Welcome back to the second part of our interview with Scott Foster, President and Founder of Dominion Capital Management.

In this episode, we learn the philosophical rules that drive his firm, and how he bridges the gap between the philosophy behind his decisions and the models he creates. We discuss the increased governmental involvement in the markets and the adjustments that Scott has had to make to adapt to new signals. Finally, we learn the personal habits that help Scott succeed. Thank you for listening to Part 2 of our conversation with Scott Foster.

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50 YEARS OF TREND FOLLOWING BOOK AND BEHIND-THE-SCENES VIDEO FOR ACCREDITED INVESTORS - CLICK HERE

In This Episode, You’ll Learn:

• Why Scott does not worry about model decay due to the principals with which he runs his firm.
• How to bridge the gap between philosophy and rules.
• How he created the Sapphire program, his firm’s signature service, and what it took to create it.
• How increased government involvement in the markets has changed his system and made him adapt to new signals in the markets.
• Why and how political feedback and involvement are affecting the markets and short term trading.
• How his firm is able to so expertly predict to potential customers their drawdowns and how they contain them.
• That investors spend too much time dissecting the drawdowns and not enough time looking at why and how they made money.
• The principals of behavior finance and the underlying philosophical principals such as self attribution bias and loss aversion.
• How alone time and contemplation have led to 80% of Scott’s best trading ideas.
• The hardest part of being the President of a fund and why it is not the trading.

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Resources & Links Mentioned in this Episode:

• Learn more about illusory superiority, the bias that the Lake Wobegon effect is name after, or Lake Wobegon itself, a fictional town in Minnesota.
• Learn more about Mean Reversion, which Scott’s firm looks at closely in the models they use.

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 “Ten Reasons to Add Trend Following to Your Portfolio” here.

Learn more about the Trend Barometer here.

Send your questions to info@toptradersunplugged.com

And please share this episode with a like-minded friend and leave an honest Rating & Review on iTunes or Spotify so more people can discover the podcast.

Follow Scott Foster on Linkedin.

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Scott

... So that kind of is a long way of answering the question of how we staff our company and why do we do things the way that we do.

Niels

Scott

Absolutely. I often express my; I won't say unhappiness, but I think trend followers could do a much better job of explaining what they're doing. Everybody seems to want to be a scientist. There's nothing wrong with that it's just that...I gave a talk a few years ago in Monaco on this about the difference between what we would call black box and what I would call white box. I was trying to make a differentiation between some forms of systematic trading and some forms of systematic/algorithmic trading and the fact that the best majority of people outside, they're in the alternative industry and won't invest in systematic strategy because they don't feel like they have the expertise to understand them or the mathematical skills to, and I was trying to make a case that, well, as it pertains to the vast majority of managed futures, they're not black box, and the reason being is what are they going after? I tried to make a case that they're going after a universal. When you ask a trend follower why do you make money? If they start talking about formulas and all of this type of stuff, the question is (really the only way they can make money is if there are trends)...the question is why are there trends and why ought there to be trends in the future? A trend follower asked, how are you going to make money in the future? I think they should respond because trends cannot not exist.

What exactly in particular does that mean, well it's what you said, it's the fact that at least in a free society, markets exist to create efficiencies for the greater good and if the price of wheat...if we start running out of wheat, the price has to go higher...it has to ration the remaining supply, it has to ration the remaining demand, it has to increase the supply. It has to incentivize people to plant more wheat because we are running out of it and if we didn't have... futures markets were created for that purpose, and without them the prices of food would be fluctuating all over the place. At the end of the day, there are inefficiencies that you can arbitrage out of the market, and there are inefficiencies that you can't arbitrage out of a market. The ones you can't arbitrage out of the market are natural law inefficiencies. They are universals as you've called them, and I've called them. Trends are one of them. If you are running out of wheat you can't arbitrage that out, the price is going higher and nobody can stop it unless the government steps in and subsidizes something or gets in the way of it, the market will go where it needs to go until there is an equilibrium between the buyers and the sellers. So in theory and this is Austrian theory, the trends are necessary. There are short time periods, and this is what is hard to explain to people who are following trend followers because usually the timeperiods of equilibrium are not as long as they have been.

So there are times when trend followers...some of the markets just randomly happen to be fairly valued, and nothing changes that in the future, but unless we become perfect prognosticators, and you know exactly how much of any given commodity is going to be needed a year from now and exactly how much supply to create to meet that need, which nobody can know that. We tried command economies, and it doesn't work. There's no way to plan. You know socialist calculation has completely devastated the idea of central planning because you don't know. The trend will tell you what to do. The trend will tell you whether you need more wheat or you need more copper or you need more whatever you have until there's equal amounts so that everybody's needs are served.

Right now I think it's pretty obvious at this point to everybody that the Federal Reserve and government intrusion in the marketplace, particularly with suppression of interest rates, has been devastating for price discovery in pretty much off all traded markets. When you control the price of money, you control the price of everything. When there is a threat of constant intervention through regulation, taxation, and nobody really knows because the government and the Federal Reserve don't know where they are going with this. They pretend that they do, but they don't, and most businessmen know they don't know, and there's no exit strategy and so it's created an incredible suppression of price trends and it's created volatility with no direction. It's wreaked havoc on the markets, but eventually, if you look at it and say what is this ultimately? This is ultimately price control, and price controls ultimately create the exact opposite of their intended effect. The question is how long is it going to take? The markets will eventually go crazy. They are going to go where they need to go, where they have not been allowed to go. Hopefully, that won't be too far in the future so that the business is still around that exist to take advantage of it, but I think it's probably closer than it's been, but I probably would have said that a year ago. I think it's a certainty, it's just a question of how long can the government, and global governments keep this illusion up, because right now, as you mentioned earlier, the perception is, based upon spreads, yields on junk, there is no risk - the lowest volatility levels and fixed income foreign exchange ever. Stock markets just a month ago finished 40 straight days without moving a percent, which it hadn't done for 20 years. The market is not pricing any risk into the situation which is irrational, but irrationality can last longer than a lot of friends can stay solid.

Niels

Back to the magic, the perception is there is no risk. It's very interesting, but let me ask you this. First of all let me just say that I can imagine with the explanation that you gave about philosophy and universal truth, that there isn't that much room in a due diligence questionnaire to fill out the box where it says I believe in universal truth as one of my founding principles. Let me ask you then this question, if that's the case, and this is the way that you develop models, which is quite different from most other managers, is your model decay, which a lot of short term managers are saying that there is model decay in the way that they trade and maybe a model last 2 years, but is my understanding correct then that in fact you don't really see that as such, or at least not to the same extent?

Scott

That's true. Model decay is not generally something that I worry about. For me, for a model that starts to underperform what it has in the past...we tend to be a lot more qualitative about that. To give you an example of how one of our models might decay as opposed to somebody else’s models because again, we're not looking at... parameters in our models are not numbers with lots of decimal places to the right. They're mostly binary switches, if this happens we do this, if this happens we do this, if this happens we do this, because it's much more qualitative. It's almost like how a discretionary trader would trade a two or three day move in the marketplace based upon how he would feel like he's reacting to a bunch of other traders that are doing something. The decay would be something that is more tied to the structure of the market and very little to do with the parameter sets or other things. For example, quite a long time ago, we had some models that were trading off where the opening price was and back at that time period and for many years prior to that there was a real psychology about a gap. A lot of people have written about it, will the gap be closed, will this happen and so forth.

I had some models that I thought there was a reason why they would be under certain conditions overreaction on the open, and then I would go against that as part of our reversion strategies or repertoires and it tied out to this particular psychology and what was going on here. Over time, that model started to deteriorate, and you get to a point where, you're always reviewing performance everywhere, what's going on here, then the light bulb goes off. Well, as electronic trading and off hours and Globex started to become more and more prevalent, and as more people in Europe and Asia were having access to the same or similar markets, risk was being able to be transferred more effectively around the clock, so the pent-up demand on the open was slowly diminishing. There still is some, but it's usually retail people executing on the open while the professionals pull all their orders, and they create the big zig zag in the first 10 minutes. It's in different character than it used to have. When we understand that this is the psychology that we're doing. We're tying this out to this one principal, but the market structure itself is no longer offering us the opportunity to utilize that principal in this construct, then we make an adjustment to it. That type of thing isn't happening. It's not like all of our different models; we think that every day they're slightly deteriorating by .01%, and it's always a clock. I don't think that way at all, as a matter of fact nothing is more surprising to me when I dust off a model that I haven't even touched in 15 years, and it's at new equity highs. It's one of those things that make you feel great. Most of the times that I can track back to underperformance or poor performance for any stretch of time, rarely can be tied to a bad parameter set. Usually it's tied to a principle that wasn't fully tied out... you're always balancing trying to make decisions about things.

One of the biggest risks is changing anything about your models because you can have incredible slippage. You stop trading one model because it's doing poorly and then you add one that's doing well, but then all of a sudden the one that you just dumped has a huge recovery and the one that you got in does poorly and all you have to do is do that a couple of times in succession and you're looking at double your max drawdown and all your clients are going away. A process by which you implement changes is as important as the changes themselves. But a big part of that is understanding what's driving the changes, because things that are coming from a universal are a lot different than things that are coming from the particulars, in my opinion anyway.

Niels

It's quite interesting because obviously one of the changes that you made, you said earlier on was caused by the introduction of the Euro. So you could say that the markets, or the opportunities set changed, it wasn't so much human behavior that changed, just the fact that there were fewer markets, but it's interesting to note that you've actually done really, really well in the last few years at a time where many people haven't done so well first of all, but also at a time where you could actually argue that, as you mentioned, markets have been somewhat influenced by other factors than normal free behavior because of the actions of the Fed and other central banks. I don't know whether it means anything, but it's just an interesting observation when I look at your track record that even in the situation where human behavior may not be so freely expressed given these constraints that your models seem to cope with that very well.

Scott

There are times when a market is clearly telling you that this market is not particularly subject to those types of emotional movements because it's in a state of equilibrium. Then if something does happen to jolt it out of equilibrium then it may enter into a type of environment where it's expressing these characteristics that we specifically are looking for. So we've learned to become extremely, we always were a low volume trader, but over the years we've become even more low volume. For example in the last 5, 6, 7 years, we've averaged about 1,700 round turns per million. That's, as you know, incredibly low for short-term trading. I think the average would probably be closer to 5,000 or 6,000, but a lot of traders are doing 10,000 to 15,000 round turns.

Niels

To me that sounds like that you are filtering out the markets where essentially there are no opportunities or as you say they're in equilibrium. What I want you to try and explain, from a system design point of view, how do you get to that point, because at the end of the day we need to bridge the gap between philosophy and coding, or rules and so how do we do that? How does it actually work when you look at your program and the structure and doing all of this in practice?

Scott

In reprogramming I tried to do some very unusual things in terms of how you go about allocating revenue and just saying here's the portfolio, how do you make it dynamic by using principles? How do you quantify things and what can be quantified? I get asked questions like this often when they say well you've listed a whole slew of qualitative things, how do you get from qualitative to quantitative? How can you every systematize half of these things that you're talking about into something objective that resembles this? It's like trying to get something to quantify how happy are you, is it a 6 or a 7 or a 9, it's very, very difficult to do that, so how do you make that transition. Well for allocation purposes we look at it in the sense that we believe that, in terms of what I was just talking about being in environments. It's just not that this is a good environment, or this is a bad environment. Because the environments for us that are constructive are ones in which a market is, for lack of a better term, it's emotionally charged. There are a lot of people with strong opinions and a lot of invested interest if the market moves too much one way or the other, so everybody is on pins and needles watching this thing. We're concerned about which way it's going to go and there's some uncertainty about it, so there's a real need to transfer risk and that's obvious because what the market will do when that happens and everybody knows this is volatility tends to increase and the increase in volatility is starting to tell you that something is very interesting. Now the interesting thing about volatility, however, is that volatility is both very persistent and yet mean reverting. That's simply because volatility as we know it generally is associated with uncertainty and the only thing that is uncertain are people's perceptions of things. People's perceptions don't, unless you have some type of significant illness, you don't get really happy one minute and really sad the next, and really happy the next minute and really sad the next, you transition.

Volatility in markets tends to trend higher over months and then it trends low over months as people are constantly reassessing and figuring out what is going on and becoming comfortable with what is going on, or whatever is going on is resolving itself. So volatility doesn't spike one month in crude oil and ten drop the next month, and spike a month and drop, it trends higher and trends lower, yet it also mean reverts because there are limits on high a low volatility. This is not just simply looking at past history and intuitively if volatility is tied to human behavior, that's what you would expect it to be. Your human behavior and emotion tends to go from very sedate to there's a certain amount of excitability that you can pretty much maximum express you are going to bounce back and forth between those and it's going to trend up and trend down and so forth. So if that's true, and if that is the nature, and most people won't debate with me simply because empirically it can be shown to be true so easily, but for me there's got to be a reason behind that, not just because the data says. If that's true then we generally know that we are very streaky in our trading. When a market comes into play we may make money in a particular market for 3, 4, 5 months in a row and then if whatever conflicts that are erupting in that market come to be resolved then there is less of an emotional footprint in that market. It usually corresponds with the pattern of volatility.

So for us we are very certain of the persistence of our performance because of human nature. It's not because we have gone back and looked and said gee; this is really interesting. We tend to make money 3 months in a row and then we lose for 2 and then we make it for 6, and then we lose for 4. We know why it happens, but if something is persistent, it's an inefficiency, it's exploitable and if it's a natural law inefficiency it can't be arbitraged away, so we can exploit it without having a negative impact on our trading. So we exploit it by, as we...we lose money as a market becomes less emotional and so forth, so as we lose money in an individual model or market, it goes into a deleveraging phase, and we start taking money off the table. I'm a blackjack player and I used to have a lot of fun counting cards and doing all of that stuff, and basically what money management is, is that you want to keep the minimum bet on the table until the odds are in your favor and then you want to take the rubber band off the bankroll. Well, we know that when this footprint is starting to deteriorate in the marketplace for us it's going to be persistent, and so we feel very comfortable de-allocating to that model/market as that's happening. Now if something intervenes suddenly and hits that market and makes it excitable again, some new fundamental or something, whatever it is, every winning trade form there will reallocate it back up until it gets back up to a full allocation scheme.

This is something that would be difficult for a trend follower to do even though they are operating off of a solid principle, I believe firmly in trend following because it's my own systems trading my own money, I worked for a firm and all that, but in trend following because of the nature of your winning percentage and your payoff and so forth, it's very difficult to keep de-allocating to a market and then possibly miss the one huge trade where you de-allocated, but that is not something that I have to worry about. There's very, very little slippage in my doing that. There are bigger benefits to this type of money management scheme of being opportunistic where for a while some markets can just get quiet and not cooperate and yeah it's great to be de-allocated to them for a while, but the more important aspect to it is that you don't end up having all the post-dictive errors in portfolio construction and in adjustments to your models. This was the bigger reason, philosophically why I went in this direction. We all know that now everybody...there doesn't seem to be anybody that is putting together any kind of portfolio that has gold and silver, and this and that or the other thing. 10 years ago, before the Bull Market started, nobody did. This is all post-dictive. It's very easy as a trader to design a portfolio simply because it's the one that worked best in the past.

Often at times when a market doesn't behave in a way that you are accustomed to it behaving you can figure out what it is down the road, but you've lost a lot of money in the process. But then as a trader you know, having done it so many times before, if you suddenly pull it out of the portfolio, it's going to go on a tear. So you are in the conundrum, what do I do? Do I leave it? It really toys with you when you have disappointing things, different disappointing instruments and disappointing particular models in certain instruments and you don't know, am I going to just keep trading this and lose money forever, or is there something in this market that's different or is this just a regular drawdown? When we build our portfolio it walks forward and it automatically handles that so if a market where to turn to be a horrible trading market for 5 years in a row, our models would have it de-allocated down to a certain level and then it drops out of our portfolio and goes into a simulation basket until it improves enough to be worthy to go back in. Meaning until it goes back in play, and people are interested in transferring risk in this market and it has those characteristics.

Niels

And what allows you to do that is the fact that you are short term. You have many trades, many observations unlike a longer term manager where essentially if you were doing that and you were waiting for some level of profitability in the signals you might actually end up being way too late because you have so few observations.

Scott

Theoretically it's impossible to create a filter to stop it because by definition it will not repeat in the same fashion. In other words if somebody goes every day and gets coffee and then throws it on the ground you might think that it's silly. But if they do it every day you don't think much about it. You think people are crazy when they do unpredictable things, and they don't know what to do. One day they're going to walk outside with a garbage can filled with goldfish or something? By nature the irrationality side of it, the universality of that irrationality side pretty much says that you can't create a filter and stop it. I thought to myself if there's actual volatility in its movement; it is a reflection of human action, so what is it telling us? Then I began to realize that it's telling us the same thing from a political perspective rather than a market perspective. The way that I try to explain that to people is that we're looking at these momentum shifts in the market place and we require very specific setups because in prospect theory we want people to be under duress when we are doing our trading, and so we're very specific, we don't just simply trade momentum, because momentum happens, we trade it when it's in a particular environment under a particular setup under very particular situations. The market place, the way we explain that is that when a market begins to increase in momentum to us that's telling us that there's urgency in the market place. That people are less concerned about the price that they execute; they're just concerned that they execute. It's the get me in or get me out order. So they're being emotionally impacted. They're not getting the price; they're just throwing in the towel, and they're having to adjust, or they mispriced the market or whatever. It's telling us that people are doing things in a way that they wouldn't prefer to do them, but they're having to do them that way.

So this momentum increase is a feedback loop, because if you are trading, for example wheat and you are watching the wheat market and the movement in the wheat market is the sum total of all the people that who are watching the wheat market who know what is going on in wheat and who have ties to the cash, and you're watching it and you're doing it and it's a feedback loop of everything all the market participants know about wheat. So generally, when you get certain bits of momentum or volatility, it's significant because all those people together usually don't misprice the market so dramatically that it just creates chaos. That's not normally the way it works. There are mispricings, but they tend to be small to medium not gargantuan like, oh geese, wheat really should be double the price, or maybe a small mispricing. What happened when the government got involved is that now everybody is watching the wheat market, but it's no longer a feedback loop of the wheat market. It's a feedback loop of what did Bernanke say, what did so and so say and then the wheat trader watches the Fed announcement and runs over and expresses himself in wheat.

Niels

So if I'm trying to understand what you are saying. Clearly the norm would be to get some kind of follow through from the point of entry and to capture a 2 day, 3 day move, but obviously what I've also observed myself from the markets in the last few years is that certainly in some markets, maybe not all, there really has been a lack of follow through, maybe because of the noise, of the media, and statements, and this and that. So the changes that you made and I'm just guessing here, but is that more to do with the fact that you don't just look for the follow through or the momentum in a direction but actually now you are also trying to capture the mean reversion side of things when things don't work out?

Scott

Correct. We've casting a lighter net to allow for the greater degree of variation and the amplitude of these price movements because it doesn't take for the psychology in a market to...we've always been an under 5 day trader, and we're rarely ever making it 5 days out, but usually 2 to 3 and the reason for that, which makes complete sense to us is that's about all the time it takes for all of the market participants to react either in favor of or to deny the movement has any legitimacy. So as the psychology roles around the globe, and everybody adjusts to the new price level due to the mispricing or what have you, or everybody having to exit a position, so I've always been asked the question, well, if the market just keeps going why don't you just hang on to it and ride it for another week or two if it's going in the right direction. The point is that we don't do that for 2 reasons: One is we're not looking to capture trend and that's what that would be, and two momentum can only exist generally in a short timeframe because for momentum to increase it's got to be that the market is up 1% percent, the next day it needs to be up 2%, the next day it needs to be up 4%. Those aren't exact numbers but the point being is that it has to keep going, and it will exhaust itself literally...for momentum to increase for 5 straight days is almost impossible. So the psychology behind momentum, if it starts to wane then it will cause you to reassess what you are doing. So for us the momentum has to continue but out of necessity it's only going to go this far. The problem is that, that's the way it exists naturally in a natural feedback loop to regular market, but the political feedback is a little bit different, because it has no tether.

There's nothing that it says that it can't change. If there's a sudden adjustment in the price of wheat, pretty soon everybody can figure all the possible outcomes, and you can get that resolved within that 3 day time period. A lot of the markets that are being impacted by the Fed and by the regulations and so forth, they're not tethered by that so they have some very weird characteristics. They're too sharp of movement and too much of a retracement after the sharp movement for a trend follower to catch, but they're completely out of character for the really short term guys, because that's not normal. If you get in and you get a move, you expect if I buy on this little bit of a move I'm going to capture 10 ticks or something, in the bond market in might be 20 ticks, you don't think that you are going to capture 4 handles. But if you get a sudden shock through the system, and that's the way the market's, are reacting how do you find a middle ground? It would be like a 6 hour conversation to try and explain it, but it can be done, and I think we've done it.

I know everybody is always concerned about making adjustments to trades and making adjustments to your strategy, and I think everybody has been pleased with the adjustments that we've made because we haven't changed any models. We've changed how we implement the models. No parameter changes, no anything on that line. We have just lined them up differently on the table in how we throw it at the market and how we view time and how we view risk and how everything works together, and it's worked out well. We were having a good run prior to that, and we've had a good run since. We've beat the long and short term averages 5 out of the last 6 years so on alpha generation we've done OK, but I always challenge people, if you are concerned, do what I always say, which is look at our correlations. Our correlations haven't changed at all, and our correlations are not just the fact that we're none correlated to everybody, every benchmark manager, fund, strategy, market that you can find. It's that we have very specific negative correlations at extreme which, I don't explain it well enough for them to see how the prospect theory and the decision making under duress impacts our overall strategy, then look at the data. If other people are having rough times, that's when we ought to be making money if we're doing what we say we're doing, and those correlations at the extreme haven't changed at all.

Niels

In trend following, many people actually say that position sizing is actually probably more important than the entry point and the exit point because of the time frame. What would you say is the most important of those three entry/exit position sizing when it comes to short term trading?

Scott

Niels

How many models or setups, however you describe it do you actually run in the Sapphire program?

Scott

We have always used the terminology that we have two strategies in the portfolio, one is directional momentum and one is mean reverting momentum. If I just stopped at that, that might describe at least a dozen other short term traders. So obviously though that's the easiest way...I don't particularly prefer to be called a short term trader because short term is not a strategy it's just a timeframe. What we do, compared to other short-term traders would be like putting a stock trader and a rental property...they're apples and oranges.

Niels

Also, in a sense, whether these setups, because we are dealing with human behavior, whether they're the same regardless of which markets, whether they apply to all markets?

Scott

They are the same for every market. We don't have any special anything for any one given market. We have the two strategies, but within those strategies we have a variety of variations, and the variations are based upon different persistencies that we see in the marketplace. They're not there for any kind of serious diversification because they're not. We can get more diversification in other ways. For example, for us it's as important...actually it's more important than the parameters of the model or even the particular setups as to what data are we analyzing? Are we looking at 24-hour data? Are we looking for a pit session? Are we looking for 1/2 of the pit session? Are we looking for the pit session plus 2 hours? We look at how we analyze data as being probably important because for us the data has very specific feedback implications to what we're trying to find in the data. So, for example, for us, I know that some traders are very happy to exit positions or enter positions at certain hours that we would never consider doing it because we don't believe that the market has the information that we need. They're probably doing it for the exact opposite reason because the market's mispriced because it doesn't have the information.

To give you a small idea of how big this is for us, we trade the NIKKEI on the Simex and the NIKKEI Osaka contract. Other than the fact that one is two times the size of the other one they're identical. However, we have different opening times and different closing times on those two markets that are not substantial, but they are different. We have no official open and close times that match anybody else's or any exchange. We build data to meet what we think makes sense. Just to show you how important that is. The two different NIKKEIs just having that small amount of difference have a .27 correlation in their performance. So we do not have any problem at all getting non-correlation even out of the same market. We can trade multiple versions of the same market and multiple models of multiple versions. The question is why and how do you piece it together so that it makes sense with your theory, and it's giving you what you need to know? So to answer your question, we make every market as open to a potential 48 different individual models, 1/2 of which are directional and 1/2 of which are mean reverting. It's not like you get all those orders all of the time. We have a whole process of going to the strongest models and markets at the time that are giving us the greatest expression of what the psychology has happened at the moment.

Niels

I want to jump to a slightly different area of risk management because I noted that you have some very clear guidelines of what you expect in terms of drawdown. I noted that you said that I think 80% of your drawdowns should be less than 10% and only 10% to 20% of your drawdowns should be more than 10% and you've, as far as I'm aware, that's exactly how it has been over a very long period of time. How do you know that, that's going to be the case, because this is something that I saw a very, very long time ago, this is not something in some of your recent information, but the fact is many, many, many years later this is still the case and in inherently volatile, uncertain, unpredictable world it's pretty good to be able to be so precise and delivering that.

Scott

Niels

It's almost kind of ironic that this is clearly something that is a very strong side to your strategy and your business and it's kind of ironic thinking of that when you go back to the story that you started out telling about your near death experiences in the risk management side, so you clearly learned something from these horrifying events very early on.

Scott

I have to stay in the game.

Niels

Yeah, exactly. Just out of curiosity we talk about drawdowns here. Although they're not, at least in my mind and compared say with equities at 10%, 15%, 17% drawdown is obviously not something to worry too much about but investors do worry about drawdowns and managers as well and it is an emotional roller coaster to go through these experiences, but given your philosophical background, I wonder, do you take a completely different approach in term of the emotional side of a drawdown if I can put it like that?

Scott

I certainly try to. I think overall, at least from what most people in the office tell me, I'm pretty stoic about it. I wasn't in the early years. There was a lot of fear. It's not that I don't ever have any fear when we have a drawdown; it's not at all destabilizing. Anytime you spend most of your time, not on equity highs. I have in my mind mental alert levels that are just roughly down every 5% to where I want to go though, and I want to check certain things, because I have certain expectations. I've also learned the hard way that you can't get to a 20% drawdown without it first being 5%, and even though a lot of 5% drawdowns don't mean anything. They are random, and it's just part of the distribution of the P&L of the trades going forward. I do know there are times where I've realized I could have, should have, would have, where there were a few things that were not where they should have been. The way our application of what we are doing was less than optimal, and it could have been more optimal. That appears early.

I'm a big believer in the trends of your internal numbers. Not the internal numbers themselves, I could care less about 1/2 the numbers that people ask me about that they think are significant. To me the questions are, are the trends in the numbers? Because they often are anticipatory of something that is going in a certain direction. When you get enough lined up it can hopefully be something that will teach you to get on track before it gets too far out of control, because it's very, very difficult to recover once you get down past that 20% level, not only does it get difficult to recover, but if it's down 25% or down 30% that you are making amazingly different adjustments to your models you are going to also miss out on that natural mean reversion you're performing. So you find yourself in a very difficult spot, so you don't want to get down too far in the hole, but you also would like to see the process possibly unfolding before it gets there. Sometimes it will look like it at times, and it's not the case, but more time than not the solution is before you, but you don't see it because sometimes it's masked. You could be making money every month, and a few things were better positioned maybe you would have made more money. You're just happy that you made money and maybe somebody else didn't make money, and so you don't dig through the details and say, well gee, I was making money because XYZ markets were just awesome, but these three models over here are generating or something's happening and it was just masked by a good run. So trying to do metrics that show us the internals if you want to call them that or some things that are not quite focused correctly has always been a huge help for us getting off the track too much.

Niels

Do you think investors spend too much time trying to completely dissect drawdowns and actually not so much the good runs, meaning really understand why you made money as much as trying to understand why you lost money?

Scott

Yes, they spend a lot of time trying to give color to whatever they're transmitting onto somebody else, and quite often in the process of collecting information, most of which I don't think is very relevant, they often miss out on some of the what I would call the obvious questions. Even if they don't have the question, you can tell quite often from somebody what they think is driving the P&L, and it leads to all kinds of confusion and at times bad decision making. When you see that this guy is making money, and this guy isn't making money. Making money doesn't make you a good manager. Over time it does, but in the short run you have two trend followers and one made money last year just simply because portfolio allocation to the one market sector that happened to be more which is completely random and so you fire the one guy and you give some more money to this guy. Well then the next year he's not going to be so lucky at having more risk in the best sector and you get a lot of trading traders and not asking the real questions of what's really driving the differences in their performance. Is it something that is intrinsic to the strategy itself or is it the portfolio allocation, is it because they are more highly leveraged? There is a variety of things. It doesn't take much to pull that out of the data.

We're empiricists after the fact in our office. We love to look at things after the fact because 99.99% of the time you generally ought to see in reality what really is true. You can be fooled sometimes by things. There are exceptions to rules, but over time, but when you look at somebody, and they say hey we're a short term trader, and you ask but why do you correlate to the long term trading index by .67? Obviously where you are getting your alpha has a huge overlap with the trend guys. You can learn so much about what somebody is actually doing, what their exposure is, what sectors, by being reasonably smart about how to dissect the data. That will tell you a lot more than probably 98 out of 100 other questions that you would ask a trader. You can see, and then once you see that, it's a lot easier to say, is what this person is saying, does it match with what they are doing?

Niels

Tell me a little bit about, just before we go to the last section, I just want to touch a little bit about research. Because clearly the way, you approach trading is quite different so I would imagine that the way you approach research is quite different. What would you say is the key things that people should understand from your research process that helps set you apart?

Scott

So when you have even professionals miscalculating their own risk tolerance in all risk sectors of the economy and all things, not just trading. Trading just intensifies it. Then you combine that with other principles like self-attribution bias, the Lake Wobegon effect where all kids are above average. Every professional you know in the financial world thinks that they are above average. Well, we can't all be above average. We definitely attribute to ourselves and our own opinions much more than probably would objectively be deserved. You throw in there anchoring and confirmation bias, and so when you put these together how dangerous it becomes and so the point is, when we are focusing on this we are focusing on capturing in the market place the unwinding of that, and that's what's driving the correlations and it's always going to be there unless people suddenly...the decision making and human nature suddenly does a 180 degree turn from the last 10,000 years of known history. We don't believe that it will so as long as we can stay on task in terms of adapting to where the risk transfer is going on, where the excitement of the human drama and play is optimally able to be observed and watched. It's funny, because that is where behavioral finance...that why it is behavioral finance. It didn't start as behavioral finance; it started studying this, and they realized that they can more clearly understand the decision making process when people are under duress - Kahneman says under “risk”. That intensifies it so that it's easier to see the bad decision, or if it's a little minor thing, and on and on.

So when you start doing these experiments, they started making it more financially significant, more about XYZ, and then it worked right into the financial markets, because what is more stressful than leverage? With a lot of money, your career is at stake, and the market is closing in an hour you have to make a decision. There's no way out. If you're fighting with your wife, or if you have something else going on that could impair your judgment, you don't have time to work it out, you can put it on hold, you can wait unit next week. In almost any other profession, you can put it off for a month. You can't here, so it makes a perfect laboratory to show how these principles operate that traders 100 years ago, the good ones anyway, were able to discover and understand and utilize. Now it's just a more formal way of describing it. Trying to get people to see exactly what it is we're doing so that the expectations...there's nothing worse than having misplaced expectations one way or the other in the financial relationship. Here's what we do, this is all we do.

Niels

It's quite interesting actually because it would appear to me at least that in the last 5, 10 years the CTA industry has clearly shifted towards European managers and I think they certainly present themselves, and probably structure themselves with a much more scientific approach to research and trading, but it's quite interesting when you talk about the way you've described your approach today, because people coming to do some level of due diligence I would think that it's much hardy for them to understand the science behind what a lot of these very quant driven funds are doing and obviously the inside of all the algorithms whilst your approach is actually, to a certain extent much easier to explain, because it's based on human behavior which we all know, even though we didn't study it, we all know what pain feels like. We all know what gain feels like. It's just quite interesting that money and investors tend to favor the more opaque science rather than, the more human nature. Maybe it's not sexy enough to say that it's based on human behavior. I don't know.

Scott

Niels

The last section I want to jump into, and I only have a few more questions that I want to touch upon, because we have already taken a lot of your time, but I call it general and fun and I know that you have actually shared a lot of personal stories which has been quite fun and interesting but I wanted to ask you whether you can think of some kind of personal habit that you might have that you think actually has helped in your success? Something that you might do on a regular basis that you think has actually been beneficial?

Scott

There are a lot of things. To smush them all together to try to put it in a time period that the commonality of things that I think are really beneficial to me are shall we say, downtime. More specifically alone time - time to think, time to recollect, to read, think about life, trading, everything from religion to politics to whatever. I get very cranky if I don't have some time to decompress in that regard and think about things. Everybody that I know of that has some kind of down time or alone time usually has some of their own routines that they want to do. I do as well, and some of them are personal and so forth, but that to me is very important. I have to cool the jets a little bit. At times, I've been able to, when your job is one of your hobbies, probably your biggest hobby, and it happens to be turned on 24 hours a day, it takes effort to do other things. I used to do them...some of the weird things about me I always have unusual hobbies like magic which we've already discussed; sleight of hand; also juggling - I used to juggle in my office all the time. It would help me think. It was just enough of a distraction to not be distracted by things that aren't important. Somehow it kind of cleared a channel path and so I do that.

I also taught myself to ride a unicycle when I was little, but I never brought that into the office. I was always trying to find these challenging things...I used to do the Rubik cube and see how fast I could solve it. When I got involved in trading here's the thing that everybody says that 98% plus get wiped out, and they can't survive, so I say hey that's the perfect thing. You want to do something to challenge yourself and so over time I realize that when your schedule finally gets...that's one of the reasons I'm not anxious to move back to a city because it will just fuel my desire to go around 24/7 as opposed to I'll go home today and I'll probably go sit out on my dock and look out at the water and have a cigar and sit and think for an hour. That kind of downtime is just magical to me. My wife always jokes with me about this because she says I really have this task I would like you to do and to me sitting isn't relaxation it's actually work because it not only helps work, but it's part of the process and how everything...how the glue stays together. 80%, 90% of all of my best trading ideas thoughts have come out of those time periods. They never come when I'm sitting in front of a computer. They never come from looking at a stack of data outputs and printouts, and that's actually toxic for me. That doesn't solve anything.

Niels

What's the hardest about the job that you do as a fund manager and what do you find the hardest?

Scott

It's that it's just not trading. If it were just trading, it's one thing when you are managing expectations of clients and employees and you're also juggling around with future obligations that you never know what to expect XY, I didn't know it when I first started the business and when I was in Chicago, being with my partner and my partner handled all the stuff within his firm and so I left to come to Michigan and I basically really took over the role of CEO, even though I just added the title part of that, and I realized how much I didn't know about running things and more importantly, I think at that point we had 23 employees or something, how much you impact people's lives and this is their career and it's important to them and trying to communicate to them and be able to manage a relationship and productivity and expectations and so forth, without ever having done that before it was quite a learning curve for me. Since that time period, I've learned a lot. After a while you learn how to deal with different situations, no different than when dealing with children or dealing with personal relationships only time helps you get through it. That's the biggest challenge. I can talk myself out of any market fear, but I can't, when you have employees or clients, and they don't see things the way that you do, at the end of the day it's a service business and sometimes your hands are tied. You can't do maybe what you want to do.

Niels

True, very true. Now I always ask people whether there is a fun fact that they can share, and you've actually shared quite a few that, but maybe there's still one left that maybe not so many people know about you, even those who are pretty close to you, is there anything that you can think of that's left in the box?

Scott

I'll share one; it's kind of weird and outside the box, but maybe there's a tie in. I just don't want anybody to take that I am thinking that anybody else should do what I do, just like I say don't max out your credit cards to trade futures. I've got a whole list of things not to do. Because I have such a core central belief system about the nature of reality and studying philosophy and theology and psychology and these types of things you get to the point where ideas matter to you a lot and you are very unhappy with unresolved thoughts in your head and so you try to figure out what you want to do and how you want to do it. At times, that process can be painful for people around you. So perhaps an unusual tidbit about me that in the big scheme of things is not really relevant but to me it's relevant because it also plays such a role in my thought process is that I...back before I started Dominion as I was studying philosophy and all these types of things I became so enamored with natural law and the classics and different things that I started to change my thinking process on how I viewed history and time and all kinds of stuff.

To make a long story short, I did something that was very difficult for my family. I was raised a staunch conservative colonist, and I decided that I was going to convert to Catholicism because of the nature of the law and I love the scholastics, I love Aquinas's interpretation of Aristotle and let's just say that it had a monstrous ripple effect with extended family, near family. I got things resolved with my wife, but at the end of the day, ideas have consequences, and so often I keep reminding of that when we talk research in the office. It's like we're all talking ideas, remember all of these ideas have consequences, and you need to tie these things out between cause and effect and who is driving and is the tail wagging the dog here? Trying to understand these principles of non-contradiction, causality and sense perception which are kind of the core elements of developing a natural theory a priori,don't forget these and also don't be afraid to go where they might take you. They may take you in places that you never thought. If you had asked me at any time growing up if I would be doing the things that I'm doing, believing the things that I'm believing, and a lot of them have been very painful and difficult transitional phases, but the common theme is follow your ideas and take your ideas to those logical extremes to see whether they are worth following; to see if you really want to do something. It's easy to sit around and complain and say I'd like to do this or do that. Tying it together...as Nietzsche says economics is a human action, it's acting, and all action is toward an end as Aristotle makes so clear, that and a sense of really truly being human.

Niels

It's interesting and it kind of ties in with my second to last question and maybe you kind of answer it because it sounds to me like what you've done, and I was trying to think of some philosophical question to ask you and my limited knowledge in that, but it almost sounds to me that what Alan Watt said in some of his work was really, if money was no object what would you really enjoy spending your life doing and it almost sounds to me like that's something that that is something that you asked yourself at a very young age.

Scott

Yeah, I don't think I was ever too concerned about the money until I started making some and then I realized I could be just as subject to a lot of bad decision making as anybody else. Find out what you love. I think when you're not really self-aware or self-critical sometimes you really don't even know what it is you love, and it takes a process to really squeeze it out of yourself to say I think I like this, or I think I like that, but what is there really that you can't live without? What is it that's really important to you and it takes a while just to come down to even getting to the point where you can resolve to follow that path and follow it wherever it goes.

Niels

Sure, absolutely. Now, Scott, my last question, we touched upon it a little bit earlier on talking about what investors are missing what they're not asking when then come and see people like yourself and so on and so forth, so I have to be critical of myself as well and ask you what have I missed today? What are the questions that I should have asked you that I didn't?

Scott

Well I think we covered most of what I would think are the important ones. I'm sure that I'll go through multiple hour meetings where I will explain prospect theory and then want to get into mathematics, they want to see what kind of computers I have in my server room, and that's fine. I know they have to kick all the tires and everything, but it's always amazing to me. It's the dog that didn't bark type thing. To me it's very, very simple and straight forward, and I think for the most part we've covered it today. But the questions I would always ask anybody is why do you make money and why will you continue to make money? Those two will very clearly steer you into what actually is the inefficiency because there is a huge difference between, as we said before, the natural law and universal claims and particulars. You can be very good at figuring out the last X number of unemployment reports for two hours after that the market did XYZ and that's how we're going to trade and you find all these small inefficiencies and as soon as they go away you find new ones, and so if you answered that question and you say why do I make money and how am I going to continue because I'm smarter than everybody else and I have faster computers and I have a research staff and so depending upon what the manager is saying is what they do I think those two things, why you make money and why will you continue pretty much will force the hand. You're not going to make money because of a formula. You use formulas, but that's not why you make money. So being very specific about what that question is I think those two questions for me they would be very important and after somebody answered that, and I looked at the data of what they have done I think you can tie it up pretty quickly. The rest of it's just personal integrity type evaluation.

Niels

I agree, and I certainly think that we have been very fortunate to hear a lot about the why today and as long as you feel that I've done yourself and Dominion justice then I think that's a good place to end. Before we finish our conversation perhaps you could let the listeners know where they can reach out to you and learn more about yourself and Dominion?

Scott

Certainly. Probably the easiest is to go to our web page which is www.domcap.com and the information there will give you a phone number, address, email contact information and so forth on how to get in touch with us and you will most likely be getting in touch with Joe Vanderbosch who is in charge of our client services.

Niels

That's great stuff and also I can say to our listeners that you can find all the show notes on the web page TOPTRADERSUNPLUGGED.COM, and I'll link a lot of the details from our conversation today with Scott there. And I also want to say to the listeners that the emails that you receive from me in there, there is a way to thank Scott actually for his time today by clicking on a little link and I would certainly encourage everyone to do that and for sure let me be the first, Scott, to say thank you so much for all of your time, all of your insights, your passion, and your vulnerability in telling stories that are of course very personal. It's been an amazing conversation. I really appreciate this transparency and just that you shared so many great stories today.

Scott

Thanks, I've enjoyed it Niels.

Niels

Fantastic and I hope we can connect at a later date and find out how the great work is coming on. So thank you so much Scott and take care.

Ending

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