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26 “The Most Repeatable Method of Trading Ever Invented” with Scot Billington of Covenant Capital – 2of2

"Trend following is the most repeatable method of trading ever invented." - Scot Billington (Tweet)

Welcome back to the second part of our interview with Scot Billington of Covenant Capital Management.

In this episode, Scot delves into the practice of trend following and why it is a great model to follow. He also discusses tips for beginning traders and investors, and advice for those who wants to start a firm. Thank you for listening to Part 2 of our conversation with Scot Billington.

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In This Episode, You'll Learn:

  • The story of Scot's childhood obsession with mathematically based, but unknown future outcomes.
  • The discipline required to follow a mathematical model.
  • The advantages of trend-following and why the media reports that "Trend Following is Dead" every few years.

"Your largest drawdown is always in front of you. But there will always be a winning period bigger than we've seen because it is over a longer period" - Scot Billington (Tweet)

  • Scot's philosophy on position sizing.

“I would rather have a small edge with proper position sizing then vice versa” - Scot Billington (Tweet)

  • How every sector in the market is highly correlated.
  • Getting comfortable with taking risks: they exist and it is impossible to avoid them.
  • The Barbell strategy: have very little money at risk, but the money that is at risk is in the most aggressive things that it can be.
  • The biggest mistake that allocators make.

"I'm a big believer that the handling of the large moves is sort of all that matters." - Scot Billington (Tweet)

  • How Scot conducts research for Covenant Capital.
  • Why he is based in Nashville and how he overcomes the challenge of asking investors to buy into the long time-frame.
  • Finding your niche as a boutique firm.

"As a boutique firm you are going to attract some people and some people will never be attracted to you." - Scot Billington (Tweet)

  • Advice for managers wanting to start firms today.

Resources & Links Mentioned in this Episode:

This episode was sponsored by Saxo Bank:

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.

"Any new business is like a small tree: it cannot take a tire swing yet” - 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

... 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 we'll attract a lot of money, that's a fact; and we'll 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 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 and had a decent aptitude for mathematically based, but unknown future outcomes. In our society, that lends itself towards trading and investments. I also find it fascinating to be able to...it takes a lot of discipline, and it takes a lot of self-control, because I have opinions like anybody else, and I will think, oh God, we got this trade, this one can't win, this and that is going to happen, and the Russians invaded this, and this will never win, and it's a challenge. There's a huge advantage to systematic method is that it's an achievement to be able to put those things aside and continue to methodically apply our method. 

Niels

I know absolutely... 

Scot

If  I was going to say that there is anything that I am proudest of that we've done at Covenant Capital, we hit on it earlier: go look through your hedge fund and see how many of them have lost 20% their second year, the answer is 1 and that's ours. We did not change our trading philosophy a bit. We did not change following the method a bit. We actually...I made fun of the "in case of emergency break glass", but we had taken the time to write that out and we actually did it. And more than that it worked, because here we are. The real tragedy would have been, assuming that we do have a reasonable model and the ensuing 15 years argue that we did, is if we had to fold then, and most people would have. By most, probably 90%, so that's a time I'm very proud of, and we've developed our business in a vacuum. We're headquartered in Nashville, Tennessee for God sake. You really couldn't have picked something worse. We've got an office in Chicago, but Brince and I have lived in different towns since 2002. Neither of our Dads was a partner at Goldman Sachs. It isn't like we went and worked for George Soros and then spun off, and somebody kicked us 50 million dollars day one. We really did build this up from a bootstrap kind of in a vacuum. Like I said, in retrospect, we never should have tried it, but we did, and at least thus far it's worked out pretty well. Those are the things that I'm probably proudest of personally of what we've done with this. We've really stuck to our guns. There's always...I remember in the mid 2000s everybody was investing in option sellers. So everybody I ran into, "Well it's an option seller. You've got to do this." 

I'm realizing all of those guys are going broke.  

"No, no, no this guy's figured it out." 

Sure he did.  

Option sellers aren't gone, in general most of that has gotten vetted out, and suspect those might be coming back. The market has been going up lately. Short term, you have to get this mean reversion short term trading, this is the new thing. They'll think of some reason - oh the central bank, now because of that this doesn't work anymore. I can pull out a futures magazine from 1991 declaring trend following dead. If you really think about it, if want to scientifically look at it and talk about repeatability, peer-reviewed ability to repeat it, trend following is probably, with the possibility of the exception of value stock...but the most successful method that has ever been created. It has been replicated time, and time and time again.  

Niels

It's a slightly different topic than where we started, but I think it's an important one, so I'd like to explore it a little bit. Although you probably know that my bias is also that I think trend following is a highly robust and sustainable strategy. If I was going to take the opposite side of the discussion here, and that is because we obviously hear the argument every time that people say, oh trend following is dead and out comes the veterans of the industry saying, yeah, we've heard this before, and it never comes true, but we also know that decompression or compression of volatility is not great for trend followers and we have to admit, maybe with you as one of the exceptions, but we have to admit that some of the people who have been around for 20 or 30 years have significantly larger drawdowns in the past few years than they have seen in their 30 year career. Some of them have even folded and stopped because they thought it was getting too difficult. The question is, of course, can one always argue and say yeah, sure it's going to come back, it's going to be fine, or is there as you alluded to before, is there always the risk that the markets, or that something has actually fundamentally changed? I'm not saying I'm a strong believer here; I'm just saying.. 

Scot

In the midst of any drawdown, that will always be a great and valid question, and I always start by saying look, I don't know the future. I can make my best guess. I can argue vehemently that my guess is very rational, but just because something has worked doesn't mean that it will work forever across any board. We would be out of business long before there was enough physical evidence to suggest that trend following didn't work. If you took the position today that trend following doesn't work, that would be an extraordinarily irrational statement because the empirical evidence before you strongly suggests that it does. 

Niels

Yet a lot of investors take that stand. 

Scot

Of course, they do, but they bought tons of collateralized debt obligations, right? 

Niels

So they did, yeah. 

Scot

I mean hundreds of trillions of dollars of them. They ran models that didn't even have an assumption possibility of a real estate price going down. Again it's easy to pick on things in retrospect, but we also bought lots of Enron stock, didn't we?  

Niels

But if we talk about evidence and I think we both agree that certain market environments are not good for trend following and certainly compression of volatility is one of them. 

Scot

In our stuff volatility is bad. You want volatility post trade entry, not pre. So volatility pre-trade entry is bad. Ultimately volatility tends to increase as a trend increases, so I think people have, for years, (now I have not studied this so this is a hypothesis of mine)... it's like lightning makes my driveway wet, because every time I see lightning my driveway is wet. I think that when silver gets to $50 volatility goes up a lot. But the trend follower has made money because silver got to $50, not because volatility went up, so it's a correlation rather than a causation. The best trends, the ones where you make the most, smoothest money are the period right before it goes crazy, when it just goes up a little bit every single week. Nobody really talks about it for a while and here it goes and goes, I think it's a perfect example. I don't think volatility compression...now if you mean volatility meaning the high-end crude oil over the last two years is $104, and the low is $89, yes, that's not very good that's a choppy sideways market. 

Niels

It's price range compression I guess I'm referring to. 

Scot

Sure, if there aren't big trends, then trend followers aren't going to do well. That would be very difficult to argue against, but I would say this is, what people forget is, your largest drawdown is always in front of you, except you're going to retire or die at some point. Let's say that my grandkids went on to trade our method, there will be a far larger drawdown between now and my great grandkids trading my model than I've seen in my model up to now, because it's more time - more instances. Now there will also be a winning period better than we've seen, so the idea that when someone is having their largest drawdown than they have ever had, therefore, this doesn't work, well did it not work when they had their last largest drawdown? Why did we think they were never going to have a drawdown larger than their previous largest? My returns are going to be distributed...and in any trading the variance is so much larger than the drift. You have to remember that like 2.5% of the time I'm going to be 3 deviations to the bad. That's terrible performance.  

I think there are so many things here. The first is that trend following gets held to a standard. If the stock market got held to that standard, the S&P wouldn't exist. I'll just take us, for example; we made equity highs in May of 2013. We're probably 15% off that high, and the question comes up - does what you do work anymore?  We make our money through the fat tail distribution of price moves, and there's a slight dependency in price moves - all trend followers we would argue do. That evidence is evidenced across all markets. We trade Yen the same way we trade cotton and cocoa across decades of time. I think AQR did a study that went back hundreds of years, and it suggested that trend following would have worked. There are definitely anecdotal examples. I can't imagine that trend following in civil war cotton wouldn't have been pretty good. Certainly the South Sea bubble and things like that.  

So there's reasonable...this idea of large outlier moves, the fat tail distribution of price moves is academically verified as anything that could possibly be. That doesn't mean that it has to happen in the future. So you've got this massive body of evidence. Furthermore, if you think about is scientifically, if you did a chemistry experiment, and you said hey, A plus B equals C, the big thing to prove in your experiment would be could your peers run the same experiment and get the same results. So now think about trend following, it has been almost without question the most repeatable method of trading probably every invented, not only through all of the turtles, but guys like me, I was "most of these people are trend followers, let's try that". We think that whatever it is that made all that work ended May 31, of 2013 - really... that was the day? 

Niels

It's a very, very interesting discussion, isn't it, because you and I agree on the answer to that, yet most of the world doesn't. 

Scot

Obviously anybody can disagree with what they want, but what is your basis, what is your logical reasoning for that change that day. So I would simply say here is the monthly variance of my returns, our performance, we're not even 2 deviations to the bad. In fact, it's shocking that we haven't had a worst period to be honest with you. CTAs and trend following; they're really the ugly red headed step children of the financial world. All of the Markowitz and all those guys and their bull about efficient markets and all this, the idea that I could slap a couple of moving averages on a chart and make money it's abhorrent to them.  They would want to vomit. It's really the case. I may not make enough for the risks, but I can turn a profit. Furthermore, they're not even that massive. You're talking about being down...I think we lost 2% last year. We spent 3.5% in transaction costs. That doesn't do a lot for our client. We hope to do better, but if your idea is that I'm going to invest in trend following, I'm never going to lose more than 10% in a year, you need to find something else. That's not for you.  I'd even go as far to say; you need to stay away from to the market passive investment. The reason that you may have had this small business that has made a bunch of money was because no one was in your front yard with an offer for your business every day, so you didn't see the fluctuations that actually occurred. The same with houses. Warren Buffet gets to have 50% drawdowns apparently twice a decade, and he gets quoted, and I'm not saying he isn't a marvelous investor, whatever, what I'm saying is we get held to this standard that it doesn't seem equal. 

Niels

Now we've talked very broadly about the entries and so on and so forth, I just want to talk about one more thing about that, and it's a little bit about position sizing. I think a lot of people underestimate the importance of position sizing, but I'm not so sure with your strategy how you view that. Is part of the success of a system like yours the way you size the positions? 

Scot

Once you have a non-random method of entry and exit, and that could be my macro-economic analysis, or it could be my insider knowledge of a recent crop report, but once I've got that my whole outcome is going to be determined by position sizing. In fact, I would far rather have a small edge with proper position sizing than vice versa. In fact, if you mis-size your positions, you can actually turn a positive expected outcome into a loser. Let's imagine that you and I were flipping a coin, and I was going to pay you six to five on heads, but you risked 30% of your bankroll on every flip, so you got a $1,000, and you risk $300, and you win. So you get times 1.2, you get $360, now you have $1,360, you risk 30%, that's $408 and you lose. You're down to $952 you have edge, and you did not have bad luck - the expected outcome came, but you lost money because you are risking too much. Now to me that is an insightful and frightening and kind of amazing - like WOW - I risked too much, and I took a winner and turned it into a loser. So for every example you could have where an unknown future wins and losses, there's a perfect amount you should risk - an optimal level. I think in my coin flip example I think it's 8%. Now if you risk 8% you make more money, if you risk 9% you would make less than if you risk 8%. That is in the nature of geometric returns if I lose $20 I have to make $25 to get back. 

Niels

Had you figured this out from the outset? Did you know the importance of position sizing and has that changed a lot over the time? 

Scot

Yes, I knew the importance of it, and the way we've done it has not changed...there's some things that we do now, I think, in the way we size the position and the way we look at risk that I think are miles ahead of what we used to do. We always have used the standard fixed fraction of the account size to risk, and I've always been aware of what our optimal level was, because risk to return is not a linear function, which you can see from the coin flip example, but risk of ruin and volatility with losses are. 

Niels

How do you manage the risk with such a long timeframe? When you put on a position, I assume you have some level of stop loss, but ... 

Scot

Yeah, you're going to put a position on, you're going to have a point at which you get out and then basically we look at every position to every stop every day and we say that's the amount of money we ever risk, and then we have maximums on a position and a portfolio level and if we hit those maximums then what we do is reduce position size to fit them back under the curve. 

Niels

Can you shed some light just to give our listeners an idea of what that risk looks like? How big a risk or indeed how small a risk do you actually see in running a portfolio like this? 

Scot

That's where we get into...I mentioned the Original program has a 25% maximum, the Aggressive has a 30%, and the Optimal has a 95%. So that's exactly how we change between programs. Obviously if an investor wanted some number in between there, we could either create it for them, or they could invest X amount in one and a different in another. 

Niels

Do you treat risk individually by market, meaning so you put on a position in corn, and you have a certain level of risk and you manage your trading stop, but you treat that independently of what's going on in other parts of the same sector, or other parts of the portfolio? 

Scot

I think what we've basically found is for trend following our markets tend to correlate higher when they matter to us. So when I'm in a position, I don't care about corn and silver's correlation when I'm not in them. Risk is going to build in a position as a trend goes our way. So our stop's not going to move up as quickly as the market might move in our favor. So when the risk of the positions really matters to us is when they are in the midst of decent size winning trades because risk is built up in multiple positions at the same time. What we found is that when that occurs, the correlations of the markets increase.  

The example I remember the best is in 2005 we had a huge winning trade in the NIKKEI and a huge winning trade in sugar, and you couldn't probably think of two markets you would think were more different, or would be more 0, but I can promise you that when we were in them and those big trades were running up, they were dead step and step. So what we think is, we basically assume that every sector is highly correlated. So when we look at it, we look at it on an individual position, because again, we're looking at that optimal level. We're saying, I know in our method that I never want to risk more than X on a given position - because that would be like risking the 30% in the coin flip. So I'm never going to let an individual that I also know as a portfolio as a whole, I never want to risk more...the way we're going to control drawdown...at no time from an equity high are we ever going to risk more than a preset level of your accounts value.  

Niels

Does it worry you that what you described there is probably the exact opposite of what big financials, institutions do in managing risk where they put everything together and they try and work out some kind of smart expected risk, taking into account all sorts of parameters, which we know that when things get tough never work? 

Scot

Well then, no. How have they done with that? We look at risk on a much...there's no reason for me to look at a derivative risk. I know where the market is, and I know when I'm getting out. That's the money I have at risk. So that's the money that needs to be controlled. So I don't know why I would go a step beyond that. 

Niels

No, no, I agree but I do think that it's interesting that the systemic risk, at least, I would say in the system seems to be increasing with the way that a lot of people are looking at risk, which is actually completely opposite of what many CTAs are doing. 

Scot

In those situations basically you have people who are looking for an excuse to put more on, because they get paid on the upside, and they don't have to pay the downside. If I'm the head of bonds at Bear Stearns, I acted exactly as a rational person should have. I came up with every reason in the world to put on as much risk as possible. I made 75 million dollars, my company went bankrupt, and I walked away with $52 million dollars. That's a winner. Really, if you think about it, none of them ever had any edge. They were all trading randomly. They chose a trading method with a high frequency of winners and a terrible winner to loser ratio. If you said to me, hey I've got your daughter captive, and you need to make 20% in the next six months, and your daughter is captive or she's done for. I would immediately start selling options because I know that's the highest likelihood of my making 20% and my making 15% and my losing 100%, they have the same outcome, my daughter's in trouble. Well, that's an officer with any publically traded financial firm. They have basically the same deal. 

Niels

Is there anything that you worry about Scot, when you go to sleep at night in terms of risk and when you look at your own methodology or are you just completely comfortable with the way it's designed and tested, or is there something where you can see, yeah, if this happened that wouldn't be good? 

Scot

Well sure. We've got positions in markets, and we've had mornings that weren't good - lots of them, and we'll have lots more. I think what I try to get comfortable with, and I don't want to sound like I'm the boater and I don't have emotional reactions to wins and losses, what I try to get comfortable with is you have to take risk. In your whole existence, you have to take risk. So once you've established the fact that risk exists, and I can't avoid it, then I basically say, OK how can I control it to the point that I'm comfortable with this is the most that I can control this thing. I would tell a client, don't invest more than you can lose - I don't. So in our own programs I've got an amount invested that if I lost it, I wouldn't like it, but my family and all is going to be more or less OK. I do things to try to be robust, and at the end of the day I look at it and I say hey, we have stops in place, I know that we can get gaps through them, but we've got a risk level that I'm comfortable taking knowing full and well if I trade long enough eventually we'll lose most of what we have at risk someday - if you trade long enough. It will probably take 3 generations of my trading for that day to occur, but it could occur tomorrow. The idea is that there's a business side of things and a trading side of things.  

For my own trading, what I realize is that I don't put every dollar that I could put into our program into the program because if something like that happened I would want to have dry powder left that I still could invest. To me it's the idea of, look you can't take risk out of your existence, particularly financially. Those Weimar Deutsche Marks don't spend very well these days. You just don't know what the next 10 years might hold, even 5 years. The one thing that you can probably be assured of is things will happen both good and bad that are better and worse than you imagine could have happened. So that having been said, we take a risk level that we're very comfortable with 

Our money is at risk side by side with our clients’ money. I am a big believer in the barbell strategy which is very little money at risk, but the money that's at risk is in the most aggressive things that it can be in. In our strategies, Brince and I both, we put all of our money in our Optimal strategy. It makes very little sense not to, because ultimately with any manager, any investor, any anything, everything you invest is at risk. You might think, oh this guy's never had a drawdown, or this thing's never happened, but you put a million bucks in, you got a million bucks at risk. That's probably the biggest mistake, in my opinion that allocators make. They are obsessed with percentage returns and they forget about dollar, and they say this thing has this volatility or this other thing and therefore I'm going to put 10 million dollars into that, and I think it's an inarguable point that you shouldn't put 2 million dollars into something that is just 5 times as aggressive. 

Niels

Now, I wanted to not spend too much time on research, because we've talked about it already in a sense, but I do want to ask you one thing, and that's you're so long term. In fact your models can only generate a signal once a week, so to speak, being so long term I would imagine that it could be difficult to...and that means also doing so few trades relative to other people, so I am imagining that actually finding out what to do next in terms of research, because it will take a longer time for you to see the results of what you have already done, looking at the trading frequency, or at least that's my impression, what does the research cycle look like in your world and where are you looking at the moment? 

Scot

Well, I don't know that your original premise is necessarily the case. Frankly, when we're looking at say 50 markets over 30 years of doing our research, that would be 800 market years, there won't be enough real time to conflict with what those results are. So in our research we try to constantly follow a process that looks at the strengths and weaknesses of what we do and tries to further enhance the strengths and tries to mitigate the weaknesses. The initial process, we try to have open Socratic discussion, and then if there is something that reaches a more formal stage, then we try to be pretty adherent to the scientific method with it, writing an hypothesis, and determining what tests will be done, determining what would prove or disprove the hypothesis, and then moving forward from there. 

Niels

But as a pure trend follower, if I can call you that, where do you see the weaknesses, in your opinion? 

Scot

Well we're going to be weak at the end of trends. We could perhaps be better at short trades. We're going to be weak in sideways markets. If there's a trend and then a sideways market we're fine, because we're just going to be in it and sit there. When it's a sideways market that is electing signals, that's when we're going to lose money. We're going to tend to be weak in downward trending markets that have short upward spikes that would elicit signals. But as you noticed, what I keep having to mention is the word elicit signals. So lots of times we'll look at things like spike up, nothing really matters until it elicits a signal. How is the balance between eliciting fewer signals...there's also some advantages to taking more signals. So those kind of market environments, how do we do in those periods? Are we mitigating our losses as best we can or are we maximizing our whims? What I basically found is that if you were a cotton trader nothing really mattered other than how you traded that move up to almost $2 a few years ago. You could have traded the heck out of it for $.65 to $.73 your whole life. But if you got on the wrong side of that, you lost everything, and I think Billie Dunn actually did, every nickel you ever made you lost. So if you're a mortgage trader, it doesn't matter how you did other than 2008, did you get out? I'm a pretty big believer that it is the handling of the large moves that is sort of all that matters. When we take a losing trade, we lose in essence one unit of risk. But a winning trade might get up, I might be up 40 units, and my stop might be down at up 20 units, well that one trade is the equivalent of 20 losers, and if I got twice the position size on, that might make a 40 unit..you see what I mean? So it's the management and position size and stop, that kind of stuff, it's the management of your huge winners those are super impactful. How can you manage those better intra-trade that kind of thing? If I were able to avoid 5 losing trades, well if I could just capture a 1/4 of that extra profit on that big one, that eviscerates those five losing trades. 

Niels

What's a good win ratio for you? 

Scot

30%, 33% 

Niels

On the more business side of things you mentioned that Nashville is a difficult place to...I mean great music, but a difficult place to be a CTA and we talked about the long timeframe and the patience that you are asking investors to have, which doesn't make it easier. Is that your biggest challenge that you have? How are you overcoming this? 

Scot

Well, we don't have any desire to ever be the biggest manager in the world, that's not our goal. 

Niels

Let me interrupt you then and rephrase a little bit, because in a sense you have a great business today. You've got lots of assets under management, and you could argue that with the clients that you have you don't need to be bigger, but, a little while back you definitely wanted to be bigger and you had the same challenges meaning you were still in Nashville and you were still long term, so how did you overcome it at that time? 

Scot

The reason we need to be bigger now is that you know that whenever you are in a losing period you are going to lose clients, and you never know your main contact at a big fund the funds takes another job, or retires, so you need to build a buffer in and we wouldn't mind growing once again. In fact our Original and Aggressive and Optimal programs, if you normalize their size Original, if they're at 175 million, we probably wouldn't mind being 500 million. So there's more growth that we would like to have. 

Niels

So how do we get there? 

Scot

How do we get there...you have to understand who we are and who we're not. We have to understand that we're a boutique, we're going to be attractive to certain people, and there are other people that we are never going to be attractive to. We do not spend any resources or time or money or whatever trying to chase those people. I do not have a science degree from an Ivy League institution, nor am I going to. I could hire a bunch of people who did, but ultimately that's just not a place in which we're attempting to fight. We think that we're a very attractive option for a certain number of investors and that there are enough of those investors for us to manage the amount of money we'd like to. So we need to make sure that those investors know that we exist, so that when they decide that they want some exposure to what we do, that they're aware of us and that they have a positive image of us and that they have an accurate image of us. 

Niels

What do you think that investors like the most about you? Let me put it this way, when you do get investors on board, what do you think convinced them that this is something that I should be invested in? The trend following space, it can be very, very hard to distinguish one strategy from another. They can, on the surface, look very similar and yet they're probably not. What do you think people latch on to when they look at you guys? It could also be personal - personal reasons. 

Scot

Other than my charming personality...ultimately we've done better than most trend followers, and I think ultimately that's something that people are attracted to. I think secondly, and maybe even primarily, in addition I think there are certain people that are attracted to the boutique. There are a lot of academic type articles that have come out in the last couple of years that makes some pretty strong persuasive arguments for managers that are exactly the way we would define boutique. They're small enough to still be able to be nimble us their trading strategies, but they're large enough that they're not working out of their Mom's garage. There are some pretty strong arguments there. So as those people, if you are a fund the fund, or allocator, or somebody like that you're trying to differentiate yourself from your peers, they have to look at it and say if I go and invest with the same 8 giant managers, I can't do better than the guys that I'm trying to compete with. So I have to offer something different. If you are a huge, and these aren't really the people that we go after, but if you are a large pension kind of person, you might look at it and say you know what, I've got a lot of trend following data from these giant managers I can get that through one of these 1 and 0 mutual funds, I'm going to go out and get a group of more specialized, or of boutique guys that maybe deliver a little bit different return stream. The other thing that we found we have the most success with is that the closer we are to the person who's money it really is, the better we tend to do. So if you're a consultant that's consulting a fund the fund and there are 9 different intermediaries between the owners of the money and the trades being made, that doesn't tend to be our best prospect. But if it's your money, they tend to like us a lot better, because then they aren't thinking about how can I explain this to my investment board if it doesn't go well. They are thinking, does this guy have my best interests at heart? Is this guy honest, and does what he is saying make sense? I don't hear that as critical of one or the other. They're far different people with a far different set of motivations, but we have found that the closer we are to the actual money the better our message sounds. And so it's our job to run our business economically enough that we don't need 500 million dollars to run it. That we can thrive as a business with 50 million dollars, so we try to do that, and then we need to make sure that the people who will find us interesting know about us. 

Niels

Speaking of investors, when you meet them, when you talk to them, what are the questions that they're not asking you that you think that they really should ask you? 

Scot

I don't think that they ask enough qualitative questions. 

Niels

Like what, give me an example? 

Scot

How many parameters do you use in your method? If you changed your parameters by 5% what kind of effect does that have on your returns? Let me see your back adjusted returns. OK, now I want you to change this parameter and this one by 8% one way and 4% the other way and let me see those. 

Niels

Would you do that? 

Scot

Sure, because now I'm speaking to robustness. Why did you pick the number that you picked? Meaning if I'm using a 50 day window for whatever, how did I pick 50. Well, how did 49 do? How does 45 do? How does 40 do? What you're really hoping for there is a smooth kind of plateau, and hopefully they've picked in the middle. That vein of question that pushes out for repeatability and robustness as opposed to, how do you protect your server? What if somebody breaks into your office and get's Jonah's laptop? Again, those are fine questions, you need to follow up on that, but there does seem to be a bit of...we'll have entire weekends on operational due diligence, and then the trading due diligence is...you get about the same thing every time. I would also say that probably they should have people with trading experience running those, not allocation experience, but actually have done their own trading, and then they could bring up other pitfalls. For instance, if we traded a lot, they should say how do you handle costs? We don't trade a lot, so the weakness of not trading a lot is, we don't get a lot of compounding...we don't get enough instances. So then they would say one of the weaknesses of your model is, since you...what I found in trading there's never a give without a take, so I want to minimize my cost to gross trade outcome ratio and to do that I'm going to have to give up the number of instances that I get in a given time period. Number one, am I even aware of that? I would guess questions along those lines. I think you've hit on some interesting things, like when did you make these changes? I think looking at a backtest of the current model in combination with the realized returns, getting into what were your luckiest periods? What were your least luckiest periods? If you really wanted to get into it I would take each parameter out, look at them individually, look at them, that might be asking too... 

The first thing that happens when people will come to me with their methods, and they're always short term, is I always say, OK, what's your winning percentage?  

It's always over 50%.  

What's your winner/loser ratio?  

Oh, it's 2 to 1.  

You make 60% of your winners; it's 2 to 1 and you do 6,000 trades a year.  

Why are you talking to me? Because if you took $25,000 and traded that for 9 months, you would have 86 billion dollars, and it's literally always something like that.  

Maybe that does work; I'm not saying that it doesn't but you certainly don't need me you need $25,000, in fact, $10,000.  

That's usually it and if it gets past that I'll say OK what's your first input 

I don't know it's proprietary.  

OK, you don't have to tell me what it is, but tell me what the edge of this input is? What is this input versus trades without this input?  

Walking through that piece by piece for each parameter. I would never take limited parameters.  

Do you trade this on all markets?  

No, only the S&P. 

Does it work on the Dow and the Nasdaq 

Hopefully, that one at least is yes.  

Does it work on Euro stocks and NIKKEI? Maybe you could make an argument that equity markets... 

Have you tried it on silver 

That kind of thing again towards robustness. 

Niels

I want to jump to the last section of our conversation. I call it general and fun, and it's partly sharing your experience, partly getting to know certain things about yourself, but I want to start off by asking, you've been there, you've done it. You've seen all the ups and all the downs. What advice would you give to someone aspiring to start today, 15 years after you started then with probably a different, it's a different ballgame out there today, what advice would you give them? 

Scot

Well I would talk first about their business plan. Do you have enough money, enough operational capital to last for 5 years without any income? If you don't you need to go raise that. That alone is going to solve a lot of your problems. What are your goals? How big do you want to be? If you want to be giant, do you have... you know they talk about the pedigree and things like that... at the end of the day was your grandfather rich enough for you to be...do you have those kind of connections that that's reasonable? If not, then you probably need to change your goals back, because I can promise you, you could return 30% a year for a decade... In 1999 if you had told me we'd do as well trading as we have done I would have thought that I would have had probably 100 times more money than I have. We've been successful, it's great, but if you said oh, you'll do this over this period, well I'd be well I'll have my own Learjet. First you have to be sure that you have enough money to let your business...I think about old Charlie Brown, that Christmas tree one, they hang the ornament on it, and it droops all the way over. I think of any new business as like a small tree; it cannot take a tire swing yet. And the needing to support a family and yourself on that kind of income from that business is like a tire swing. So by having enough operational capital that you can exist for 5 years, that's going to give your tree time to sprout roots and grow and not put immediate pressure on it. In the partners that you have brought in, if there is a team, do you have sales - a person who's more a natural born salesman? If so that's going to be useful. Do you have somebody that has a reputable science degree that's going to be useful? Can you program? I'm none of these things. In other words, look at me and then do the opposite, because programming is going to be an irreplaceable tool. 

Niels

Is part of your success, just out of curiosity, and this is with the warmest intention I ask this question, is part of the success in a partnership the fact in a sense that you and Brince actually live apart? Do you know what I mean, it's almost like in a marriage sometimes you do need to be away from each other to make it work. 

Scot

Brince and I were really good friends before we were business partners. Before becoming business partners, we spent a lot of time making sure that our philosophies and goals for the company matched.  And we still spend a lot of time every year going over what are your goals for this company, what are your goals personally, where are you financially. In our operating agreement, neither of us is allowed to take on personal debt without the others OK. I think we were pretty smart in laying that stuff out. Even though we were friends, we wrote every agreement down, because you forget. So our outlooks on things matched very well from the get go, and we have spent a lot of time making certain when we started the business we were both single, and I could live in a 55 square foot apartment with occasionally running water. When you start adding families and children, and as those things change, we need to stay on top of...before, Scot, managing 150 million was enough for you or is that too much? That's going to come with more time, how do you want this to be? We probably existed for 7 or 8 years before we hired our first employee and now we have them do things that we would rather not spend time doing, and we've hired them for skill sets that they have that we don't.  

I think being very honest in making sure that you fit (is important). There are definitely people that I like a lot as people, that I could never be business partners with, and if Brince and my financial goals diverged sharply, we'd have to really spend time talking about what that meant, because the size of firm you are going for is going to...if Brince said, you know what, I want to buy the Cubs, so I need to make 2 billion dollars. Well, then things are going to have to change and going to have to change a lot, and we're going to have to hire, and I don't know if I'd be necessarily psyched that would be very different. Or if he said Scot, I'd be perfectly happy trading 10 million dollars. Well, I want to manage more than that, and although I can remember the day when managing 10 million dollars seemed like, oh my gosh, if I could every just manage 10 million dollars it would just be...all of those things have to match very well on a business side, and the advice I would give someone is first you would have to go through your trading model like that, then you have to go through your business plan like that. But I would probably, if they had designs on being a 10 billion dollar firm, unless they were well connected and already had the things that help you go up that ladder, I would strongly discourage it. In fact in general I would probably discourage it now.  

It's a hard business, it pays a lot, it's like being an actor, it's hard and you're going to need some good luck, because you are not going to attract any money until you have a couple of lucky years, because you're expected isn't going to be good enough because someone is going to be getting lucky. So I think that rather than starting it the way that we did, it's probably advisable to spend some time working with some small and then larger firms than trying making those kind of contacts and trying to spin it out from there. 

Niels

Do you have any personal habits that you think have been part of your success? Something that you do every day? Maybe you're disciplined; I don't know what it would be. 

Scot

A lot of people try to make trading out to be something that is almost like mystical, and I'm sure in your travels you've run into that. I don't go for that. To me again it gets down to something pretty simple. You've got to have a non-random way of entering and exiting markets. From there, you have to appropriately risk given the amount of edge or non-randomness you can capture. The more you've got and winning percentage does come into play here, but the more you've got, the little bit more you can risk, and, more importantly then, you've got to have the discipline to follow the thing that you know works. The greatest poker player in the world, if he didn't make the plays that he knew were the proper ones, wouldn't be the greatest poker player. You've got to have the discipline, or I don't know if I have the discipline, so I've created a system rather than making discretionary decisions. Now we have hired someone that actually does the actual trades, and so that further gets it away from my emotions and one of the co-system creators, etc.  

Once you've got those things, and they are simple but difficult, I don't think you need to get into this super psychological, those things are great...I read an interesting book on the biology of trading and it went into the electrochemical reactions are going on and testosterone and cortisol and etc., etc. It's a very stressful endeavor, and it's unlike other things in that I can't just start working harder to try to do better. I think that probably good health in eating properly, exercising, are probably advisable. It is a profession that can lend itself to...I think you particularly want to avoid substance abuse, and there's probably, certainly down on the floor that kind of stuff was out of hand, but there's this kind of cowboy mentality that goes with it that is really a myth, you would particularly want to avoid it if you were a trader. I think that keeping your brain chemistry, keeping yourself healthy is something that I pay particular attention to and it's possibly helped me, but that doesn't mean that a 400 pound chain smoker couldn't also follow our system.  

I remember on the floor we would give them a few pretty basic... I think you have to have an analytical mind. You need to be good with probabilistic thinking...getting out of losing trades is pretty important, so you need to not be so arrogant that you can't stand...I mean I lose 70% of our trades, so you've got to be OK with admitting when you are wrong, but I think a probabilistic is the best way to look at it...if you take sports, if a coach makes a decision and the team wins, that doesn't make that decision right, he could make the wrong decision and the team could have gotten lucky and won. You need to think of it is, if we played this game from this point on 10,000 times, and he made this decision 5,000 and he didn't make this decision 5,000 what are the outcomes there? I would say if your general thought process lends itself to that way of thinking, you'd probably rather have that characteristic than not. 

Niels

I've only got; actually, two questions left that I wanted to briefly ask you. One is very simple, whether there is a fun fact that you can share about yourself? Maybe even something that Brince does not know about you that you spent hours and hours together, and know each other, is there anything that you can think of? 

Scot

I did not have a cell phone until I was 40 years old, and my wife was...I did not get married until late in life, and my wife was pregnant with our daughter and she finally said listen, this silliness has to end, so I am in general... I much prefer a pad and paper and a pencil to...I had to go out and buy this headset today to talk to you. I had Skype, but I had one other person on it. I had one friend that wanted me to Skype him to look at something and actually he was an aspiring trader, and he wanted me to be able to look at his computer, and so maybe the fun fact is that I didn't have a cell phone until I was 40. 

Niels

As long as you have an iPhone so that you can listen to this podcast on your iPhone that's... 

Scot

I do not have an iPhone, but am sure Android, or whoever does my thing will make it available for me. 

Niels

Fantastic.  Final question now, I asked you earlier today, what are investors missing when they are trying to talk to you and discuss things around you. What did I miss today, if anything?  Did I do you justice and Covenant justice in our conversation? 

Scot

I think so. I think you actually did a great job in hitting on things that I think are interesting. I think we did a great job of staying away from your typical due diligence. I don't remember mentioning a single statistic about Covenant, which I think is great. I think you have obviously done this before there's nothing that I can think of. I thought this was very well done. Conversational, low key, I don't like the hard press selling and over promoting and over trumpeting of things and I think we've been able to sit around and talk about Covenant and our history and trading and certainly offer opinions and things without banging our chest about some sharp ratio. 

Niels

Great stuff. Now before we finish though, could you tell our listeners where they can best reach out to you and learn more about you and Covenant 

Scot

Sure, the web site is covenantcap.com. I think the best way to get a general...it's written in the same method in that we have a lot of papers on there that we've written and various opinions about different things. We try not to throw up a bunch of statistics on somebody, if somebody went there and found it interesting and wanted to talk further about investment, I think a call to the head office in Nashville would be the second step. 

Niels

Great stuff. And of course our listeners can also find all of the details about our conversation today in the show notes for this episode on TOPTRADERSUNPLUGGED.COM and I also want to mention for those who listen to this who are on the mailing list, they will receive an email where there is a link, and this link can be used to say thank you to Scot for sharing his story, his expertise, and I really encourage you to do so, so let me be the first, Scot, to say thank you ever so much. I thoroughly enjoyed it. I think it was incredibly interesting to take a different approach, like we did today, but still be incredibly transparent and sharing your insights about what you feel strongly about. I think for people who listen carefully, they will have picked up quite a lot of really important information, so I do appreciate that, and I hope that we can connect at a later date and see how things are working out. 

Scot

Great Niels, thank you very much for your time, and I really like these interviews you are putting forward and thanks again. 

Niels

You're welcome. All the best Scot, take care. 

Ending

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