Even if you are a minority of one, the truth is the truth.

—Gandhi

What we’ve got here is failure to communicate. Some men you just can’t reach, so you get what we had here last week, which is the way he wants it.

—Cool Hand Luke

It is a capital mistake to theorize before one has data.

Sir Arthur Conan Doyle¹

Anyone can tell you they have a successful method or system, but the only objective measurement is raw data. If a claim is to be made, it must be supported. The numbers in this volume, across numerous third-party reporting services and inside disclosures on file with American and international regulatory authorities, don’t lie. You could be the skeptic and say: “Hold on, the numbers could be faked!” That doesn’t fly with decades of data across unrelated traders located in dozens of countries. This is not about one isolated Bernie Madoff track record open to hanky-panky. Thus, in reviewing legendary trend following performance histories and assorted research studies I alone might own (my insider investigation methods are a whole other book), I zeroed in on six key data concepts:

1. Absolute returns
2. Volatility
3. Drawdowns
4. Correlation
5. Zero sum
6. Berkshire Hathaway

Absolute Returns

An absolute return trading strategy means you are trying to make the most money possible. Author Alexander Ineichen defines it succinctly: An absolute return manager is essentially an asset manager without a benchmark—Bench marking can be viewed as a method of restricting investment managers so as to limit the potential for surprises, either positive or negative.²

Trend following in its purest form doesn’t track or attempt to mimic any particular index—ever. If trend following had a coat of arms, Absolute Returns would be emblazoned upon it. It thrives and profits from the surprises benchmarking artificially stops.

This ain’t clipping coupons. No risk, no return. No balls, no babies.

Anonymous

However, not all trend followers are shooting for absolute returns or the most amount of money possible. Not all play the game full tilt. Jerry Parker, for example, purposefully aims for lower returns to cater to a 
different client base (those who want less risk and less return).

But John W. Henry long made the case “[that] the overall objective is to provide absolute returns. Relative return managers, such as most traditional equity or fixed-income managers, are measured on how they perform relative to some pre-determined benchmark. We have no such investment benchmark, so its aim is to achieve returns in all market conditions, and is thus considered an absolute return manager.”³

Shoot for a benchmark in returns and you run with the crowd. Benchmarks such as the S&P might make you feel safe, even when that feeling is clearly artificial. Trend following, on the other hand, understands that trading for absolute returns and not from blind adherence to benchmarks is the best way to handle uncertainty.

The concept of indexing and benchmarking is very useful in the EMT world of traditional long-only passive investing, but it has almost zero usefulness for an absolute return process. Again, it gets back to what it takes to achieve an absolute return—you need an enormous amount of latitude and freedom in executing a trading strategy to ensure capital preservation and achieve a positive return. At its core, the concept of absolute return investing is antithetical to benchmarking, which encourages traditional managers to have similarly structured portfolios and look at their performance on a relative basis.⁴

If you base your trading strategy on benchmark comparisons, it doesn’t matter whether you are a talented trader or not because all decisions are about the averages. Why is any trading skill relevant? It’s not. That’s why 80 percent of mutual funds don’t beat averages.

Volatility versus Risk

There are organizations that rank and track monthly performance numbers. One organization gives a star ranking (like Morningstar):

The quantitative rating system employed ranks and rates the performance of all commodity trading advisors (CTA) . . . Ratings are given in four categories: a) equity, b) performance, c) risk exposure, and d) risk-adjusted returns. In each category, the highest possible rating is five stars and the lowest possible rating is one star. The actual statistics on which the percentiles are based as follows:

1. Performance: Rate of Return
2. Risk: Standard Deviation
3. Risk Adjusted: Sharpe Ratio
4. Equity: Assets⁵

The class of those who have the ability to think their own thoughts is separated by an unbridgeable gulf from the class of those who cannot.

Ludwig von Mises⁶

Dunn Capital once received one star for risk, the implication being that an investment with Dunn is more risky. However, these rankings don’t give accurate information on Dunn’s true risk. This rating group uses standard deviation as their measure of risk. But this is a measure of volatility and not necessarily risk. High volatility alone does not necessarily mean higher risk.

Volatility is the tendency for prices to change unexpectedly.⁷

It’s doubtful Dunn, with a track record exceeding 40 years, is overly concerned about being inaccurately penalized, but using standard deviation as a risk measurement does distort a true understanding.

This same firm’s ranking of then-active trader Victor Niederhoffer demonstrates the star system’s weakness. At the time of Niederhoffer’s public-trading demise in 1997, he was rated as four stars for risk. Based on Niederhoffer’s past performance, the rankings were saying he was a much safer bet than Dunn. Obviously the star system failed for people who believed Niederhoffer was less risky. Standard deviation as a risk measure does trend following an injustice. One of my goals is to dispel the simplistic notion trend following is risky or that all trend following strategies have high standard deviations, which means they are bad.

A good illustration begins with this 10-year chart of various trend following performances (see Table 3.1).

Just saying a trader is volatile and thus bad makes little sense if you examine absolute return performance (Table 3.1). Raw absolute returns should count for something far more than fear or career risk—they equal the only way to massive wealth.

Nonetheless, volatility (what standard deviation measures) is still a pejorative for most market participants. Volatility scares them, even when a young student can quickly analyze any historical data series to see volatility is normal and expected. But most investors try to run away from the hint of volatility—even when running is not possible. Some markets and traders are more volatile than others, but degrees of volatility are basic facts of life. To trend following, volatility is the precursor to profit. If you have no volatility, you have no opportunity for profit.

The press is always confused as seen in BusinessWeek: “Trend followers are trying to make sense out of their dismal recent returns. ‘When you look past the superficial question of how we did, you look under the hood and see immense change in the global markets,’ says John W. Henry’s president. ‘Volatility is just a harbinger of new trends to come.’ Maybe. But futures traders are supposed to make money by exploiting volatility. Performance isn’t a ‘superficial question’ if you were among the thousands of commodity-fund customers who lost money when the currency markets went bonkers.”⁸

Focusing on one period in isolation while ignoring a complete performance history misrepresents the full picture. I wondered if this reporter had written a follow-up article correcting his observations about trend following, because the following year trend trader Dunn produced a 60.25 percent return, and trend trader Parker produced a 61.82 percent return. It didn’t surprise me BusinessWeek archives revealed no 
correction.

Some suggested a few years ago that trend following had been marginalized. The answer is we haven’t been marginalized—[trend following] has played a key role in helping protect a lot of people’s wealth this year.

Mark Rzepczynski⁹

Drawdowns

With trend following, however, comes the inevitable drawdown. A drawdown is any losing period during an investment record. It is defined as the percent retrenchment from an equity peak to an equity valley. A drawdown is in effect from the time an equity retrenchment begins until a new equity high is reached—that is, in terms of time, a drawdown encompasses both the period from equity peak to equity valley (length) and the time from the equity valley to a new equity high (recovery).¹⁶

If you were to put all the trend following models side by side, you would probably find that most made profits and incurred losses in the same markets. They were all looking at the same charts and obtaining the same perception of opportunity.

Marc Goodman 
Kenmar Asset Allocation¹⁷

For example, if you start from $100,000 and drop to $50,000, you are in a 50 percent drawdown. You could also say you have lost 50 percent. The drawdown is thus a reduction in your account equity. Yes, that happens for buy and holders, too, but the big difference is that trend following has an exit strategy built in. Not surprisingly, many investors and regulators have made drawdown for trend following a dirty word, while leaving mutual funds free to disguise their true drawdowns.

Dunn Capital’s retort:

Investors should be aware of the volatility inherent to [our] trading programs. Because the same portfolio risk profile is intrinsic to all . . . programs, investors in any . . . program can be expected to experience volatility similar to our composite record. During 40+ years of trading, the composite record, on a month-to-month basis, has experienced eight serious losses exceeding 25 percent. The eighth such loss equaled 40 percent, beginning in September 1999 and extending through September 2000. This loss was recovered in the three-month period ending in December 2000. The most serious loss in our entire history occurred over a four-month period, which ended in February 1976 and equaled 52 percent [Dunn did have a 57 percent drawdown in 2007, which it recovered from and made new highs as recently as July 2016]. 
Clients should be prepared to endure similar or worse periods in the future. The inability (or unwillingness) to do so will probably result in serious loss, without the opportunity for subsequent recovery.¹⁸

Dunn Capital Management’s documents include a summary of serious past losses. The summary explains that the firm has suffered through seven difficult periods of losses of 25 percent or more. Every potential investor receives a copy: “If the investor is not willing to live through this, they are not the right investor for the portfolio.”¹⁹

Unless you understand Dunn’s philosophy, you might refuse to invest, even though that 40-year plus track record is the envy of Monday morning quarterbacks. Examine their drawdown history in Figure 3.1. 
I used this same chart in Chapter 2 to illustrate performance, but it serves another purpose.

Imagine the valleys between the peaks are filled with water. First, place a piece of paper over the chart and then slowly move the paper to the right and uncover the chart. Imagine you have made a large investment in the fund. How do you feel as you move the page? How long can you remain underwater? How deep can you dive? Do you pull out the calculator and figure out what you could have earned at the bank? Do you figure out you lost enough to buy a vacation, car, house, or perhaps solve the hunger crisis of a small nation?

Obviously you don’t want to overhaul a program in response to one year just because something didn’t work. That’s when you’re almost guaranteed that it would have worked the next year had you kept it in there.

Eclipse Capital

The 25 or 50 biggest trend followers are essentially going to make money in the same places. What differentiates them from one another are portfolio and risk management.²⁰

To the eyes-wide-open player this drawdown chart (Figure 3.1) is tolerable because of the absolute returns over the long-term, but that doesn’t make it easy to accept. An accurate discussion of drawdown inevitably leads to the recovery conversation, which means bringing capital back to the point where a drawdown began. Historically, trend following has quickly made money back during recovery from drawdowns.

However, you can’t neglect the math associated with losing money and making it back. What if you start with $100 and it drops to $50? You are now in a 50 percent drawdown. How much do you have to make to get back to breakeven (Table 3.2)? You need 100 percent to get back. That’s right—when you go down 50 percent you need to make back 
100 percent to get back to breakeven. Notice as drawdown increases 
(see Table 3.2), the percent gain necessary to recover to the breakeven point increases at a much faster rate. Trend following strategy lives with this chart daily. It handles this math:

Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.

Warren Buffett

Note: Since 1980 Berkshire Hathaway has had drawdowns of −51%, −49%, −37%, and −37%. In addition, Charles Munger Partnership dropped −31.9% in 1973 and −31.5% in 1974.

David Harding goes after drawdown haters:

A key measure of track record quality and strategy “riskiness” in the managed futures industry is drawdown, which measures the decline in net asset value from the historic high point. Under the Commodity Futures Trading Commission’s mandatory disclosure regime, managed futures advisors are obliged to disclose as part of their capsule performance record their “worst peak-to-valley drawdown.” As a description of an aspect of historical performance, drawdown has one key positive attribute: It refers to a physical reality, and as such, it is less abstract than concepts such as volatility. It represents the amount by which you are less well off than you were; or, put differently, it measures the magnitude of the loss an investor could have incurred by investing with the manager in the past. Managers are obliged to wear their worst historical drawdown like a scarlet letter for the rest of their lives.²¹

We have not made any changes because of a drawdown. While we have made minor changes since the program started trading in 1974, over the course of the years the basic concepts have never changed. The majority of the trading parameters and the buy and sell signals largely have remained the same.

Bill Dunn²²

If the complete story of an absolute return trading strategy is understood, drawdown fear is mitigated.

You have to keep trading the way you were before the drawdown and also be patient. There’s always part of a trader’s psyche that wants to make losses back tomorrow. But traders need to remember you lose it really fast, but you make it up slowly. You may think you can make it up fast, but it doesn’t work that way.

David Druz²³

However, you can’t eliminate catastrophic risk, much less drawdowns, from trading. A great example of getting scared at the wrong time during a drawdown can be seen in this trader’s story: “I [once] opened an account for a client. At the time we were down 10–12 percent, and I explained the drawdown and our expectation for losses. Suddenly, when his account went down 20 percent, he became very anxious. He eventually closed his account. He made the business decision to stop trading because of the pain he was feeling from the drawdown. I continued to track his account hypothetically so I could see what would happen if he would have continued trading.”

He added: “As it turns out, he closed his account within 2 days of the drawdown low. Had he stayed invested he would be up +121.1 percent from his closing value, and +71.6 percent from his starting value (through October 2008). I am reminded of a statement quoted many times from Peter Lynch, the manager of the Fidelity Magellan Fund. In light of Lynch’s trading success, he revealed over 50 percent of the investors in his fund lost money. He explained the reason—most investors pulled out at the wrong time. They traded with their gut and treated drawdowns as a cancer, rather than the natural ebb and flow of trading.”

Interestingly, there is another perspective on drawdowns that few consider. When you look at trend following performance data—for example, Dunn’s track record—you can’t help but notice certain times look better than others to invest.

Some clients do look at that performance chart and buy when the fund is experiencing a drawdown. Because if Dunn is down 30 percent and you know from analysis of past performance data that recovery from drawdowns can be quick, then buying while on sale is an option. This is commonly referred to as equity curve trading. Trend trader Tom Basso:

I haven’t met a trader yet that wouldn’t say privately that he would tend to buy his program on a drawdown, particularly systematic traders. But, investors seem to not add money when, to traders, it seems to be most logical to do so . . . Why don’t investors invest on drawdowns? I believe the answer to that question lies in the investing psychology of buying a drawdown. The human mind can easily extrapolate three months of negative returns into “how long at this rate will it take to lose 50 percent or everything?” Rather than seeing the bargain and the positive return to risk, they see only the negative and forecast more of the same into the future.²⁴

Correlation coefficient: A statistical measure of the interdependence of two or more random variables. Fundamentally, the value indicates how much of a change in one variable is explained by a change in another.²⁵

Campbell & Company, a trend following managed futures firm with almost [billions] in assets under management, has returned 17.65 percent since its inception in 1972, proving that performance can be sustainable over the long-term.²⁶

If an investor had invested 10 percent of his or her portfolio in the Millburn Diversified Portfolio from February 1977 through August 2003 he or she would have increased the return on his or her traditional portfolio by 73 basis points (a 6.2 percent increase) and decreased risk (as measured by standard deviation) by 0.26 of a percent (an 8.2 percent decrease).

Millburn Corporation

Not only do some trend followers tell clients to buy into their funds during a drawdown, they also buy into their own funds during the drawdowns. I know employees at top trend following funds who are too happy when they are in a drawdown because they can buy their fund cheap.

Other trading styles have drawdowns, too. For example, some of the best names on Wall Street (non-trend followers) had tough sledding in 2008—but they don’t have the drawdown stigma associated with trend following:

• Warren Buffett (Berkshire Hathaway): –43 percent
• Ken Heebner (CMG Focus Fund): –56 percent
• Harry Lange (Fidelity Magellan): –59 percent
• Bill Miller (Legg Mason Value Trust): –50 percent
• Ken Griffin (Citadel): –44 percent
• Carl Icahn (Icahn Enterprises): –81 percent
• T. Boone Pickens: Down $2 billion since July 2008
• Kirk Kerkorian: Down $693 million on Ford shares alone

It is paramount to determine how quickly you can recover from a drawdown and get back to making new money again—regardless of trading strategy.

Correlation

Correlation comparisons help to show trend following as a legitimate style and demonstrate the similarity in strategy used among trend followers. Correlation is not only important in assembling the portfolio you trade, but it is also a critical tool for analyzing and comparing performance histories of trend followers.

In a research paper titled Learning to Love Non-Correlation, correlation is defined as a statistical term giving the strength of linear relationship between two random variables. It is the historical tendency of one thing to move in tandem with another. The correlation coefficient is a number from –1 to +1, with –1 being the perfectly opposite behavior of two investments (e.g., up 5 percent every time the other is down 5 percent). The +1 reflects identical investment results (up or down the same amount each period). The further away from +1 one gets (and thus closer to –1), the better a diversifier one investment is for the other. But to keep things simple, another description of correlation is instructive: the tendency for one investment to zig while another zags.²⁷

Let’s look an an example. I took the monthly performance numbers of trend followers and computed their correlation coefficients. Comparing correlations gave the evidence that trend followers trade typically the same markets in the same way at the same time.

When I was young I thought that money was the most important thing in life; now that I am old I know that it is.

Oscar Wilde

Look at the correlation chart (see Table 3.3(a)) and ask yourself: “Why do two trend followers who don’t work in the same office, who are on opposite sides of the continent, have the same three losing months in a row with similar percentage losses?” Then ask: “Why do they have the same winning month, then the same two losing months, and then the same three winning months in a row?” The relationship is there because they can respond only to what the market offers. The market offers trends to everyone equally. They’re all looking at the same market, aiming for the same target of opportunity.

Table 3.3(b): also shows trend followers using similar techniques.

Interestingly, correlation can be a touchy subject. The Turtles were all grateful to Richard Dennis for his mentoring, but some were ambivalent over time, obviously indebted to Dennis, but struggling to achieve their own identity: “One Turtle says his system is 95 percent Dennis’ system and the rest his ‘own flair . . . I’m a long way from someone who follows the system mechanically . . . but by far, the structure of what I do is based on Richard’s systems, and certainly, philosophically, everything I do in terms of trading is based on what I learned from Richard.’”²⁸

Even when correlation data shows similar patterns among Dennis’s Turtle students, the desire to differentiate is stronger than their need to honestly address obvious similarities in their return streams: “There no longer is a turtle trading style in my mind. We’ve all evolved and developed systems that are very different from those we were taught, and that independent evolution suggests that the dissimilarities to trading between turtles are always increasing.”²⁹

A Turtle correlation chart paints another picture. The relationship is there to judge. The data (Table 3.4) is the ultimate arbiter:

There is more to the story than correlation, however. Although correlations show Turtles trade in a similar way, their returns differ due to their individual leverage and portfolio choices. Some traders use more leverage, others less. TurtleTrader Jerry Parker explains, “The bigger the trade, the greater the returns and the greater the drawdowns. It’s a double-edged sword.”³⁰

If they can get you asking the wrong questions, they don’t have to worry about answers.

Thomas Pynchon

Zero Sum

The zero-sum nature of many markets is arguably the most important concept in markets. Larry Harris, chair in finance at the Marshall School of Business at University of Southern California: “Trading is a zero-sum game when gains and losses are measured relative to the market average. In a zero-sum game, someone can win only if somebody else loses.”³¹

The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price Efficiency and Market Liquidity, see http://turtletrader.com/zerosum
.pdf.

Harris told me he was amazed at how many people came from my websites to download his white paper on zero-sum trading—the topic left out of most strategy discussions. It’s one winner and one loser.

Harris examines the factors that determine who wins and who loses in market transactions. He does this by categorizing traders by type and then evaluating speculative trading styles to determine whether 
the styles lead to profits or losses: “Winning traders can only profit to the extent that other traders are willing to lose. Traders are willing to lose when they obtain external benefits from trading. The most important external benefits are expected returns from holding risky securities that represent deferred consumption. Hedging and gambling provide other external benefits. Markets would not exist without utilitarian traders. Their trading losses fund the winning traders who make prices efficient and provide liquidity.”³²

There are those who absolutely do not accept that there must be a loser for them to be a winner. They cannot live with the fact everyone can’t be a winner. Although they want to win, many do not want to live with the guilt by their winning, someone else has to lose. This is a poorly thought out yet all too common view of the losing trader’s mindset.

Harris is clear on what separates winners from losers:

On any given transaction, the chances of winning or losing may be near even. In the long run, however, winners profit from trading because they have some persistent advantages that allow them to win slightly more often or occasionally much bigger than losers win. . . .

To trade profitably in the long run, you must know your edge, you must know when it exists, and you must focus your trading to exploit it when you can. If you have no edge, you should not trade for profit. If you know you have no edge, but you must trade for other reasons, you should organize your trading to minimize your losses to those who do have an edge. Recognizing your edge is a prerequisite to predicting whether trading will be profitable.³³

Nobel Prize winner and cofounder of famed trend following incubator Commodities Corporation Paul Samuelson adds, “For every trader betting on higher prices, another is betting on lower prices. These trades are matched. In the stock market, all investors (buyers and sellers) can profit in a rising market, and all can lose in a falling market. In futures markets, one trader’s gain is another’s loss.”

Dennis Gartman adds to the perspective: “In the world of futures speculation, for every long there is an equal and opposite short. That is, unlike the world of equity trading where there needn’t be equal numbers of longs versus shorts, in the world of futures dealing there is. Money is neither made, nor lost, in futures; it is simply moved from one pocket to the next as margins are swapped at the close of trading each day. Thus, every time there is a buyer betting that prices shall rise in the future, there is an equal seller taking the very opposite bet, betting that prices will fall.”

I was talking to myself, saying like, ‘Just relax, man. The comeback is so great already. Let it fly off your racquet and just see what happens.’ I think that’s the mindset I got to have, as well, in the finals. Sort of a nothing-to-lose mentality. It’s been nice these last six matches to have that mentality. It worked very well so I’ll keep that up.

Roger Federer on pep talk he gave himself in the fifth set of his 18th grand slam win

These observations will save your skin if you’re willing to accept the truth, but as you can see throughout this volume, many are either ignorant to zero-sum thinking, choose to ignore it, or refuse to believe it condemned to exist inside biases.

George Soros

The trading success of famed speculator George Soros is well known. In 1992 he was labeled the man who broke the British pound for placing a $10 billion bet against the pound that netted him at least $1 billion in profit.³⁴

Yet even successful pros sometimes miss a key point. Years back, Soros appeared on Nightline, an old-school ABC news program. This exchange between Soros and then-host Ted Koppel goes to the zero-sum understanding—or lack thereof:

Ted Koppel:

As you describe it, the market is, of course, a game in which there are real consequences. When you bet and you win, that’s good for you, it’s bad for those against whom you have bet. There are always losers in this kind of a game?

George Soros:

No. See, it’s not a zero-sum game. It’s very important to realize.

Ted Koppel:

Well, it’s not zero-sum in terms of investors. But, for example, when you bet against the British pound that was not good for the British economy?

George Soros:

Well, it happened to be quite good for the British economy. It was not, let’s say, good for the British treasury because they were on the other side of the trade . . . It’s not—your gain is not necessarily somebody else’s loss.

Ted Koppel:

Because—put it in easily understandable terms—I mean if you could have profited by destroying Malaysia’s currency, would you have shrunk from that?

George Soros:

Not necessarily because that would have been an unintended consequence of my action. And it’s not my job as a participant to calculate the consequences. This is what a market is. That’s the nature of a market. So I’m a participant in the market.

Soros opens a can of worms with his description of zero-sum. From a blog post that incorrectly analyzes Soros’ interview: “Cosmetically, Koppel wipes the floor with Soros. He’s able to portray Soros as a person who destroys lives and economies without a second thought, as well as simplify, beyond belief, something that should not be 
simplified.”³⁵

What objectivity and the study of philosophy requires is not an “open mind,” but an active mind—a mind able and eagerly willing to examine ideas, but to examine them critically.

Ayn Rand³⁶

This is nonsense. The fact Soros is a player in the market does not establish him as a destroyer of lives. You might disagree with Soros’s political ideology, but you can’t question his morality for participation in markets. You have a 401(k) plan designed to generate profits from the market—like Soros. Others, such as Lawrence Parks, a union activist, correctly state that Soros is in a zero-sum game, but Parks then goes jealous by declaring zero-sum unfair and harsh for the working-man:

Since currency and derivative trading are zero-sum games, every dollar “won” requires that a dollar was “lost.” Haven’t they realized what a losing proposition this has been? What’s more, why do they keep playing at a losing game? The answer is that the losers are all of us. And, while neither rich nor stupid, we’ve been given no choice but to continue to lose. And every time one of these fiat currencies cannot be “defended,” the workers, seniors, and business owners of that country—folks like us—suffer big time. Indeed, as their currencies are devalued, workers’ savings and future payments, such as their pensions, denominated in those currencies lose purchasing power. Interest rates increase. Through no fault of their own, working people lose their jobs in addition to their savings. There have been press reports that, after a lifetime of working and saving, people in Indonesia are eating bark off the trees and boiling grass soup. While not a secret, it is astonishing to learn how sanguine the beneficiaries have become of their advantage over the rest of us. For example, famed financier George Soros in his recent The Crisis of Global Capitalism plainly divulges: “The Bank of England was on the other side of my transactions and I was taking money out of the pockets of British taxpayers.” To me, the results of this wealth transfer are inescapable.³⁷

Parks says his only choice is to lose. He loses, his union loses—it’s a pity party. It seems everyone loses in the zero-sum game (even though Parks’ fund will of course have their assets invested in the very funds he criticizes). Look, there are winners and losers and he knows that. Yes, the zero-sum speculation game is indeed a wealth transfer. The winners profit from the losers. Life is not fair. If you don’t like being a loser in the zero-sum game, then it is time to consider how the winners play the game.

Trying to understand Soros’s reasons for denying zero-sum would be speculation on my part. Soros is not always the zero-sum winner, either. He was on the losing side of the zero-sum game during the Long-Term Capital Management fiasco in 1998, in which he lost $2 billion. He also had severe trouble in the 2000 technology meltdown: “With bets that went sour on technology stocks and on Europe’s new currency, the five funds run by Soros Fund Management have suffered a 20 percent decline this year and, at $14.4 billion, are down roughly a third from a peak of $22 billion in August 1998.”³⁸

These wins and losses took a toll on Soros: “Maybe I don’t understand the market. Maybe the music has stopped but people are still dancing. I am anxious to reduce my market exposure and be more conservative. We will accept lower returns because we will cut the risk profile.”³⁹

Berkshire Hathaway

Amidst the recent celebration of Berkshire Hathaway’s 50 years of investment returns, trend following trader Bernard Drury and his firm Drury Capital wondered if a portfolio holding Berkshire (BRKA), already hugely successful, could nonetheless be improved by combining holdings of BRKA with other assets. An ideal candidate for investment alongside BRKA would be an asset with both positive returns on a stand-alone basis as well as low correlation to BRKA.

In 1983, Dr. John Linter published the classic paper, “The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds.” In this study he pointed to gains in risk-adjusted rates of return that potentially could be obtained by combining equity investment with managed futures.

To examine a portfolio combination of stocks and managed futures (read: trend following), Drury focused on Berkshire because of its legendary performance. On the managed futures side, Drury’s trend following fund satisfies the requirements of having both strong performance and almost-zero correlation to Berkshire.

If you have sound philosophy, and superior strategy, the day-to-day slows down. If you don’t have such every distraction appears consequential.

Michael Covel

While Drury cannot cite the same longevity as Berkshire, it has been in continuous operation for almost 19 years. At least for these years, it is useful to examine Drury in relation to Berkshire for a possible improvement of overall portfolio returns. The two performance records, taken individually during this period, are broadly similar. (See Table 3.5.)

The correlation between the two return streams is 0.01. Despite the overall similarity of returns, the paths to producing these returns have nothing in common. Consequently, as modern portfolio theory would predict, the performance of a portfolio holding Berkshire is potentially improved by adding a noncorrelated Drury. (It is of course equally true a portfolio holding only Drury is potentially improved by being coupled with a noncorrelated asset such as Berkshire).

Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time...Valeant, of course, was a sewer.

Charlie Munger2015, 2016

A look at the efficient frontier for this two-asset portfolio suggests a blend of approximately 50/50 would have produced the highest ratio of ROR versus standard deviation of returns:

The portfolio with 50 percent each in Berkshire and Drury raised the risk-adjusted ROR to a level higher than either could achieve individually. For the holder of Berkshire, the diversification reduced the portfolio volatility by almost one-third and reduced the depth of the peak-to-trough drawdown by almost half. Finally, perhaps even remarkably, the combination of Berkshire holdings with this noncorrelated asset cut the length of the drawdown associated with holding Berkshire alone by a whopping 43 months. This means instead of experiencing a 61-month period (December 2007–January 2013) underwater, relative to the latest high price, while holding Berkshire shares alone, the combined portfolio reduced the underwater period to only 18 months. (By the same token, of course, the underwater period of holding Drury alone is reduced from 55 months to the same 18 months).

There are no facts about the future, just opinions. Anyone who asserts with conviction what he thinks will happen in the macro future is overstating his foresight, whether out of ignorance, hubris or dishonesty.

Howard Marks

Columbia University professor Benjamin Graham led academia and Wall Street with pioneering work across value investing. Famously, Warren Buffett was one of his students in the 1940s. And years later, the Nobel Prize–winning work of Harry Markowitz explored the effects of combining noncorrelated assets to improve risk-adjusted returns. Markowitz is credited with the often-repeated quip that “diversification is the only free lunch in finance.” Thus it’s not surprising that adding Drury’s trend following as diversification to Buffett and Berkshire clearly enhances an overall portfolio return while reducing volatility.

Ultimately, performance data is the driver, the only truth we can take in for analysis. If there is no data, no believable narrative can be used to explain anything. And trend following data is a very clever way to illustrate human behavior with numbers—and it happens to also be proof of concept any skeptic would want before jumping into the deep end to deploy their risk capital. Yet where does trend following performance data come from exactly?

Summary Food for Thought

• “F-You money”: If you trade for absolute returns you have the chance for F-You money—the money it would take to leave your job and never work again.
• Ewan Kirk: “When people ask: ‘What do you think is going to happen in the future?’ We always say: ‘We don’t know.’ I can’t really project whether next year will be a good year or a bad year.”
• Absolute return means trying to make the most possible.
• In a zero-sum game the total gains of the winners are exactly equal to the total losses of the losers.
• George Crapple: “So while it may be a zero-sum game, a lot of people don’t care. It’s not that they’re stupid; it’s not speculative frenzy; they’re just using these markets for a completely different purpose [hedging].”
• The U.S. Army War College introduced the acronym VUCA to describe general conditions post Cold War: volatile, uncertain, complex and ambiguous.
• Mark Rzepczynski: “If a manager cannot explain what he does and his edge in 45 minutes, you should not invest.”⁴³