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25 Why a Mechanical, Long-Term Trend Approach is Best with Scot Billington of Covenant Capital – 1of2

"Nobody ever started trading a model that didn't make money in the past. But we don't know if those things were luck or skill." - Scot Billington (Tweet)

Our next guest takes a mechanical, long-term trend approach to trading to a new level, and you'll find out why he thinks it is the better option in this episode. He started Covenant Capital with his business partner in 1999 and has grown it into a profitable boutique firm. But in early 2002 after they ended the previous year down 20%, they really had to grind it out and stick to their guns which ultimately paid off in a big way.

Thank you for listening to the show, and please welcome our guest Scot Billington.

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In This Episode, You'll Learn:

  • How Scot started his firm, doing the testing by hand.
  • The difference between a discretionary model and a mechanical model and why Scot chose a mechanical one.

"I figured that there may be other ways that one can make money in the markets, but this seems to be the first place that I ought to look." - Scot Billington (Tweet)

  • How he met his business partner Brince Wilford and started with 3 accounts in 1999.
  • How narrative bias can affect a trader's decisions.
  • How the firm got through a year that ended with them down 20%.
  • What made Scot believe in his model and stick to his guns.

"I was doing all of this back testing by hand. So, well that's a good way to not be curve fitting." - Scot Billington (Tweet)

  • The offerings that the firm currently has, including the differences in the trading models.
  • The pitfalls of investing in shorter term models and not allowing managers to see a full cycles with markets.
  • Why most allocators and investors are chasing 24-month returns on stocks and why that may not be the right approach.
  • About different types of CTA firms, including boutiques, battleships, emerging, and experimental.
  • What to look for in a CTA.
  • How to get investors to share the long-term horizon with his firm when certain markets do very well in the short term.

"I moved into the smallest apartment in Nashville, and cut my living expenses to next to nothing" - Scot Billington (Tweet)

Resources & Links Mentioned in this Episode:

This episode was sponsored by Saxo Bank:

"Our first major change to the model was in early 2002, was basically eliminating short trades and using a volatility filter for long trades." - Scot Billington (Tweet)

Connect with Covenant Capital Management:

Visit the Website: www.CovenantCap.com

Call Covenant Capital: +1 (615) 678-6742

E-Mail Covenant Capital: info@covenantcap.com

Follow Scot Billington on Twitter.

"More or less, we like to look at trades like, here comes a refrigerator, put in the shelf, here comes a refrigerator, put in the shelf." - Scot Billington (Tweet)

Full Transcript

The following is a full detailed transcript of this conversion. Click here to subscribe to our mailing list, and get full access to our library of downloadable eBook transcripts!

Niels

Welcome to another episode of Top Traders Unplugged. Thanks so much for tuning in today. I know how valuable your time is, so I appreciate you spending some of it here with me. On today's show I'm talking to Scot Billington, of Covenant Capital Management. Covenant is, to say the least, very different to most investment managers out there due to the way they approach strategy design, investment horizon, and trading activity. So I'm sure you will learn a few new things that are thought provoking and perhaps will even lead you to reassess the way trading success is considered today.  

Now, for those of you who are new to the show, I just want to let you know that you can find all of the show notes including a full transcript of today's episode on the TOPTRADERSUNPLUGGED.COM web site. Now let's get started with part 1 of my conversation. I hope you will enjoy this. 

Scot, thank you so much for being with us today. It's great to have you on the podcast today. 

Scot

Niels, thanks for having me. I'm excited to chat with you a little bit about Covenant Capital. 

Niels

Fantastic. Now you quote Leonardo da Vinci in your marketing material with the words "simplicity is the ultimate sophistication" and this is about 500 years ago he said that. Now, one could say that if this is more than just words to you, you should be able to explain your strategy on the back of a napkin, and as far as I know, that's exactly what you did back in 2003 when you sat down with Dan Collins of Futures Magazine. So it would seem that Leonardo da Vinci's words are quite important to you. So naturally, I'm excited to be able to dive into this topic with you today because too many people believe that more advanced algorithms, developed by an army of PhDs must be better than a very simple approach. So I'd love to discuss this from a conceptual point of view, and of course specifically in relation to what you do at Covenant. Before we go into all of those details and where you are today, I really would like for you to take us all the way back to the beginning, and tell us your story of what led you to take this path, and feel free to go back as far as you want. So it's really important for us to see what led you to where you are today, so tell us a little bit about that. 

Scot

Well, in the mid 1990s I worked for regional investment bank out of Nashville, Tennessee, and I worked in brokerage and trading. We did some commercial hedging. We did a lot of attempting to predict where the market would go for our commercial clients and some advisory and that. We were paid on commission, and what I quickly, or maybe not so quickly, but what I ended up coming to realizing was that I needed to be able to make...number one I didn't like sales very well, and I found an inherent conflict in the transaction business. I also figured that if I couldn't trade markets profitably, then I probably needed a different industry - that at the end of the day that was the reason for doing this, and everything else was superfluous.  

So I, at the time, took the Barclay's top 20 CTAs over the past 10 years and I think 15 of the 20 described themselves as long term trend following. So I was 27, 26 at the time, so I figured that there may be other ways that one can make money in the markets, but this seems to be the first place that I ought to look. So I started putting together a trading model.  

In my opinion, they were three big picture decisions that somebody had to make when you talk about what kind of trader you are going to be. The first was discretionary or systematic and mechanical. So I would define discretionary as I bring in different inputs, whatever those inputs might be. I weigh them in a non-standard fashion, meaning that I don't weigh them necessarily the same way every time. I might bring in the same inputs, I might look at different ratios, but sometimes input A overwhelms input B, and sometimes input B might overwhelm input A. Regardless of what that might be, and then I would make the trade decisions in that fashion. Systematic I define as I do the exact same thing every time. I might argue that, if you have any discretion, then you are discretionary. So that even if I have a mechanical model, but I decide 7 times a year to override it, I suspect those seven times a year are going to be 7 of the more volatile and the larger outcome periods, and in essence you have a discretionary model, which is fine but you are a discretionary trader.  

The reason that I and we have gone with systematic is three-fold. The first is that we wanted something that the efficacy of which could be at least estimated through historical modeling and backtesting and the like. So if I'm a discretionary trader, one of the difficulties that we found was how do I know that my theory is accurate? I think that XYZ, whatever XYZ is, it might make perfect sense, but what I have there is a good hypothesis that will be interesting to test, but I really have no method of testing it. Therefore, no way to prove that at least my idea had worked in the past. The second reason that we went with a more systematic model is that we felt that it would be much easier to apply to a wide variety of markets. If I was going to be..and that also ties into the inputs we might use...but if I were going to be discretionary, and I was attempting to trade the Yen and cotton, it would perhaps be very difficult to be an expert in both of those two markets. Now you could be discretionary and not necessarily have fundamental inputs, but that will be the second part of this answer. The primary reason that we wanted to be systematic is that we felt like we wanted the emotions taken out of the trading process. We wanted something that was repeatable, so that I could say the same decisions that I made in June of 2004 I'm going to make in December of 2018. It's the same process. It's a much more repeatable process than my weighing all these different factors. The other thing is that we think that it's...I don't know about impossible, but extraordinarily difficult to separate your decision-making process from your own emotional state at any given time. I think it's probably a bit fanciful to say that I would make the exact same decisions on the day that my wife left me as the day that my son won an Olympic gold medal. (This applies) also within trading: If I've just had 4 straight up 15% months I think it's extremely difficult to bring the same analysis as if I just lost...if I'm in the middle of a 30% drawdown. What we basically said was that my wife has just walked out on me should not have any effects on the trades that I take.  

So the second thing that we looked at was what kind of timeframe are we going to trade? If you look at timeframe as a spectrum, am I going to be shorter term or longer term? Is there some logical reason to make that selection? We've elected to be longer term for one, and it's not a very sexy reason, but it's in our minds it's extremely important, is that random trading's expected outcome in a frictionless or costless world would be to break even. So if I'm trading randomly, my expected loss is my cost. My commissions that I pay, and more importantly the bid/ask spreads that I pay. That's also going to encompass any kind of gaps or slippage in a fast market, but again that's just a wider bid/ask spread. Those costs come into play every single time I trade, but they're fixed, so if I hold a trade for 8 minutes, the bid/ask spread is just as wide as if I held it for 8 months. I might get a little break on the commission from my brokerage, but at the end of the day, the holding period of my costs has no impact on my costs. My costs are going to be fixed regardless of my holding period. So if you look at it from that perspective and you say that the amount of what we call a trading edge is a non-random entry and exit decision. It means that I have some non-random method of deciding when I'm going to buy and when I'm going to sell. The amount above randomness that my method needs to have to break even is my costs. The costs are, in casino terms, the cost of the house edge. That's how positive I need the deck to be, or that's the amount that I need to be able to forecast future price moves to break even. So we would consider forecasting future price moves to be extraordinarily difficult. Therefore, we want that hurdle to be as little as possible. Does that make sense Niels? Do you see where I'm going with that? 

Niels

Definitely. 

Scot

Now, there is another side of that coin. A shorter term method is going to have more instances in a given time period, and therefore a smaller net profit, meaning after cost profit can be profitable, or can have a good method. So I need a larger gross edge, because I'm going to give up so much more of my edge in the costs, but a smaller net edge can be profitable in a shorter term. Does that make sense? So with that, the lower hurdle to clear with the lower cost parameters, to us was an overwhelming argument for having a longer term method. 

Niels

Now this was something that you were doing sort of research while working, or how did that...I'm kind of interested in taking you back to the very beginning of it and sort of, obviously what you decided to do, but also the phase of when you decided to do this. 

Scot

So this was a couple of years before we started Covenant Capital, and I was interested in trying to develop a winning trading method, so I started doing some backtesting, and at the time, this was the mid-1990s, I was doing all of this backtesting by hand. So, well that's a good way to not be curve fitting (laugh). I say that in jest, but that's actually accurate. It eliminates your ability to curve fit or try to fine tune everything to fit past market behavior. 

Niels

Sure, absolutely. 

Scot

I remember this, is that we were brokers and we had a client, and I remember when I would get the P&L for the clients at the end of the year, and I looked at this client and I said, "oh wow, they lost $109,000 last year, they must not have been very good traders." But then I looked over, and I noticed, well wait a second, they paid us $174,000 in commission. These guys were great traders; they just had bad brokers, and that doesn't even include the bid/ask spread that they pay. So if you think about it, the points at which they decided to get in and out of the market were, frankly, excellent. They just traded way too much - so then take that the next step.Well, if I'm trading two or three times a week, how good am I going to have to get at getting in and out to pay for all those costs? See what I mean? 

Niels

Absolutely, but since we are talking about costs at this point, I'm just wondering...I mean obviously cost today for trading is a lot lower than they were in the mid-1990s, does that change your view in some sort? 

Scot

Some, but not particularly. It's still...we track our costs very closely. When you add it all up, and average them over 30,000 contracts we traded in X amount of years, we still see, including roles, we still see about $35 a round turn. So if I'm a CTA that does 3,000 round turns per million, 35 times 3,000, that's $105,000 a year, that's 11%, so the best guys in the world make 20%, that's half of that. So if I just do immediately 1,500 round turns, this other guy's got to beat me by 5 1/2% a year just to tie me. You see what I mean? We'll probably touch on this latter, but to us that's a fact that's not an opinion and it's something that's based on empirical evidence. That's just a straight mathematical fact. So when we get into the modeling and testing, and all that, there's a huge weakness in that it's all empirically based, and I can try to make it my empirical base as solid as possible. I can try to make it as robust as possible, but at the end of the day, the future might just be completely different than the past. In which case all of those...that's the black swan kind of idea that Taleb put forth in his series of books, and it's a very accurate one. However, if I'm saving 5% a year in costs, that's not perceptible to a black swan. In fact, it can only be helped in that the less I trade, and the wider my trading parameters are, the less impact massive gaps would have on my outcome. You see where I am there? So what I want to do is I want to line all of these facts up in my favor before I'm forced to use empirical evidence. Does that make sense? 

Niels

Sure, sure. 

Scot

Think about it this way, a truly losing trading strategy, by definition, has to be as rare as a truly winning one. Right? Well, I could just take the opposite of the trades. If you had a truly negative losing expectancy, that is very valuable, because I could just take the opposite of your trades, and I would make money. So those have to be very rare, correct? Or as rare as a winner - which means that most trading is random. People think that factor A, B, C says something about the future of price movement, but that factor is either fairly valued at the current price or does not have any impact, and it's no different than my drawing a trade out of a hat. But just because I draw a trade out of a hat, that doesn't mean that trade's going to be a loser, it's just a random trade. So most people are trading randomly with an expected loss of cost. Almost by definition, that almost cannot not be true. So I all of these people and I say, OK, well Janet Yeltsin is going to say this thing about whatever interest rate, and OK if that happens the dollar is going to do Y. When they go through there they might sound very smart, and I don't doubt they're well educated, and it might be a well thought out opinion, but by definition that is either not predictive of the future market move, or it's already been fairly valued by the market, because most trades that people put on have to be random. They're not losing, their random. You see what I mean? I was a market maker, and I would stand in my pit and I would look around and maybe not including myself, but I'd think...because a lot of guys made a lot of money, I'd be like, you know, there are 100 guys in here and the average take-home after their own costs of paying commissions and paying clerks, renting the seats, and all that is maybe 1/2 a million dollars, so that's 50 million dollars a year that this pit makes. Well, who pays that? It's the people who want to take positions. Right? 

Niels

Definitely. 

Scot

So when we look at that, and we think about costs, we think about this is exactly the amount of nonrandom price behavior I have to capture to break even and then go on to be profitable. The lower that cost is, the less of anomaly I have to capture, and, even more importantly, the more room I have for the future to be worse than the past.  

Niels

Sure. 

Scot

Nobody every started trading a model that didn't make money in the past. Right?  That's happened never. No investor has ever allocated money to a trader that didn't have a winning track record. But we don't know if those things were luck, or skill, and so what I'm saying is that when we test something, and it made X% over whatever, and we do our things to try to make sure that's as robust as possible. If the future is the same as the past, we don't have a worry in the world, and if it's better than the past we definitely don't have a worry in the world, but what we need to worry about is, what if it's still in an anomaly, it's still a capturable, persistent, non-random price movement? Whether it's the mispricing of a corn crop yield or the mispricing of a more quantitative measure or whatever my inputs are. What if that anomaly exists in the future, but less than what we've seen in the past? Can I still make money? 

Niels

Was this something sort of a philosophy that you shared with your partner at the time?  How did you actually meet with your business partner back in the day? 

Scot

Well, the first time I went through the model, I think I tested it on a shorter timeframe and I think I used $75 or $100 around turn contract as a slippage cost estimate. I remember that the returns came out OK, and I looked at it, but I was like, WOW! I paid $200,000 a year in costs. If I just went to a longer timeframe, let's say that I went to 4 times as long, it's pretty reasonable to assume that 80% of that would flow immediately into the profit column. Right? 

Now there are some things I'm going to have to give up. Nothing is free. I'm going to have to give up some other stuff, but WOW! I'd like to see it like that. So at the time that was the thing I recall most specifically that led me towards the longer trading, timeframe, and so I put together a trading model. I back-tested it. There was another broker at our firm that was using it to trade a little bit in some client accounts, and I had, I guess in retrospect, I was insane, but at the time I thought I had decent chance that I had something that would work. So I was out now looking to start my own business, so I needed two things. I needed some client capital - some people to actually believe me and trade the cockamamie scheme, and I needed some operational capital, I needed a business partner to run the business side and allow me to leave my current position and start this new business. Just like any other business we needed original capital. 

Niels

Just out of curiosity, we're in 1999, what were you thinking in terms of how much money do I need in terms of trading capital to start a business? What was your recollection of that? 

Scot

Well, I had made out a pretty detailed business plan, and I'd also made out a pretty detailed, and I think relatively conservative...what I basically took as a business proposal was that whoever would partner with this would have 1/2 the company and they would put up, I think it was $90,000, and then I moved into the smallest apartment in Nashville, and cut my living expenses to next to nothing, and basically with that $90,000...you know, it didn't take much to run a startup CTA - basically, you paid some fees and some quotes, and that was it. So then I was going to make $30,000 a year, and then if we didn't make any incentive fees, I would dial that...we had contingency plans for how we would dial back our costs, but the general idea was that we would make that $90,000 last for 5 years. 

Niels

And how much trading capital were you looking to start within your plan. We were hopeful...we started with 3 $250,000 accounts, and that was roughly what we...I mean I guess we were hoping that we would get one or two more, but that's more or less what we thought we would start with. Those original accounts traded at 0 and 20.  

Niels

It's not that I want to stop you in your story, because I do actually want that story, but I just want for people who are listening to this to realize that we're now 15 years later, and if you read the press today, they talk about that you can't start a hedge fund, if it's less than 100, 200, 300 million dollars in size, and you started a business with 3 $250,000 accounts and $90,000 in working capital. That's extraordinary. 

Scot

As I said, it was insane, but thank you (laugh). 

Niels

That's how entrepreneurship works isn't it?  That you do things that are probably a little crazy, and as Steve Jobs says, to the crazy ones. 

Scot

Our big thing was time. We figured if we had a winning method, the only thing that can hurt us is bad luck. Bad luck is finite. So if we could survive the bad luck, essentially we'd make clients’ money, and then eventually we'd make money. And that works on the assumption that you've got a winning trading model. If you don't have a winning trading model, you are done for anyway, so it's all a moot point. So our thing was the tragedy would be if we had a winning trading model, ran into bad luck early and had to quit, which we almost did. 

Niels

Yeah, I'm going to come back to that one because that's a really interesting story in itself. So you and Brince start off in 1999, and both of you sort of, with a financial background, or how did you get into it in the first place? 

Scot

You know my background - I'd worked for the investment bank, and so I had 4 or 5 years experience, and I worked in the Futures department, so I had that. Brince, his background was a lot in healthcare. He did a lot of healthcare. I mean later he did a lot of healthcare, building acquisition, so he had that type of analysis in his background. He was really someone that we met through a friend of ours that was an accountant, and we got into discussing investments, and Brince is the one person that somehow found a way in the mid to late 1990s not to make money trading stocks. He would be like a very typical person. You know, Kahneman and those guys have gone on to prove there is a narrative bias, when we hear a great story, we tend to believe the outcome of that story more than if there is not a narrative story with it. So he would have somebody come up, and oh, there's this company, and they tell him this great story, and it does all this and that, and Brince would go invest in it, and then it would lose money, and he'd lose money on it. And again, there's no plan to it, there's no structure, where are we getting out of this trade if we get in? How many shares are we going to buy?  There's no risk parameters, but I think that's a typical persons initial foray into any markets. As we talked about it he said, I am so tired of chasing my tail on these stories. I've lost way more money than I should have. The market's gone vertical and I've still lost money, and he was very attracted to the systematic process oriented repeatable very boring nature of what we did, or of what I was proposing that we do. More or less, we like to look at putting on trades almost like here comes a refrigerator, put in the shelf; here comes a refrigerator, put in the shelf. A lot of times in interviews like this people say, tell me about one of your more devastating losses. It's not that I like having losing trades, but every loser looks the same, and the worst losing two weeks that I had, those are the ends of my best winning trades. It's hard for me to say that was devastating because I made a lot of money on them. I guess we have more outlier large winners that might be more of an interesting bar room chat about a trade, but we really don't have that kind of narrative. It doesn't fit well with our trading style. So none the less, Brince would be chasing around doing that, and he was very attracted to the methodical nature of what I was proposing. So we formed the CTA. We went out and we got three accounts, and we started trading in September of 1999. Brince kept his job, and I was the only one who took any pay from Covenant Capital. So the first four or five months we made a little bit of money. We got some small incentive fees. In 2000 we more or less broke even, and then in 2001 I think we ended the year down about 20%, and for those listeners that might do trading, you can imagine that was a scary period. Here we are, we lost one of the three accounts, we're down 20%, and the big question is, does this model work? 

Niels

Absolutely. This is something that I certainly wanted to talk to you about because I think that the psychology, what keeps you, in early 2002 with a tough start, to say the least, what makes you believe that this is still something that you should pursue? Can you remember what went through your mind so to speak at the time? 

Scot

I can distinctly. At that point, there are only one of three things has occurred. Either the model worked in the past and the whole nature of whatever the model used in the past profit completely changed whenever the drawdown started - May of 2001. Now that's possible, but that seems pretty unlikely to me, that we've tested all these different markets. We used two parameters. We used the same parameters on every market. All these things are robust. We tested them over decades and the anomaly that we were capturing disappeared May 31st 2001. It could happen. I'm not eliminating...but that seems farfetched. The second possibility and the one that we needed to protect against is, somehow in our modeling and testing we lied to ourselves. We curve fit some things. We had done all of this by hand, so had I made mistakes, and falsified this? And then the other possibility is that we just ran into some bad luck. Because, like anything else, there's going to be some distribution of returns in the thing we're doing, and if we're operating even one deviation to the bad, that's going to be losing. Right? So there's no other possible outcome. Those are the only three things, and I felt relatively comfortable eliminating the first. So basically we went back and each individually, and it took hundreds of hours, but, of course, what else am I doing? If we don't trade very frequently, and there's certainly no marketing I'm going to do, so I've got a lot of time on my hands. So I went back and Brince went back and we both, by hand, redid the entire backtest, and both of them came out equal to what we had done in the original backtesting, and we felt that pretty safely eliminated number 2, which means that, in reality there's probably and 80% to 90% probability, if not higher, that we're just in number 3. It has to have been bad luck. There's a chance, but I'd probably put it at 85% to 95% chance that it's just been bad luck. So in our business plan we had written out some things, like "in case of emergency break glass", and we actually had to break the glass. I thought, WOW, when I wrote this out I sure didn't think we'd be doing this, but here's what we do, and basically what we do gets back to that time aspect in that if, at the time the model was so low maintenance...we only had two accounts, we made maybe 30 trades a year, it really didn't take a full-time...we left stops in with the brokers...it didn't take a full-time employee, so I needed to find an alternate source of income so that I didn't have to take money from Covenant Capital so at the time I moved to Chicago. I took a job making markets down at the CBOE, the options exchange, and Brince and I, between, handled the trading duties between us for the next...I guess that was 2002 through 2004, and basically at that time, we were only spending a couple of thousand dollars a years, so that really perpetuated the existence of Covenant Capital, and gave the method a long enough timeframe that it would be unlikely that bad luck could persist that long. Also, when we went back through and did that research again, we did come across a couple of fairly critical insights with which we've evolved the model. So not only did the market conditions improve for us, but the model also I would say maybe rather dramatically improved with those changes. From that point on, we've really had some pretty good returns. 

Niels

Absolutely. It's very interesting to see back and actually from the time where it looked the darkest, probably 3 or 4 straight exceptionally profitable years came along and as you said the rest is history. I think it's an important story to share, because most people may not realize that certainly businesses in general, but also businesses in our industry; it's not a straight line. It's a fight, and if you have the passion, and you sometimes have to grind it out, and that's what you did and certainly the success has come back. So bringing us up to date, you run three programs. Tell me a little bit about where they stand from an assets under management point of view? 

Scot

Well, we have...I guess we really have 4 programs. One of them is what we would call a custom program. So one of the things that we do is that for clients that are large north of 25 or 50 million dollars to invest. If they want to take our trading model and customize it to their needs, we will do so for that level of investment. So what we've done is there's a large institutional client and what they basically want us to do is trade our model long only, and commodities only. So we basically take our return stream, and we peel out all of the shorts, and we peel out financial markets. So, since it's customizable, it's not investable by anybody, but we have about 100 million in that program. We've got our Aggressive and our Original and our Optimal - all three of those take the exact same trading signals. The only difference between them is the position sizing, Original being the least aggressive, and Optimal being the most aggressive. We've got about 150 to 175 million spread across those two. Most of it is in the Original and Aggressive, or probably 60 and 90 million each, and in Optimal I want to say 5. 

Niels

Sure, fantastic. Great story. Thank you for sharing that Scot. That's really impressive. Now I want to ask you one thing before we leave the timeframe point of view, and maybe we'll come back to it later, but I just want to ask you one thing, it looks to me that on one side we have, for sure in the last 10 years seen a number of short term traders come and some have gone, but there are few that have become very successful - lots of money under management, and doing well. But it seems to me also, that at the same time a lot of the established managers have actually, in fact, become longer term themselves.  I just wanted to ask you in general, is there a risk somewhere, do you think in more and more people becoming longer term in the sense that when things do change one day, and trends may change direction, that more and more people, and most likely the larger managers, so to speak have to run for the exit at the same time? 

Scot

I'm not a big conspiracy theorist. Meaning that I don't spend a lot of time out looking for that kind of bogeyman. If that were the case, we would see a dramatic increase in our slippage. That's what we're really saying is I think I'm going to get out at $122.09 but because all these giant managers are getting out at the same time, I'm really getting out at $121.09.Another thing might be that had these managers all not needed to get out the market would have maybe only declined to $123.00 but because all these other guys had to get out it pushed the market down into my stop at $122.09, so perhaps I would have stayed in that trade some amount or whatever. So the two things that we would see, if that were the case...the first one you would see is a dramatic increase in slippage, right? That's your primary fear in that regard. Then you'd see some kind of either decrease in winning percentage or truncation of my average winner, meaning that these trends wouldn't go on as long because on small reversals they would turn into big reversals, and I'd be forced to get out. So, those are not things that we have seen. So I think that pretty much there's always going to be a flavor of the three-year period. Whatever happens to have done well in the last three years, you are going to see more of those kinds of people. Because they are the ones who have made some money, and they'll probably be the ones that have attracted more money. The aspiring new traders, that's the world they're going to have seen. People tend towards shorter term.  I probably have 5 or 6 new traders a year will call me and say hey, you've had some whatever level of success, would you mind talking to me about this and the business and whatever. I've never had one of those people be a short term trader. So then you've got to assume that almost all of them are going to fail just by definition. No one ever comes to me and says, hey, I've got a long-term model, It's always intra-day, intra-week at the longest.  

Niels

I agree with that. I do see evidence of that as well happening. I also see evidence of people who have been successful in the past and probably people who have been around for a while I would say, and who have actually done reasonably well in the last few years where it's been difficult and where they tend to become longer term, but what I wanted to ask you as well as the final point before we move on to the next section is really as managers in some ways, and arguably for good reasons that you've shared today, should be longer term, investors seem to be going the other way. Investors seem to me to becoming shorter term, and not actually allowing their managers much time to go through a full cycle. Is there anything that we can do to persuade investors to see it the way that you see it and explaining how important it is to have a long-term horizon? 

Scot

Now when I say long term, I mean the holding period of a given trade, and not necessarily a given allocation. OK, but to answer your question, no there isn't. There's not, and the reason that investors are looking for short term is that short term has done a little bit better in the last 3 or 4 years. 

Niels

Sure. Now... 

Scot

You've been around long enough. It's almost like it's coded in our DNA. They're almost always going to be chasing whatever happened to have been hot in the last 18 to 36 months. 

Niels

Yeah, sounds about right. 

Scot

Right? When did people start talking about loving the stock market again? 2012 because it did well in 2009, 2010 and 2011. Right?  If you look at mutual fund inflows, certainly if you looked at our inflows, it's almost laughable that I can promise you in February of 2002, which would have been the best moment to have every have invested with us, we were years away from getting a phone call, never. Then we brought tons of money in, in 2006, right before we had a two-year flat period, and then we brought a lot of money in 2010, right before we had a couple of year flat period, maybe they'll catch the tail end. Regardless of the alleged sophistication, it is very rare...there are sometimes a little bit, but at the end of the day, regardless of the alleged sophistication, allocators and investors are chasing 24 month's returns. 

Niels

Now I want to move onto a slightly different topic, which is more about how you've designed your organization, just from a broad point of view, but I want to bring up something that caught my eye, and that is you make a point about labeling different types of managers - such as boutiques, you have battleships, you have emerging, and experimental managers, why do you do that, and what's the important thing that people need to understand in this regard? 

Scot

Well we try to look at whether it's CTAs or hedge funds. We break down the whole landscape into those 4 categories. Talking about CTAs, we think that there are two, somewhat critical lines of demarcation. Where we draw the line is certainly, we look at a 10 year track record. Now does that mean an 8 year track record is not good? No, obviously we picked 10 because it's rounder, but the idea is that one of the few things that actually can predict just sustainability of a hedge fund is the fact that it has lasted longer. I think if you read Antifragile, another NassimTaleb book, he talks about the best way to estimate how a long technology will exist is how long it has existed. That shows that there's a certain robustness there. Our industry is fraught with overestimation of the usefulness of statistical techniques, and if you look at a top returner, probably they are over performing their expected future return. That would be a whole other discussion. But regardless, we think length of track record is very important. The second thing that we draw a line at is the amount of money under management. 

When we look at the battleships, those are going to be in, for CTA terms, let's say north of 750 to a billion dollars. They are going to be giant group, and longer than a 10 year track record. So these are the biggest established, well-known names. They're obviously pretty good at trading, or they wouldn't have lasted that long and gotten that much money. Their limitations are going to be the liquidity of the various markets is going to limit them to primarily financial. You just can't do a 15,000 lot in cocoa. They're going to have some commodity exposure. Their commodity exposure is probably going to come in group, so all the grains together are about the equivalent of a full market size, all the energies, etc., etc.  

So then from there we move into over a billion but under a 10 year track record, and we call those experimental. To me, I find these the most interesting, is that you've got a 4, 5, year track record, and two billion dollars. To me we call that experimental for a reason, that's a pretty big experiment, because you haven't proved, and not that 10 years proves anything, but you definitely haven't proved much, and yet you have a lot of money to manage. So the other problem with your larger managers is, you start seeing returns get dumbed-down, and you know that's what most of our clients want anyway, but just do the math. If you're managing a billion dollars and you're getting a 1% management fee, that's a lot of money. All I need to do now is not lose that money. So, and again some, and even maybe many clients, that's what they are looking for. But the experimental with the shorter track record and a lot of money. You're talking about a lot of growth and infrastructure, a lot of growth in having to handle that in a short amount of time, with a method that certainly probably hasn't made it through two different market environments, if I can use that phrase. 

So the next thing that we would look at is the emerging manager, and that's your typical under 10 year track record - under 500 million, probably under 10 million dollars in management. Where we are, and what we think is attractive (obviously because that's us (laugh) is that we're a boutique. We're not attempting to be the Fidelity of CTAs, or the TD Ameritrade, or whatever the biggest. We want to manage a stable amount of money to keep the business stable, but not so much that it's going to impede our ability to have exposure to a wide variety of markets. We have over a 10 year track record. We have appropriate infrastructure. We have traded through multiple presidents, and economic cycles and world events and unpredictable world events and we've at least shown the ability to stay alive throughout that process. Our lower levels of assets under management allow us to have exposure, long and short, to multiple different markets that, while the larger groups might trade them, they really can't have any impact on their outcome. With that, we'll do things like customize portfolio, if that's what you want. So with that we think...we look at ourselves like a watch maker F.P.Journe, they make 400 watches a year; they don't make as many watches as Timex, but those watches get a lot of attention, and so we look at ourselves in that same vein. I think we can kind of bring the best of both worlds. It's not overdone, but we have a reasonable infrastructure. We've got a long trading history. We've got the protections in place to make an institution feel safe. But we also not encumbered by our size, and we're also still interested in return rather than just milking a perpetual management fee. 

Niels

Sure, Absolutely. How many people are you, but the way? 

Scot

We have seven. Brince and I and then 5 employees. 

Niels

Sure, sure. Now, track record...we've touched a little bit upon the track record. What I'd love to do is to ask you how one should read your track record because we all know that strategies evolve over time, and, therefore, in a sense, one could say that actually a track record...sure it shows that you survived. It shows that you have had some innovation, but I think sometimes people get maybe fooled to believe that a track record is a great indication of what the future is going to look like because they really don't know what changes have happened along the way in the model. So in some ways one could say that maybe it's better to look at the backtest of the current model when you look at a manager, maybe that would say more about the future, I don't know, but I'd love to hear about what your view and what your observation is about your own track record, because you mentioned the short side of things, and I know there was a period where I think you didn't take any short trades at all, so I'd love to hear your philosophical view about short trades, because I don't think many people realize that there is a big difference between the long side and the short side in terms of success and profitability, but also generally maybe putting that into context about your own track record and why you made the changes along the way? 

Scot

Well I think you make an excellent point about track records. I think people look at them as some kind of a one loss record in a sporting event, and they miss the enormous amounts of variance and randomness that happened to have lined up and occurred to produce whatever monthly return is shown, or daily return. I think that most groups don't do enough qualitative analysis of the trading method, and simply crunch performance numbers as though they're the end all be all of what the future is going to be. You make an interesting point. I would probably argue that a backtest of the current running model is probably the best, except that it is also going to...if you are hoping to be a 5 or 10 year investor, there're going to be future changes. And so what I might say is, as we've progressed, our changes have been successful, and therefore perhaps one would conclude that our future changes would also be successful. That's a different discussion. Our first major change to the model was in early 2002, was basically eliminating short trades and using a volatility filter for long trades. 

Niels

Were the short trades the cause of your drawdown back in the beginning? 

Scot

No, no. 

Niels

So why did you make a change to eliminate short trades back in 2002? 

Scot

Well, short trades, and this is particularly appropriate in our timeframe, on a shorter timeframe I don't think this would not hold as much. Let's imagine in our timeframe we're trying to hold a good winner for, let's say over a year. A short trade is bounded...it's certainly bounded by 0, and in reality, in a lot of these things it's bounded by something north of 0, right? But I'll give you even to 0, the point is still the same. So a short trade is going to be...it's going to face several hurdles. The first is if you took every sell signal of silver at $9 and I took every buy signal of silver at $9, and I'm looking for...our trading system is trend following, it's built around large deviation winners and outlying large moves, all of your trades are going to be limited to make $9 and mine aren't. Furthermore, let's imagine we had two good trades, you sold yours at $9, and it moved $5 down to $4, and I bought mine at $9 and it moved $5 and it's at $14, now how are we sitting?  - because you are in aterrible position. You have virtually nothing that can be made, probably a lot of risk in the position in that you've had a large and rapid move, and you're seeing an intra-trade de-compounding effect. Because now a 10% move for you is only $.40. While I've had the exact opposite happen. I'm getting a compounding effect, meaning I got to enter in a volatility and even a percentage move, where at $9 and now I'm into $14, and every dollar I go up... a 10% move for me now is $1.40. So if you imagine that, these rare moves (however you want to define them) come along equally infrequently. You and I have the same chance of one of these rare moves occurring. In your rare move, just for this trade example, you had to risk $.50 in silver to make $6? So you could have a 12 to 1 winner at best, and that's riding $9 down to $3 and not only is the market at $3, but your exit has got to get to $3. You see what I mean. You could catch some rolls in there, but we have to both agree that would be a huge winner short. My buy at $9...well silver has gone to $50 twice, right, so for the same $.50 risk and equally as likely an outcome, I'm going to make, let's say I got out at $45, 68X my initial risk. Well, start doing the math. You make 12X, I make 68X. You are going to have to be...it's going to have to happen 6 times as often for you to tie me. Does that seem likely? Now that doesn't mean in a 3 year period...in 2008 you're going to murder me, right? This is where people, in a three-year period shorts could do way better, and honestly, in a 10 year period they could do a little better. That gets a little less likely because a lot of these markets are reciprocals of each other: long dollar is short Euro and Swiss, but there could be a long term in time in which there was a large decline in overall prices in which shorts might do better, much better. Shorts might make 30% a year while longs lost 5%. This gets back into the qualitative and quantitative of it. Qualitatively, I don't think my point...there's no point against me. Logically, if we sat in a courtroom and argued it, I'm killing you on that argument, you see what I mean? I think we both know if we both took 10,000 in trades and you took all shorts and I took all longs in what I just described, you can't beat me. You're just done for, but that doesn't mean in a 5 year period that your track record might not be better than mine. That's a good insight into how we try to look at research, and how we try to look at trading, and trading from a strategic standpoint, or even a philosophical standpoint, and I would say strategic, and how we might attach a research problem. What we really evolved into is that shorts and longs need to be treated differently. Initially, when I buy at $9 and you sell at $9, those trades are very similar for the first dollar or two move, they're very similar. It's only as they progress that yours gets worse and worse and worse while mine, conversely, is getting better, and better, and better. So I need to appropriately weight the fact that my long trades are ultimately going to be a lot better, but I can also maybe make some adjustments to how I handle a trade intra-trade to mirror the way a trade evolves. Does that make sense? As the years have passed, what we have attempted to do is just get better at how we trade short, because there are shorts, over time, that have proven to be the best diversifier versus longs. They're part of the portfolio, and have been for years, but I'd like to think (obviously we wouldn't have made the changes if we didn't think they were better) that we've gotten better at understanding how short trades work and why they're worse than longs and how that evolves, and that we've created tactics to minimize the weakness of short trades. 

Niels

So has that really been the main changes over time, has been the taking out the short trades and putting them back in, in a different form so to speak? 

Scot

In a big picture, what I think we've done better with over time is basically if you took a...we're not big into the tactics. I always say...one of the first challenges that we give anybody that we hire is follow these five strategies, and you can use any tactics you want, but you won't be able to come up with a losing model. You see what I mean? Basically, long term trend following...there are a dozen different people getting in...we have to draw a line in the sand somewhere that says a trend might be beginning. Then we have some volatility base point that says, this is where I'm exiting. I have to have some method to handle trades that win. That's it right? Then I'm going to position size, I'm going to control risk through my position sizing, and in a big picture...I mean...we talk writing something on the back of a napkin, if you looked at what went into every piece of the model it would probably look more complex, but from a big picture standpoint, those are really the only things you need to think about. So, we're not big into trying to predict where the market is going to go, we don't think that we can. We're not big into...we don't think we have any magic pixie dust that tells me when a trend is going to start, but I do know this, if I get a signal long, and you some other time have the same signal, same risk short, I know that mine is better. That I know for a fact, and you see what I mean? I'm not trying to guess, oh well, Hillary Clinton is going to get elected, and that's going to do this and that. People can do that, and maybe they can do that effectively, I don't know, but I can tell you for sure my long signal is better. Now what I would argue is you're going to have to get awfully good at predicting future worldwide elections and results and all that to overcome that my long signals are way better, because they are unbounded and they're going to compound in the trade. You see what I mean? So what we think we've gotten better at, along the way is, I've got a basic trend following model and it generates signals. Which of those signals are worth taking risk on and which aren't without trying to predict if a trend will ensue, and how far or how large a trend might ensue. Does that make sense? Like I mentioned, a volatility filter. If, again I'll use silver. Let's imagine I get a long signal in silver at $9, but the recent volatility has been very high, and so through whatever metrics we use, I'd have to risk $.90. Then there's some other point in time you get the same signal at $9 but recent volatility has been low, and you're only going to have to risk $.45. So the first thing that we know is if we're risking the same amount of money on each trade, if I do 5 contracts, you're going to get to do 10. Well, let's imagine the same trend comes along, you're going to make twice as much money, and we knew that at the inset. We knew that for a fact. I'm going to need twice as large a trend account to make the same amount of money as you. By definition, a trend that's twice as large...if trend A is twice as large as trend B, trend A has to be more rare, right? So those are the kinds of improvements we like to think that we've made on our model, as well as diversifying...there's some advantage to diversifying entry points, diversifying exit points. It isn't that one is better than another, sometimes one is going to better, sometimes the other is going to be better. The main thing is that we try to achieve a robust, or even a smoothing effect to that. 

Niels

If we dive into the model itself and try to understand...my understanding is that you, in terms of the data input, actually don't look at even day to day as far as I understand you have an even longer timeframe. 

Scot

We tend to look mostly at weekly data. 

Niels

So at any given...say in a week you run your model and new signals come along, but explain to me how many different...I assume from our conversation that you actually treat, maybe with the exception of long and short trades, but you treat generally all markets as equal, so you run the same model on all markets, would that be fair to say? 

Scot

We run the same model on all markets...every input is the same. 

Niels

How many different entry points, or models is the better word for it maybe, that can generate an entry point do you actually run? 

Scot

Well I suspect it depends on how you want to look at it. We have three different potential points for an entry, and then the filters that apply to those points are the same, and each of those entry points is derived through the same method. So you could say, one...to me the fewer parameters - if I were making allocations, one of the first things I'd ask anybody is how many parameters do you use? I remember one time Brince and I were talking with a guy, and he said, I got 63 different models. Now models 1, 9, 12, and 16 they work great on wheat. A lot of people think this, and I guess you can, but maybe I'm wrong bit I don't think so is...so really, those work on wheat but they don't work on corn or the S&P? No. S&P now, 2, 4, 9, 16 works pretty good there but it doesn't work good...you know. To me that's the ultimate height of curve fitting. If you are going to allow me 63 different models, each one that has eight different parameters...yeah, I'm going to win in the back history an unlimited amount of money, but to think that that's going to work going forward is questionable at best, I would say. Robustness is probably the cornerstone of anything we would do in research. I would put it this way, whatever we might discover has probably performed better than its future expectation. Let's imagine that there are 9 different trading strategies that one could use to make money in the future, and they're all going to have huge variance with how they've done. Whenever you find something out of an unlimited group like potential trading strategies, and the one that you find has "done the best over a given period," it is almost by definition, and it has to have been outperformed in expected future return. It's like when guys look at managers, and they say, OK, here's the top 10% out of 500 over 3 years, well those guys are going to be the ones who the markets happened to have fit what they're strategy is the best, and they are also going to be the ones that took the biggest risks on those. I just bought a lot of Apple, and it went way up. Right? The same with us, if it happened to have been...you know 2002, 2003, 2004 are a perfect example. That was perfect for us, low volatility, markets screaming upwards, I don't think we necessarily took the most risk, but if we had taken more risk, we would have had higher returns. That return set...our expected return isn't 50% a year. 

Niels

What is it? 

Scot

It depends on which program you look at. 

Niels

If we look at the Original program, what would you be saying to people, saying what should I expect? 

Scot

Oh, I think after fees it's pretty reasonable to expect...I try to over perform... I think it's reasonable to expect 15%, and I think if you expect only 15%, it's unlikely that you would be disappointed. I think there's a decent chance that we'll do better than that, but again this is over a decade. This is going to be over a decade, with you putting X amount of money in, and not increasing and decreasing. If you said to me, "Hey Scot, I really like what you said today", I think you put that in there, I think 15% is a very reasonable amount and the way we do our risk now is that everything is based on containing the largest drawdown, so I could do that with a virtually guaranteed less than 25% drawdown, so I think it's very acceptable.  People that can do better than that - great - have at it. I think we'll find enough clients for that. Now I would advise something else. I would say that you should invest less money in the Optimal program. That is a far smarter thing to do, but that's a whole different soap box. 

Niels

Sure, sure. So you have three ways of generating signals and to me that would suggest that you build up your position in three stages, although, maybe in theory it could all happen in one day, but that's how I understand it. 

Scot

You're going to get in and then if it rallies a little bit more you're going to get in some more, if you're going long. Then the same thing with going short. I would probably say that we put our positions on one way, but we have three different points of doing so. 

Niels

Just out of curiosity, and I obviously don't know if this applies to you, but I suspect it does, and that is that you either are using moving averages or you are using price breakout channels. I'm curious to know which one you have gone with, but also why? 

Scot

I would one up you with that and say that doesn't matter. We've chosen something because we had to choose it, but, and actually in our research we also use a lot of...we've created three different what we call dummy systems, so that when I, if I want to test a theory, for instance the efficacy of short trades, not only do we run it on our model, but we run it on each of the dummy models. Because if short trades are worse on our model, they really ought to be worse on the other ones too, right? The changing of models should not change that philosophy, but I can promise you that whether we used channels, moving averages crossing, percentage moves, linear progressions, standard deviations, we've looked at all those things, and many more, none of those things make any difference. In fact, that's probably the biggest...I think the biggest misconception is that...or whether we'd gone out and created our own in-house proprietary indicators. Now the timeframe is important, very important, but if you said, "Hey Scot, I want you to use whatever your favorite thing was. I could create something that's future expected of return would be the same as ours." You could tell me whichever one you wanted. That's not to make me sound grand, but the way, virtually any (I think) experienced, well established CTA could. 

Niels

We talk about timeframe as maybe being something that has influenced returns in the last few years, and we talk about whether the short-term traders have done better than the longer term, and some instances we've certainly seen examples of longer term traders having done better than short term, but actually I want to throw in one more thing in this discussion, and that is sector allocation, because in my mind, I think one could argue that sector allocation either by design of by default have made a huge impact in recent years. You could say that because large managers, by default have had to be more focused on bonds and equities, they perhaps have made money more by luck than by skill, or is that too harsh? 

Niels

Well their outperformance in a short timeframe...any outperformance in a short time frame is 100% luck. So yeah, if you were comparing us to a 10 billion dollar manager that in a 3 year period, or even a 5 year period, it's pretty much going to be how did bonds and currencies trend versus commodities. That's going to be a whole deciding factor in 3 years. Again, this is why...now in 10 years the idea would be that those things would have started to cancel each other out - cotton and coffee did awesome this year, and then the Euro currency did awesome this next year, and then those start to cancel out and then the real strategic differences between the two start to show up. But if you look at it scientifically, the fact is that if I had a certain trading edge, the more times I can apply that edge the better. So, on a future expected basis, trading more markets is without question more desirable than trading fewer, although, just as you said, and that's again why the investment horizon of an allocator and how they look at things can be so misleading. If I only traded stock indexes, I would have crushed it the last couple of years. But that would be a foolish way to trade. Because then I'm saying oh, well stock indexes adhere to this anomaly that I have, not other markets. Or if other markets do adhere to it, but I don't trade them, why wouldn't I want to get...that would be like the Bellagio closing down all its blackjack tables except for the one that had done the best in the last hour. That's foolhardy. So trading more markets is a huge advantage, assuming that they are diversified enough. Trading more markets is an advantage, and it's only an advantage in that I get more instances in a timeframe. In a given year, or 3 years, or 5 years, yes, some sector...if we're talking trend following, or whatever it is...some sector is by definition something has to have done the best. This gets back to my earlier point. When you then go sort the managers by their 3 year track record, who's going to be at the top? Whoever happens to specialize in that sector. Does that mean they're more likely to make money in the future? 

Niels

Nope. 

Scot

Well maybe, if that is where you want to make your stand, then have at it. It's pretty questionable. 

Niels

But it's interesting. I find it fascinating the way you talk about timeframe and you talk about these long-term timeframes, and I can imagine it's not easy to get investors to share that horizon, so to speak. 

Scot

If you want to take ''not easy" out, and replace it with "impossible" then you would be correct, but that's the business that I've chosen. I know full and well that the next time we get hot for 24 months will attract a lot of money, that's a fact; and will keep attracting money as long as we "stay hot"; and then the next time we have a drawdown, which will come, that's guaranteed, and it will last for X amount of period, we'll lose 1/3 of the money that we had. That's going to be...that's just a fact of the matter. We attempt, we try, we talk about these things with our clients, but it is probable that the Homosapien is not particularly hardwired very well for trading. 

Niels

Why did you choose such a difficult path, Scot? 

Scot

No one has ever called me a smart person (laugh). There are obviously huge advantages. The industry is extremely high paying. I've always been interested in...I remember when I was 10 or 11 years old, my Mom tells a story that I was home sick from school, and I told her to go to the library and bring home every book on gambling she could find. I distinctly remember being 11 or 12 and sitting with a notebook and a book open trying to find some system to beat a roulette wheel. So I've always been attracted...  

Ending

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