what what what what to expect on the downside so one thing you can do is to completely forget about your real data and just run experiments with completely artificial data and this has an advantage because if you have some real data you just don't know whether you've been lucky or unlucky so it might be that you're you know you've drawdown was exceptionally small exceptionally large just just through good look or bad luck and then whether that's realistic to inspect in the future and that may lull you into a false sense of security or may scare you and you wouldn't think about training the system because it's too dangerous so what you can actually do is run a number of different account codes with random data with some Sharpe ratio with some skew whatever use you want to do and then you can then look at the measure the draw downs in each of those simulations and then what you can then do is is actually look at the the distribution of the draw downs across those simulations so that sounds kind of complicated but but let's take if I'll give you a specific example so let's say that you're running a system with a risk target of 20% yeah and you expect your Sharpe ratio to be 0.5 which maybe is a little bit pessimistic but you know even if your true Sharpe ratio is more than that as one on one and a half it's not beyond the realms of possibility that over a 10 year period you might maybe even if you look at the big CTAs over the last 10 years that's probably roughly where the Sharpe ratio is so completely now if you look at the you can then plot the distribution and you can so resolve if you pop the distribution of the average drawdown so in any given day in any of these random simulations your average drawdown is about 10% so most the time you should have a drawdown of about 10 stone if you have a drawdown that's that's you know then this to 10% sounds a lot is half your risk target you know that's the kind of rule of thumb but there are also realizations 10-year periods where your average drawdown is 50% so that's pretty pretty rare but it could it could happen so you need to have that in the back of your mind people probably don't worry too much of an average drawdown and they worry about worse from whatever no what's the what's the kind role the worst-possible-case so if you look at worse drawdowns over a 10-year period then the the average is around 40% so it's twice your risk target right that's a good run other good rule of thumb is that you're a retain year period you're worse draw around would probably be about twice your risk target okay so if you have a if you've been running a system for a few years and it goes down 40% you probably shouldn't panic because that's kind of roughly what you should expect but again if you look at the streams then you know there are runs where you you know you can have an 80% drawdown which I think most people on the other side exactly you know so that's not impossible and to me that really really just I mean you know just reinforces the message that you really want to be in a position where you you can lose all the money you're trading right as it could happen when you hope you won't but it could okay and you know why need be extremely unlucky if you've got you've got a shot ratio of 0.5 or higher you'd be extremely unlucky to be in that situation but it could happen and that should always be in the back of your mind sure so those those are nice rules of thumb and there that's easier and better than looking at a back test which is I said may be biased and give you an unrealistic picture of what the drawdown really ought to be sure sure sure sure now being mindful of the time I want to jump again - just another section and just ask you a quick question before we end up in the last part of part of this conversation now you've clearly been part of many diligence meetings phone calls investors wanting to ask questions about you know the strategy you were working inside and so on and so forth and interrupt if you take that hat on what are the things you find that investors should be asking but they never do and well one is the question I done earlier which is what can go wrong right you know what what keeps you awake at night and the no one likes to hear bad news I guess which is my you know and it also seems potentially I suppose like quite a rude question to to walk into a room and say to somebody right you know what when are you gonna screw up how's it gonna happen tell them all about it but um you know really that's a very important question to ask particularly if you've got a strategy that's exposed to a you know a really bad risk that hasn't happened yet yeah the other question I think I would probably go back to the three points I made at the beginning about over trade like the betting trouble and overfitting and a lot of I mean investors will look at the risk properties and I think you know savvy investors understand things you know I'll fulfill for for things like leverage and we'll know that if you make 40% in one month and potentially you know you've got a high fire risk and you might be over betting there that they kind of understand that what they don't necessarily understand so well is is the the overfitting so and this obviously is is hard for someone who's coming from a different background to uni and doesn't isn't familiar with it but you know as you said only explain to me in terms of my grandmother would understand how you how you feeling what's the process you go through in trouble and if the the research is described oppressors that it seems to involve a lot of iterations then immediately alarm bells should be going off in your house so oh you you a better question is to say tell me about this particular model as they may if you ask them how do you fit your models they may just rattle off some corporate es so that you know about yes what we follow this very very much process blah blah blah so if you say well how did you fit this model you know where did the idea come from you know did you know what did you look at then then it's they're gonna be it's probably going to be you're gonna get more honest answer out of them and you can get a feel for whether there are some is some danger of overfitting going on there and if so how it is true and the same with over trading I think very few investors asked about trading costs you know as I said I think it really is something that most people in the industry don't pay enough attention to sure no there's no doubt that transparency in these situations is very important and as you mentioned in your book that goes also for politics [Music] anyways the last section Rock we're almost there general and fun and I'm just gonna pick a couple of ones I think would be relevant for our conversation today because we've clearly touched upon a lot of the the technical stuff you've written a book but if you couldn't recommend that which other book would you recommend for someone who wants to get into this business or want to learn to understand it better is there any book that you read that sort of stands out to you yes so my book wouldn't be the first book you read and I think if you were interested in in the systematic training business so there is a book I read myself about 15 years ago before I knew what systematic trading was and it's called the predictors so there was if you heard of going farmer using something called econo physics okay and he was one of the inventors of chaos theory mm-hmm and he in his youth fee he did funny things like trying to build a we're what we now call a wearable tech a computer that we predict where a roulette wheel would okay Landen and you know try and make some money out of that better the technology wasn't sufficiently advanced and I believe there were some electric shops they were he moved on and ended up founding a a hedge fund which was doing systematic training and this was in the early nineties and it's a very well-written book it's not technical and I read one read this book and thought this is what I want to do and it gets across really the field for you know how how you do this job and the things you have to worry about and there's some great passages in there about the little anecdotes that really get across one over fitting is I mean the phrase is never used in the book you really get the feel for what it is and and how you have to worry about execution costs and overtime now I just thought this is a really interesting book already readable book and you know I just find it fascinating I'm sure sure sure and in in your and and and I'm not entirely sure which career I would because you've kind of had a couple of different careers you could say so so you can relate the question to to to what you want what what would you say has been the biggest failure on your side and and what did you learn from it and I used the word failure loose yes I think you've done pretty well I've made a lot of mistakes so if I think about when I was working at AHL you know there were a number of times when I did things that I would I would no longer do now it's it's quite hard to pick out the biggest one the yeah I'm slightly lucky I've never had a kind of single kind of blow up disaster if you like that that sort of really knocked me back I've had a long series of small disasters we should left me still standing and able to learn from them without being be completely knocked down so I mean arguably you you could say that you know when when I left Barclays Bros trading that would that was a failure arguably because I failed at doing the job that I've been hired to do in the sense that I I thought it was not what I was any good at sure and there's a really from that I I learned but trading is not what I am I can't trade sure you know discretionary trading is not something I can do and most people a lot of people think they can do it I don't think they can either but I was fortunate enough to lesson quietly ons ya know that that's an important one that's an important one for sure now you told us an interesting fact about yourself which I had no idea about your your stellar sailing career long time ago you say but can you tell me a fun fact about yourself something that even people who know you and let's maybe exclude you or your wife and children here but people who who may even know you don't know about you is there anything is there a different side to Rob Carver that that we don't know about I have a real addiction too trashy television okay can you make in a minute can you recommend any particularly there's a what I would call them trashy business programs okay I say well I mean there's a there's a couple there's a couple I mentioned this in the run in this country and what one is the apprentice which i think is international now surely know there's a US version which had mr. Trump yeah interesting isn't it you know this this program is absolutely appalling because it is completely unlike you know it's completely you would not run a business the way this program works sure it encourages people to behave in ways that are incredibly bad burn great television and this this I don't know why I enjoy watching it I don't know whether it's schadenfreude there because I'm thinking gosh I'm so bad I'm not like these people right then I had to put myself through this or or what but yeah and it it's it's compelling stuff though and then there's another program called Dragon's Den in which people have which practices and so well known outside of the UK where people have to pitch ideas to some venture capitalists yep and again is it's a complete that's slightly more realistic than the apprentice but it is a bit of a classical representation of how they were the real world of business works through and of course the irony is if there was a highly realistic program about this is it was being kind to be done and I wouldn't want to watch it either so and I'm assembling these programs and they exactly exactly I hate them and I hate myself for loving them so much so there we go yeah dragons stand in the US they call it the shark tank so that's what it is it's over here now you mentioned you have children and I was curious to know if you could choose only one of your own skills to pass on to your children what would that be and and and why I mean if I was to choose an attribute rather than a skill okay it would be but I'm a very optimistic person sure that's allowed I always you know think and I also never never ever look back and regret anything that's happened in the past sure so there's two things for me at least go together so and that makes a life you know more fun and more tolerable and I think that's probably a more use than and saying oh I wish my kids were you know as as good at maths as I'm not that I'm not good at math secondly you know sailing perhaps apparently that seems to be a good no that's important absolutely now we're coming to an end Rob I have one particular question left and I asked earlier about what investors were missing out when they talked to people like yourself what they should be asking so I'm gonna turn it always on myself at the very end and say you know was there anything today that I missed I want to make sure I give justice to you and and and in your book so so is there anything you want to bring up to the at the end here that I fail to ask you today I'm just going to be really cheeky and and just plug the books the more and say that if you go to www.assist.org then you can find out more about it and there's also a link to my blog a link to the publishers page where you can you can buy if you want sure no absolutely and I was going to absolutely mention that and I'll probably mention that a bit later as we wrap up I want to think Urich's the exchange for sponsoring today's episode and as many you listeners today will know York's is a great place to to trade especially if you're systematic trader because there's quite a lot of liquidity in most of their contracts that just launched a mini tax future which is a really really interesting contract because the the tax is a bit large but we turn our traders of the moment for that well thanks very much for that because I was not aware of that I'm sure they'll be happy to - here's discuss that and and promote that from my side I also want to mention to to our listeners that it might be a good idea to go to your smartphones and activate the subscribe button because I've noticed that some of these feeds on the podcasts are no longer automatically updating the media player so if you wouldn't mind just to pick up your smart phone and and make sure you are subscribed to the to the podcast and and that really leaves me to to thank you rob this has been a great conversation on on a Saturday morning a true master class and systematic training which I really appreciate and I I also appreciate your willingness to share your your insights and your views in in this field and the book the book of course is systemic trading as Rob mentioned and and I suggest you grab a copy or two of that and of course the listeners can also find all the details of today's conversation in the show notes on top traders on plot comm so Rob I hope we can connect at a later date and get an update on your great work I really appreciate your time and what you've done so thank you ever so much thank you very much it's been quite fun absolutely take care about thanks for listening to top traders unplugged if you feel you learned something of value from today's episode the best way to stay updated is to go on over to iTunes and subscribe to the show so that you'll be sure to get all the new episodes as they're released we have some amazing guests lined up for you and to insure our show continues to grow please leave us an honest rating and review on iTunes it only takes a minute and it's the best way to show us you love the podcast we'll see you next time on top traders unplugged [Music] [Applause]

Channel: Top Traders Unplugged

Views: 1,750

Rating: 5 out of 5

Keywords: investing, hedgefund, trading, trend following, managed futures, risk management, niels kaastrup larsen, top traders unplugged, popular traders, investing money, investing for beginners, best traders in the world, worlds best traders, Robert Carver, Author Trader, diverse trading, systematic trading, how to manage risk, trading strategies, fund managers, sharp ratio, trading systems, trend following strategies, how to start trading

Id: VNSu5Pt8at0

Length: 73min 58sec (4438 seconds)

Published: Mon Nov 26 2018