Turtles Outperform Industry In a Challenging Year
Copyright 2000 Barclay Trading Group, LTD.
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In 1983, C&D Trading Co. ran a classified advertisement in the Wall Street Journal looking for individuals who would be willing to learn how to trade futures. These individuals, upon completion of a training program, would be given trading capital by C&D. Compensation would be a percentage of their trading profits.

C&D Trading, owned by Richard Dennis, received approximately 2000 responses to this advertisement. Mr. Dennis and his partner William Eckhardt, using a process that included reviewing written applications, evaluating exam results and interviewing finalists, selected a group of thirteen. Upon completion of a two-week training period, this group was funded and sent off to trade. Thus were born the Turtles. This curious name supposedly had its origins in a trip to the Orient taken by Dennis. Upon visiting a turtle farm, he felt that he could grow traders as easily as one could grow turtles

This initial group was so successful that C&D decided to start a second group of eight in 1984. By the time the program ended in early 1988, C&D had made approximately $120 million on its share of the Turtles' trading profits. After the program ended, many of the Turtles went into the CTA business. And while a few have dropped by the wayside, many of the original group continue to earn attractive rates of return for their clients.

On balance, 1994 was a difficult year for the CTA community. The Barclay CTA Index measured a loss of 0.66% and many traders in the industry lost money. Among Turtles, however, we found that eight of nine made money in 1994.

In order to get a better understanding of what is behind their successful trading, we invited a panel of former Turtles to comment. Our panel includes:

Mike Carr, M.C. Futures

James P. DiMaria, J.P.D. Enterprises, Inc.

Paul Rabar, Rabar Market Research

Howard Seidler, Saxon Investment Corporation.

Q: Given the risks inherent in managed futures, what rate of return on average do you think CTAs ought to be able to provide to investors in order to compete with all the other investment categories vying for capital?

Carr: The tendency to think of managed futures as an asset class that is competing for investment dollars is, unfortunately, typical of the short-sighted view prevailing in the investment community. This error is compounded by the media, which is always touting the current hot performers. Although fine-tuning asset allocations makes sense, there is a tendency to chase the latest fad and move money around to the hottest sector (bond funds, exotic derivatives, foreign stocks, or whatever), often making for some crude surprises, as we have seen recently.

Managed futures are a proven way to enhance overall portfolio performance as part of an asset mix, assuming you have good CTAs. The prudent investor should allocate funds within comfortable risk parameters, then sit back and let those CTAs make that money grow. It is essential that they take the long view and not be so focused on short-term numbers or whether managed futures are "outperforming" other asset classes over a period of time.

DiMaria: The most important thing to remember when looking at managed futures versus other investments is that managed futures is completely different from traditional investments (e.g. stocks, bonds, real estate, etc.). Thus, a huge benefit of managed futures is that it provides excellent diversification when used properly in an investment portfolio. Last year (1994) was a great example of that: stocks and bonds were lackluster at best, and managed futures, at least in the Turtle universe, were quite positive. Managed futures, by virtue of its diversifying properties, can actually make a portfolio less risky.

Simplistically, though, it seems that in managed futures one should expect to average at least 15-20% per year, and have the potential to capture larger returns (35-100%) every few years. Managed futures is not a game that should be played with the intention of making only 8-12%. Why take the risks typically associated with managed futures to make an incremental 5% over much safer investments (likeT-bills)?

Rabar: Obviously, CTAs have to return more than T-bills, which are riskless. But it's difficult to determine more precisely the absolute rate of return needed to justify investment in managed futures. Instead, I would consider a CTA's risk/reward profile. For example, a CTA should at least be able to provide an average rate of return that exceeds its largest drawdowns. (Note, incidentally, that this would require trough to peak run-ups at least twice as large as such drawdowns.) In this respect, the risk/reward profiles of many CTAs surpass those of almost all other investment categories, many of which are widely and mistakenly considered more conservative than managed futures.

Provided that the aforementioned criteria are met, and that an investor is satisfied by other aspects of a CTA's record and operation, the investor should probably include the CTA in his portfolio for diversification.

Seidler: Given that there are millions of portfolios worldwide, each with its own unique needs, profit goals and risk aversion, there is no magical threshold of profit which would ensure that managed futures are a desired asset class. However, for certain types of portfolios there is no doubt that any CTA program that produces nearly all positive 12-month returns is worthy of consideration as an investment.

Q: Many CTAs are heavily weighted towards trading currencies and financial futures rather than physical commodities. After the experience of last year, do you think the pendulum will swing back? Are the commodity markets liquid enough to handle increased volume?

Carr: I think the pendulum of market emphasis may swing back somewhat, but it makes sense for the big money to remain where the markets are more liquid. I get the impression that liquidity is improving in some of the markets, but there is still a ways to go, and it will take time.

DiMaria: First, I do not think that last year was a glaring example of why trading the physicals is important, as JPD captured profits in the financials as well. I gather, however, that the industry has the impression that the physicals were where the money was in 1994. Assuming that to be the case, I suppose that there might be increased activity in the physicals. I believe that most of the markets are capable of handling quite a bit more activity. One must remember not to look only at the futures markets, but also at the underlying cash markets. Even if a given futures market appears to be thin, if there is a large underlying cash market, then I believe the cash/futures arbs will allow for increased activity.

I do not think of one year as being a very long period to make a decision. One should not begin trading a market simply because it showed a positive year in 1994. Conversely, a bad year in a given market certainly does not mean one should not trade that market the following year. You could really end up chasing your tail if that is your mentality. I think the answer lies in diversifying markets traded, not trying to guess which markets will be good in a given year.

Rabar: After huge profits were earned in certain physical commodities last year, some investors will surely seek portfolios that are weighted towards these markets, and a few pool operators and CTAs will no doubt respond to this demand by providing applicable products. Perhaps we will even see some coffee trading programs or other similar novelties. But it would be a mistake to base a decision to rebalance a portfolio on a mere year of market activity, a period of time far too brief from which to draw almost any meaningful conclusions.

Furthermore, the largest CTAs' portfolios are heavily weighted towards trading currencies and financial futures primarily because they currently are, and will likely remain for the foreseeable future, the most liquid markets. Therefore, I do not expect to see the pendulum swinging back toward the trading of physical commodities on a large scale.

With regard to whether these markets could handle increased volume, the report must be mixed. Large traders already must handle many of these markets very carefully, and I don't believe they are currently liquid enough to accommodate substantially increased volume.

Seidler: It is helpful to maintain balance and diversification among many different sectors within a portfolio. There may be some movement back towards trading commodities. However, traders with very large amounts of capital will find that they are somewhat liquidity constrained.

Q: While most CTA programs lost money in 1994, eight of nine former turtles were profitable. What do you feel has been the most helpful concept learned as a result of your experience with Richard Dennis and the Turtle Program?

Carr: With a reasonably good trading program, the number one priority is staying in the game--to be there to participate and benefit when the really outstanding market opportunities come along. That means that good money management is essential. If the severity of drawdowns can be limited, comebacks are much easier--and the clients stay happier, a not inconsiderable side benefit!

DiMaria: Perhaps the most helpful concept I learned in the Turtle Program was that trading decisions need to be looked at over the very long term. The results of one trade are almost meaningless. It is only when "good" trades--not necessarily profitable trades--are consistently made over a long period that the chances of profitable results increase dramatically. A bad month, quarter, or even year, does not mean much. It is not fun to live through, but in the grand scheme of things, one should gear for the long haul. A three- to five-year time horizon is a minimum.

The most important thing, though, is having a sound trading approach based on valid assumptions and tested in the real world. That was the real value of the Turtle experience; it gave us some very sound concepts, not systems, with which to begin our trading careers. After that, it is a question of development.

Rabar: It is well known that over a period of several years, Richard Dennis traded an initial stake of $1,200 into $300,000,000. By at least some measures, he thereby achieved the greatest performance in the history of the markets. To do so, his methods must have been different from or contrary to those of other traders in some important respects. The concept of contrarianism is perhaps the most important of those imparted by Dennis.

Because each futures market is a zero-sum game, even a marginally profitable trader must extract capital from other market participants and, therefore, must use methods that are different from those of other market participants. Contrarianism in one form or another, whether or not a trader consciously identifies it as such, is the first requisite for profitability.

Seidler: "Do the right thing!" In other words, you must follow the concepts of your methodology and you must do it with consistency.

Q: With the aid of powerful computers, traders utilizing the same data are attempting to solve the same puzzle. Do you believe that this phenomenon has had an effect on market action? What changes have you made in your trading to accommodate these and other changes?

Carr: I think that computer analysis has had some effect upon market action, and it may be exacerbating certain aspects, such as increasing volatility at times or affecting market activity at certain price points. My own strategy to cope with market changes is to be somewhat more conservative in my approach, further diversify into promising markets, use complementary but different trading systems, and to be somewhat more selective in the analysis of potential trades.

DiMaria: There is no question that for a trend-follower, the markets are "worse" now than they were ten years ago, and quite a bit worse than they were 15-20 years ago. They remain, however, a positive game for the best of the trend-followers, and I think there is a lot of degradation that would have to take place for that to go negative. What will happen first is that not all trend-followers will be playing a positive game, only the best of them. I have said for years that the Turtles are nothing more or less than the best of the trend-followers; perhaps 1994 was an example of that. One year, good or bad, doesn't provide us with a lot of data to try to make that type of determination.

A trading approach is something which must be fine-tuned, but a good approach should not be overhauled based on too little data. JPD makes minor adjustments from time to time, as our research dictates. Most of the changes come from new ideas, however, not from new data. One has to be careful of making (large) adjustments based only on a year's worth of data, even if that year is the most recent data. Since JPD uses a diverse group of entry and exit points, we do not fall into the trap of over-fitting to the single "best" way to trade, at least according to the research.

Markets are going to trend or not trend depending on the underlying market conditions. Traders cannot sustain or terminate a true trend. The secret is identifying those trends and managing to hang on at the right time. Many traders may miss trends because their time horizon is wrong or they are trading at only one point. By diversifying both initiations and liquidations, JPD tries to capture a good portion of any large move--and that, to me, is a big part of being profitable. The small profits pay for the losses; the big moves are where the profitable returns originate.

Rabar: There is no question that the growth of technical trading has degraded the profitability of certain markets, particularly those that are less liquid. To accommodate this change, we constantly seek more and different places to initiate and liquidate our positions. But any market's potential profitability for us is still determined primarily by the frequency and extent of large price changes that are driven by that market's fundamental factors such as supply and demand.

Seidler: I think the effect of powerful computers causing people to trade differently is nearly inconsequential compared to much larger forces influencing the markets. Each dollar that comes into or leaves the markets has an effect on market action, whether or not there are powerful computers behind them. The natural flow of money between financial instruments and commodities, worldwide governmental policies increasing or decreasing liquidity, the post-Cold War effects on the markets, all overwhelm the effect from everybody "trying to solve the same puzzle".

Also, there really are a lot of ways to trade and make money--and there are an essentially infinite number of ways to lose money--so we are not necessarily trying to solve the exact same puzzle.

So we have not made any changes that specifically address the effects of powerful computers.

Q: As a result of growing institutional interest in managed futures, some traders are attempting to lower their volatility relative to their returns. De-leveraging lowers volatility relative to returns on a 1: 1 basis and doesn't change the risk/reward trade-off. Given a mature trading system, is it possible to lower volatility and actually enhance the risk/reward profile?

Carr: With any trading system, de-leveraging lowers the risk of ruin, and that fact alone will improve the risk/reward profile because the chance of "busting out" will be lessened or effectively eliminated. Realistically, that "bust out" point is more the drawdown level where the client decides to throw in the towel, rather than the pure mathematical model that may make sense in theory but is somewhat less relevant in the real world. Because the prudent trader cuts back trading size when equity declines below certain levels, avoiding those levels makes comebacks easier and preserves much of the upside potential--and hopefully keeps clients and their money onboard. This is all part of the concept of staying in the game which I mentioned previously, and which is a key to success in the long run, allowing the trader to take better advantage of the outstanding trades when they occur.

DiMaria: The whole idea of trading system development is to maximize the rewards with respect to the risks taken. However, I think much too much is spent on trying to minimize volatility, in the most general sense, rather than on finding trading methodologies which will be profitable over the long haul. Volatility, if you think about it, is a rather short-term concept, if the trading system is sound and truly positive. The question should be, "Where will I be in five years?", not "Did I make money every month (or even every year)?" That's why I have trouble with the concentration on Sharpe/Sterling/Barclay Ratios. It's important that the tail not wag the dog.

In my experience, the best way to improve the reward/risk ratio is, in a word, diversification. In theory, if one traded an infinite number of (positive) markets, one would never have a losing day. Of course, we are limited to quite a bit less than an infinite number of markets, so we have losing days/weeks/months/years. Increasing the number of markets traded, and diversifying the initiation and liquidation points, is the best way to reduce volatility relative to return.

Rabar: Enhancing the risk/reward profile should be the goal of every trader, regardless of who his clients are. Most ways to accomplish this goal involve variations on the concept of diversification. Specifically, we seek to increase the number of markets we trade, the number of methods we use, the number of variations on those methods, and so on. Portfolio balance, involving a subtle analysis of market correlations, also plays a particularly important role in this effort.

Seidler: We do not advocate de-leveraging as the preferred approach to reducing volatility and improving the risk/reward situation. To make the portfolio manager's job easier and allow him/her to allocate money more efficiently and maximize returns within the risk constraints, we should fully utilize the capital we have under management. To trade a fraction of the capital under management for the sole purpose of "reducing volatility" is doing everbody a big disfavor in the long run. A portfolio manager who knows what he/she is doing can incorporate a high volatility program into a portfolio and make more money with lower volatility rather than by simply allocating less to the CTA.

I don't believe that a system is ever completely "mature". Only the very core of our system is mature. We continually nurture the rest to help it evolve and grow (research, research, research!). Since we--and I assume all other traders--are constantly evolving and striving to produce the maximum return per unit volatility, over time we will produce--and have in the past produced--higher returns per unit volatility. But this is because our system is not "mature", nor will it ever be.

Copyright 2000 Barclay Trading Group, LTD.

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