The days of Richard Dennis and his “turtles” with their alleged 100% per year profit are long gone, but their mystique lives on. And with it comes one attempt after the other to emulate them, to create trading systems that will knock the socks off the competition.
Robert Carver is more modest—and more realistic. At the same time he has more to offer the investor or trader who has a spark of creativity and intellectual curiosity. Systematic Trading: A Unique New Method for Designing Trading and Investing Systems(Harriman House, 2015) is a thoughtful, and thought-provoking, journey through the process of creating modular rule-based portfolios.
Although the book addresses three classes of traders and investors—the staunch systems trader, the semi-automatic trader, and the asset allocating investor, Carver is at heart a systems guy. He himself runs a futures trading system with around 45 instruments, eight trading rules drawn from four different styles, and 30 trading rule variations. But this doesn’t mean that he is writing only for those with large portfolios who can code. It does mean, however, that his book will be of value only to those who either already think systematically or are open-minded about learning how to analyze and assess the ingredients of a model investing framework. I would wager to say that this group should include every investor and trader, though in practice of course it encompasses but a tiny fraction of people who have money in the financial markets.
Here I’m going to be decidedly unsystematic and pluck out two ideas that are illustrative of the topics covered in the book.
First, according to Carver, the most overlooked characteristic of a strategy is the expected skew of its returns. “Assuming they have the same Sharpe ratio, the returns from a positively skewed asset will contain more losing days than for those of a negatively skewed asset. But the losing days will be relatively small in magnitude. A negatively skewed asset will have fewer down days, but the losses on those days will be larger.” (pp. 44-45) Equities normally have a mildly negative skew, foreign exchange carry is a negative skew strategy (sometimes disastrously so—think the Swiss franc in January 2015), and gold tends to have a positive skew. Trend following strategies and long option strategies have a positive skew; fixed income relative value (remember LTCM?) and short option strategies have a negative skew. VIX futures have a highly positive skew, “around four times higher than their underlying index.” (p. 46) Negative skew trades often seem more attractive; after all, they are like selling an insurance policy. But managing risk in these trades is more difficult since losses are large and infrequent. Moreover, they often require leverage to achieve decent returns in normal times, so they get killed in bad times.
Second, systematic trading requires forecasting. “A forecast is an estimate of how much a particular instrument’s price will change, given a particular trading rule variation.” (p. 102) “A forecast shouldn’t be binary—buy or sell—but should be scaled. … There are three reasons why scaled forecasts make sense. Firstly, if you were to examine the returns made by a trading rule given the size of its forecasts, you’d normally find that forecasts closer to zero aren’t as profitable as those further away. Secondly, binary systems cost more to trade, since to go from long to short you’d need to sell twice a full size position immediately. Finally, the rest of the framework assumes that the forecasts you get are not binary or lumpy in other ways. It’s better to see forecasts changing continuously rather than jumping around.” (p. 113)
To set forecasts, Carver recommends using volatility standardization. Forecasts are “proportional to expected risk adjusted returns. For example, suppose that the Bund has expected returns of 2% a year and an expected annualized standard deviation of 8%. Schatz futures have an expected return of 1% a year, but you only expect volatility of 2% a year. After adjusting for risk the expected return on Schatz … is twice as much as on Bunds…. That implies the forecast for Schatz should be twice the forecast for Bunds. … If you continuously adjust your estimate of expected volatility then you also cope with risk changing over time.” (pp. 114-15)
Carver spent ten years in the City of London—initially trading exotic derivative products for Barclays and then serving as a portfolio manager for the hedge fund AHL, where he created its fundamental global macro strategy and managed its multi-billion dollar fixed income portfolio before retiring from the industry in 2013. So he isn’t just some ordinary Joe with a computer and a bunch of back-testing software. He has clearly thought about what makes a good systematic trader and a good systematically-driven portfolio. We can be grateful that he decided to share his insights with us.