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.

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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.
• 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.
• 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.

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Resources & Links Mentioned in this Episode:

• An article on Covenant and Scot Billington in Futures Magazine.
• Check out Discretionary vs System Trading.

Follow Niels on Twitter, LinkedIn, YouTube or via the TTU website.

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And you can get a free copy of my latest book “The Many Flavors of Trend Following” here.

Learn more about the Trend Barometer here.

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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

Scot

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.

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

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

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

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

Scot

Niels

Scot

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

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

Niels

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

Scot

No, no.

Niels

Scot

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

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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