Managing a Trend Following Hedge Fund – A Conversation with Andreas Clenow

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trend followingAndreas Clenow is a trend following hedge fund manager who wrote the book, Following the Trend. The following is an edited transcript of the podcast interview that I conducted with him.

He covers a wide range of topics with respect to trend following specifically and trading in general. I learned quite a bit from this conversation, and was particularly impressed with his explanation for writing a book in the first place. 

When did you first realize that you were interested in trading?

It was probably back in the early ‘90s. I was in business school in Sweden, Gothenburg School of Economics, and we had this trading room over there.

This was of course in the ‘90s boom years and I was interested in stocks at the time.  I was hanging out more and more over there and trading a bit, doing fine for a while. Blissfully ignorant of how lucky I was to start out in a bull market.

I was utterly clueless, but it was a good start so that probably helped.  Of course, I had big losses later on, but the fact that I started off with getting lucky with some profits probably helped a lot.

What kind of strategies where you trading back then?

Strategies?

I was drawing some lines on a chart and thinking that I knew what I was doing. Of course, like most people starting out, I was just going long. I was just trading stocks and it was a bull market so the strategy kind of worked.

At what point did you realize that you needed to evolve into something a little more involved?  

I’m constantly realizing that.

The way I see it you never really finish evolving these kinds of things. There’s been so many times in my life where I realized just how little I actually know.  I think it’s part of learning to realize that you might have a lot more to learn.

Were there any actual instances that tipped you off that you needed to actually develop some sort of systematic approach?

Well, 1999 and 2000 were two big hints.

I particularly remember being long Nokia. Now, Nokia doesn’t sound very interesting these days, but for those who were around in the ‘90s, that was quite a stock to play around with back then.

I was buying and selling it, buying and selling it, and in retrospect, maybe I would have made more money just holding it the whole time. There was one time that I had some rather severe losses on it, and that got me thinking a little bit. That’s really where you learn.

I do things very differently now and it’s been evolving a lot, but back then things seemed much easier. I was very much in to all kinds of technical analysis books. I was trying anything; most of it, of course, is not terribly useful. It’s mostly distraction, but you name it, and I probably tried it.

I wanted to read the quote you have at the very beginning of your book’s website. It says, “When was the last time you read a trading book written by a real hedge fund manager?  Did that book give you any details on actual trading methods?”  That sums up everything that I love about your book. 

That was my attempt to provoke a little bit, just to see what happened.

You have to bear in mind here that when I wrote this I had absolutely zero media platform or exposure. I was still doing more or less what I’m doing now, but getting exposure for a book and getting it noticed is not that easy, and I had no idea how. This has been an attempt to see what happened.

Apparently, as it turns out, this particular article that you’re referring to got quite a bit of attention. Those are provocative statements that are there quite deliberately.

What I mean with this basically is that very large amount of trading books out there don’t really tell you much that is useful. They are mostly summaries of other trading books. Small variations. They’re nice to read and all. It’s nice distraction. I mean you can read through it for interests, but most of them I read, and I read quite a few, they don’t really add that much. I just wanted to see if I could do a very different thing.

I deliberately picked a very different approach for the book and I was quite prepared for the ways it would be slaughtered in the reviews. I kind of break most of the rules about how you’re supposed to write trading books there, and I did that quite deliberately as a test, but much to my surprise no one actually pointed that out so far.

What rules are you talking about? 

Well, for one thing, if you write a book like this about trading systems, you’re supposed to discuss a lot of different methods. Most books are a semi-academic style of listing all possible methods. Here are 10 different ways of calculating the average, and here are the 5 different ways of calculating the RSI, and these kinds of things, right?

I wanted to avoid all of these things. I wanted to avoid all indicators, all the things that just distract. I mean some is useful, some is not, but mainly they serve as distractions. I wanted to show one single thing.

I started the book by saying that this is essentially a whole book about a single trading strategy that’s been widely known for at least 20 years.

Second thing, my year-by-year hundred page chapter, I was kind of thinking people were going to say it’s a space filler. In my view, that’s the most valuable chapter in the book, but I didn’t think people would see it as that. I’m quite happy that most of the feedback I got was that they liked it.

I think it’s a very refreshing book. There are very few books that actually give the nuts and bolts of actual systems.  I think you did a really nice job with that.  

In my view, rules are overestimated. In the retail-trading world, the non-professional trading world, especially the ones that are geared more towards technical analysis, there is an obsession with trading rules and indicators. As if this will solve the problem.

You don’t actually see this on the professional side. You don’t see two professional traders debating moving averages, or RSI versus various oscillators. This is mainly a distraction in my view, distraction from the main points. This belief that trading rules in themselves are incredibly valuable, they are really not.

That’s interesting because you really didn’t spend as much time on that actual definition of the system, where you spent a whole chapter on the markets you should trade.    

One big mistake I see from the retail sector is that they focus on one trading system on one market. It’s possible, but that needs an enormous amount of skill and probably a lot of luck. This is not how most professionals work.

This obsession with building the super system for the Nasdaq for instance, that might end up with this system that’s great over the next 10 years, but in the next five years it’s going to lose so much that you’ll be out of it anyway.

The retail trader often has the view that they want some action, and they want every position to matter. Everything should have a clear impact. What we really do is take on a lot of positions where most of them really don’t do much at all.

Most of them lose, and they lose small. We enter a whole lot of positions that just end up being small losers. Any given position is not terribly exciting. Now and then something exciting comes along but most positions, they’re simply not exciting.

There’s a part of your book where you reference exactly how many positions to trade. I think it was less than half a percent the whole time you hold the position, whether it was up or down and then, obviously, no huge losses but every once in a blue moon you hit a big winner.   

Exactly, and this is the whole point of diversification. With this kind of system, you need to run them across many markets in many diverse asset classes. Sometimes it could be that equities as an asset class just keep losing for five years in a row. Some years, maybe the agricultural or the energy or the metals keep losing.

Even if you only trade equities and you think you’re diversified because you have 50 different stocks in your portfolio, you still only have stocks. That’s mostly beta anyway.  The key in my view is real property diversification across everything. You find where you have low correlations then you make sure that you’re exposed to a lot of different things.

I feel like so many authors try to make their systems sound more complicated than they actually are.  When you actually spell it out, it’s very simple stuff we’re talking about. 

It’s not just authors. It’s also a lot of asset managers. It’s in their interest of course. If you’re a manager of $10 billion and you’re running a trend following CTA fund, you can’t say that you don’t really need the entire budget. That you don’t really need the 50 PHDs.

We get the bulk of their return with something that is very simple. All of the staff, all the research, and all of the computer equipment are just really details. That’s for grinding out an extra 1–1½% per year. If the compound is 15-16%, the bulk of it is probably from very simple trend following models. But that doesn’t make such a good story.

You also do a nice job in your book of pointing out how using a simple breakout strategy can mirror the returns of most of the famous trend followers that are widely discussed.

There’s nothing wrong with these funds, that’s something I just want to be clear about. They’ve been generating larger returns, some of them for several decades, for investors. That’s excellent.

They’ve been outperforming equities by massive amounts. If you bought and held equities for the last 20-25 years, you would have compounded at 5%. You would have seen drawdown at 60%, and several in the 40% range.

What these managers have done is a massive value to their investors. What I’m trying to say is that it’s not as magical as you might think. The question, of course, is will the future be the same, and no one can answer that. But, we can look at what the past was, and it was not that complicated.

That’s a good point that we should probably address. The goal with this trend following system that you’re discussing in your book is that there’s no prediction whatsoever, right? 

In this business, we don’t predict. If the trend starts moving, we jump on to it. We know that we’re going to be wrong between 60-70% of the time. But that’s what we do. We would have a better win ratio if we just flip the coin but that’s not how things work in reality.

It makes perfect common sense to me, but there’s so many times that I run in to people and they want to talk about “the markets,” and they’re just blown away that I don’t have a prediction.  

Could you give us an overview of what’s a normal day like for you?  

It varies a lot. I run my models when I come in the morning. Everything to be done during the day is all on my screen when I come to the office.

I execute everything manually, which means I don’t send any direct orders to the exchanges. Some people do, some people don’t. It’s a matter of taste and how much you trust yourself I guess. I know very good managers who are on both sides of that camp, but I like to do it manually.

I have my rules for when things are going to be done depending on the market. That’s the biggest routine of course. There are all kinds of boring things. You need to update portfolios. You need to do your reporting. You need to write various reports. Of course, all the time it’s continuous research, evolving, finding and correcting your mistakes.

That’s very interesting to hear how you spend your time, and how you allocate your resources.

One thing to mention is that I think one common mistake is that people stare too much at real-time programs. It’s very easy. It’s very addictive to stare either at the tick chart or stare at the screen full of ticking instruments. It is even more addictive to stare at your P&L regardless of what portfolio system you have. Looking intraday at how your portfolio value goes up and down doesn’t help you. It really doesn’t help you. You’re better off closing it down.

Do you trade on a pretty long-term basis with most of your systems?

Yes. I get daily signals. I don’t trade on intraday models. I trade on daily models only. My signals come in once a day, and depending on the market, there are different time frames where I execute them.

There are some models that actually have predefined stops and targets in the markets.  Those are, of course, handled automatically, but for most positions and most models the intraday action doesn’t really affect my positioning.

I confessed to looking at the market anyway, but I probably shouldn’t.

We have exchanged a couple of long emails about different software packages that you recommend.  What’s your favorite right now?

I use a few different ones, but one of my absolute favorites is the RightEdge package.  RightEdge is quite a little known software. I think they made a great piece of software that they haven’t really marketed much.

It’s based on CLR, which means you can program in C#. You can actually program in other CLR dialects as well, but if you really want to do BB.net or something like this, then it works fine for that as well. I build almost everything in C#. I think it’s a good language to standardize on if you’re on Windows platform.

The nice part of the software, which sets it apart massively from a lot of other retail-level applications, is that it’s extremely customizable. I make a lot of additional functionality. I modify a lot of the existing functionality. I also like that I can do proper currency handling in portfolio modes. You can do proper modeling with the cross currency asset universe.

It does the aligning of the time series correctly which is unusual, which means it’s event driven and handles the time series day-by-day as they come in and not instrument-by-instrument like most of the other applications do.

It’s a little bit complicated software. You need to be a little bit familiar with programming in general, and be comfortable in the actual programming environment, but it’s not that difficult. You can pick up the book and learn basic programming.

You actually have a book you recommend, right? Head First C#.

Yeah, that’s a good one. I’m sure there are many good ones, but this one I found quite good when I was getting in to C# a few years back.

If anyone wanted to hear more information on anything you’re talking about, Tradersplace.net will be a good spot to look, right?

Absolutely. Thanks for the plug. Tradersplace.net is an attempt that seemed to turn out quite successful. We are trying to create a friendlier and more professional social site for traders.

We are requiring real names and real profiles and basically behavior like if we met in a real professional context in person. We started by getting a lot of friends in the market in, so we had a base membership of hedge fund managers, investment bankers, asset managers, prop traders and they seemed to work quite well. We continue to hold a very high level of conversation and we’re aiming for quality over quantity on the site.

We are maintaining a policy that it’s supposed to be completely free site, so it is completely free for members and it will continue to be completely free.

So you believe in openly communicating different discussions on trading styles, software, and approaches?

Obviously, all of us have a few details here and there that we probably keep a little bit closer, but the overall strategies, ideas, and concepts; we discuss them all the time. We go out for beer in the business, so why not here. It’s not really secret stuff.

The most common question I got about the book was “If you have such a super strategy, why would you give it away for free?” The initial answer is that it’s not a super strategy. It’s a very, very simple strategy that’s been known for a long, long time. I just wanted to explain some features of it and explain how we use it in the business.

But why do I talk about it? Well, look at it this way; you have something like $250-300 billion, more or less a quarter of a trillion in the CTA business. There’s quite a lot of money already in this game and everyone who is active in this game, they already know what I’m writing about in the book.

If they know already, with a quarter of a trillion dollars, what difference does it make if a few more people come in? It’s not like people are going to read the book and they’re going to scrape a couple of million together, go trade it, and the opportunity will disappear. The whole point is it’s a very scalable concept.

It makes perfect sense why you wouldn’t be afraid to share, but that brings up a question of why would you take time away from trading to actually invest your personal time writing the book?

They say that you write a book to make a lot of money, right? People who say that don’t understand the economics of publishing a book with a major publisher.

If you really want to make money publishing a book, first get yourself published. Then you should promise to make millions in no time, whether the market goes up or down, and make some insane statements. Then, you self-publish so you get to keep most of the revenue for yourself. You sell until people realize that’s not a realistic return. That’s the way to make money from books.

A book like this, especially with the price point that I picked and the big publisher, I make nothing of this. It’s peanuts.

Direct marketing a book is ridiculous in terms of time spent, but one difficult thing people might not realize is that you can’t market hedge funds in any way that you please. It’s just not legal in most places, at least not in compliance with various regulations. You can’t put out advertisement to come and invest in a hedge fund, but you can write a book, and that’s pretty good for marketing.

If you write a book with the purpose of gaining not money, but for the credibility, then that’s a pretty good marketing material for selling funds. It’s more about the connections and the business opportunities that came along because of the book, because of the exposure from the book.

That makes perfect sense. 

And of course, I just want to be nice and share.

What I like to get into for the last third of this interview would be advice and recommendations for someone like me. I really want to invest successfully. I want to be a trader. What do you believe is the key thing that I need to do in order to get there?

If you want to increase your rate of success, you need to increase your rate of failure. You need to try it, and you need to fail a few times. Regardless of how much you read about what not to do and how to avoid the problems, until you actually experience the problems yourself and feel some pain from it, it’s hard to really understand it and make the changes.

You probably have some losses in front of you, sorry to say, but we all have some losses.  You also need to consider what kind of trader you want to be and what you want to do for a living, so to speak.

If there were one thing that you could say is the most critical ingredient to becoming a successful trader, what would you say that is?

I think the first thing you need to do is look at the word trader, and see what it means.

I was asking some questions about that recently and I got a lot of heated debate from it.  There was some Internet forum somewhere, and someone asked why all the traders and the banks don’t just quit and trade their own money? I tried to enlighten them a little bit about what trader means in the business, because there is a big misconception of how people outside the business see the word trader.

Almost everyone with the title of trader in the world, whether they’re banks or as management companies, most of them are just salesman.  They are various flavors of brokers.  They’re called traders or sales traders, but most of them are salesmen who live off of commission.  They don’t really care, up or down. They get a print in front of them, buy a 100,000 IBM, and they can either do it right away or maybe they get some discretion. Maybe they get to spend the next 10 minutes doing it, or even an hour, but in the end, that’s what they do. Executing other people’s trades, getting a commission.

Then of course we have all of the prop traders, which many banks now are stopping for good reasons. Prop trading with banks, with some exception of course, a very large part of it has always been insider trading. They have access to flow information. They have access to a client orders. They’re not supposed to, but we all know they do anyway. They are front-running on other people’s trades and making money off of it.

A lot of banks are stopping because compliance is getting tougher and regulators are getting a little bit closer to getting serious about enforcing the rules. Not completely serious, but a little bit more serious anyway. I wish it would get much more serious.

The point is that most people out there who are called traders are not actually doing what the public think. There are very few people sitting around just trading an account all day and just picking whatever they like to trade and doing it.

Most people doing it by themselves at home, they might work the way they think that professionals do, but most of these people, the day trader segment, almost all blow up sooner or later. A few survive and most lose their money. If you want to be a trader, first define what type of trader you want to be. Learn about what the business does and where you might fit in.

I’ve read through all of the market wizards books now and the thing that sticks out in interview after interview is that they all have completely different approaches and totally different styles, but it appears that you can be successful with any of those styles provided you have a system, stick to it, follow the rules of that system, and monitor your risk.

If you pick, on random, 10 different extremely successful traders in the world, they will say things that severely contradict each other. I once read two quotes next to each other where Jim Rogers was saying “I’ve never met a rich technician,” and Buzzy Schwartz was saying that he things the most arrogant thing in the world to say is, “I’ve never met a rich technician.” He actually lost money when he was a fundamental trader and he switched his technique to technical and then he started winning.

That’s really good.

Take two very strong personalities like that and put them in a room together and they will fight.

What do you think is the reasonable amount of capital to start with?

It depends very much on the strategy, but I will say it’s better to start trading small. Expect that you will lose more than you budget for. If you calculate how much you think you can lose at the most, you’re probably going to lose more. So you better do it with smaller money until you get more confident.

It’s much nicer to say afterwards that if I traded with double the capital, I would have made so much more money.  That’s one thing, but it’s not as fun thinking that if I wouldn’t have traded with my full capital, well, I might not have lost half of my fortune.

It’s better to lose small in the beginning, and really that’s not a comment at all on your trading abilities, which you frankly don’t know anything about, but we lose at some point.  That’s just a likely thing to happen.

If someone were looking to develop as a trader, what would you recommend is the first book they should read?

There are a lot of books out there, but the problem is that most books contain some useful stuff and some stuff that, in retrospect, I find less useful.

I think a good idea is to read a lot of books, but don’t necessarily trust everything you read. Read a lot of books and try to judge for yourself what might actually work. In the end, it’s your own research that matters.

I always say, read the books with the purpose of learning for doing your own research, and then you verify the ideas. You test it. You should definitely not read a book and then just start using the techniques from it, regardless of what book it is. That’s a very good way to lose your money.

Are there any non-trading books you would recommend that have helped you along the way?

I’ve always been a fan of Sun-Tzu, of course. The Art of War is an excellent book.

I mean it’s a cliché to say that, but it’s still an excellent book. It has a few chapters that are really good. It’s been a decade or two since I read it last, but it’s a very strong one.  Especially the chapters about how the true skill is to put yourself in a position secure against defeat, waiting for the opportunity for the enemy to show his weakness.

Think about trading. Don’t lose your money until you see real opportunity. Don’t risk your money until you see an opening. The trick is not losing. He made a lot of points that it’s not just about winning; it’s about not losing. If you can avoid losing, you will win. There is a lot of that in trading.

The only other thing that I wanted to ask you was about the way you talk in your book about how you allocate your capital based on the volatility of the market. 

One common error when people trade is that they take a fixed position size in terms of number of shares or contracts. You might have a rule saying always buy 5% of my portfolio at any given position. If you have identical instruments, maybe that makes sense, but even if you’re just trading stocks for instance, stocks will have different volatility and different risks in them. Why would you allocate equal risk to all of them without looking to the risk patterns, the volatility?

If you start trading futures across everything, then you really have a problem with those kinds of approaches. Look at something extreme like Palladium that can move 3-4% in a day, or like silver, which is actually down 4% as we speak today. At the other end of the spectrum you have something like the three-month Euro dollar rate, and if you take equal exposure on both, well, then you only really have exposure on the volatile instrument.

Something like the Euro dollar might move 0.1% in a day, that’s huge. Why would you allocate equal amounts? You need some sort of way to take deliberate risk. This is really basic stuff. Anyone in a professional environment, especially one in a hedge fund environment, would work in these kinds of things.

It’s interesting that you say how basic that is, because it’s not discussed on TV very much? 

I wouldn’t know. I don’t watch TV.

Well, that sums it all up right there. 

I can’t really remember when I watched normal TV last. Well, I do watch the ABC children’s channel, but that’s for my son. Otherwise, I don’t really watch TV.

It always puzzles me how people take an exact percentage, or even worse an exact number of shares in a position size. It doesn’t make any sense at all. It’s just completely random.

The same thing applies to stop losses as well, right?

Yeah, exactly. You have to decide a strategy to stop losses. Just putting an arbitrary number in there, or drawing a line, or even worse the Fibonacci line doesn’t make any sense at all.

I always measure stop loss in damage to the portfolio as a whole. Not damage to the position, but percent of the position, or anything like that, but rather how much will it cost in basis points of the whole portfolio to hit the stop. If you look at correlation analysis, you see that, at times, five positions might actually be more or less one because they, at the moment, have such a high correlation, but then you measure potential pain per risk concentration area.

Is there anything you want to promote or discuss that we haven’t already covered?

No, not really, but I do hope to meet people on the Trader’s Place. Nothing in particular, but feel free to get back to me if you have any more questions.