In this episode, we talk with Benn Eifert of QVR Advisors.
Benn is the managing member and CIO of QVR. He was previously co-founder and co-portfolio manager of Mariner Coria in New York and the Wells Fargo proprietary trading desk, which became Overland Advisors. He holds a PhD in Economics from UC Berkeley.
We talk about the history of the derivatives markets and the mixed impact of Dodd Frank legislation, why some derivatives buyers are price insensitive and the opportunities that creates, and then we really geeked out on three trading strategies using the VIX, dispersion trading and everyone’s favorite topic: European dividend futures. Underlying all of this is Benn’s unique way of looking at markets.
I hope you enjoyed this conversation as much as I did.
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Have comments about the show, or ideas for things you’d like Taylor and Jason to discuss in future episodes? We’d love to hear from you at info@mutinyfund.com.
Transcript for Episode 20:
Taylor Pearson:
Hello, and welcome. I’m Taylor Pearson and this is the Mutiny Podcast. This Podcast is an open-ended exploration of topics relating to growing and preserving your wealth, including investing, markets, decision-making under opacity, risk, volatility and complexity. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, Mutiny Fund, their affiliates or companies featured. Due to industry regulations, participants on this podcast are instructed to not make specific trade recommendations, nor reference past or potential profits.
Taylor Pearson:
Listeners are reminded that managed futures, commodity trading, forex trading and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors and you should not rely on any of the information as a substitute for the exercise of your own skill and judgment in making such a decision on the appropriateness of such investments. Visit www.rcmam.com/disclaimer for more information.
Taylor Pearson:
In this episode we talk with Benn Eifert, managing member and CIO of QVR. Benn was previously the cofounder and portfolio manager of Marina Coria in New York, and then before that the Wells Fargo proprietary trading desk, which became Overland Advisors. He holds a PhD in economics from UC Berkeley. This was a really fun episode. We started off talking about the history of the derivatives market and the impact of Dodd-Frank legislation on the derivatives market, why some derivatives buyers and sellers are price-insensitive and the opportunities that can create, and then we really started to get into the weeds on three different trading strategies using the VIX, dispersion trading, and of course everyone’s favorite topic, European dividend futures. But beyond the details underlying all of this was Benn’s unique and interesting way of looking at markets. So I hope you enjoyed this conversation as much as I did.
Taylor Pearson:
So Benn, you’ve been involved in the derivatives market for quite a while. Basically to start with it would be interesting to kind of have a history of the derivatives market through [inaudible 00:02:37]. Yeah, why don’t you give us some background just on how you’ve been involved there and kind of how you’ve seen the market change over that time?
Benn Eifert:
Sure, absolutely. So my background, I’m an old emerging markets macroeconomist originally. I worked for the World Bank for a while. I have a PhD from Berkeley. My first real job in finance and derivatives was on the Wells Fargo prop desk, which isn’t the most famous of prop desks, so the Goldman guys and the Morgan guys definitely had us one-upped probably on brains too, but certainly on PR. But the key thing about Wells back in those days, we went through the credit crisis and a lot of the big banks in the world were under a lot of pressure from sub-prime and from synthetic credit derivatives and everything, and Wells Fargo is a very conservative backwards bank that had almost no exposure to any of the nasty credit parts of the credit derivative universe at the time.
Benn Eifert:
So Wells prop actually was in a very strong position, and we had a ton of support from the bank and a huge balance sheet to work with, so we were very aggressive and a very large part of the market at the time when a lot of the other prop desks were getting downsized and their positions were getting liquidated and everything. We were heavily involved in convertible bond arbitrage and capital structure arbitrage and derivatives trading, multi-asset class, special situations, the whole gamut. We had an active center hedging book where we, depending on what was going on in the world, I mean we would use currency volatility, commodity volatility, interest rate volatility, all types of cross-asset class structures to customize the exposures in the book and to overlay hedge risk exposure and so forth.
Benn Eifert:
I got involved in a lot of that kind of stuff, and then really we hired a guy … After the desk spun out of Wells Fargo into a hedge fund called Overland Advisors, a little later we hired a senior guy named John Laughlin, who would later become my partner but who had started and run the Blue Mountain Equity Alternatives fund. They were really the original pioneer of absolute return derivatives trading on the buy side in the world. There was a grade fund dating back to ’04-’05 that had been involved in all kind of things. Anyway, John had started that and John really became my mentor in the derivatives markets where he and I got along really well. I was the head quant and ran the quant team on the Wells prop desk.
Benn Eifert:
I hired a replacement to run the quant team and I went to work for John as his sidekick. We hired a few traders, and we kind of rebuilt a lot of what he had done previously with a new angle, and combining a lot of the stuff that I had been doing, and built a derivatives portfolio and derivatives trading effort there at what was then called Overland Advisors. John was a really, really smart guy and a pioneer in the space and taught me a ton of what I know now. But a few years later we had had a lot of success and we had left to start a fund together on the Mariner Investment Group platform called Mariner Coria, based out of New York, which John and I did for about three years. John did it a little bit longer. I was commuting out to New York at the time, every week back and forth from San Francisco. When I had kids that kind of had to shut down, so I ended up coming back out here and starting QVR, where we are now.
Benn Eifert:
But I mean, to your point about thinking about the evolution of the derivatives market really over that window of time, there have been a lot of very dramatic changes. I mean, back in the pre-crisis and through the credit crisis, and even the first few years after that, the derivatives markets still had very active risk-taking participants in the forms of the big banks. The big banks had a lot of risk tolerance. They were very actively involved in position-taking and risk-taking on their own, and warehousing inventory. There were a lot of banks involved, and banks would facilitate pretty aggressive trading from relative value hedge funds. A dozen banks would show up to make a tight market and big size and almost anything that you wanted to trade.
Benn Eifert:
There was a two-way market in everything, and big size and the amount of risk being on bank balance sheets was quite large. I think people think of the crisis as the catalyst for that starting to decline, and that wasn’t actually really true. I mean, banks were taking an unbelievable amount of risk all the way through the crisis, at the height of the crisis and for the first few years after. It was really when Dodd-Frank started, when the rules really started to be implemented and to bind, starting closer to 2013 and 2014, where you started to have very tight stress test oversight on banks across very detailed stress tests, drilling way down into every sub-portfolio in the bank. Where you started to have capital requirements tightened dramatically, intra-day liquidity coverage ratios and all of the whole kind of array of post-credit crisis reforms where regulators really looked at those big banks and thought about 2008 and said, “This was a systemic banking crisis that happened because banks were taking crazy risks in derivatives markets. We just want them to stop,” right? Because banks should be more like public utilities.
Benn Eifert:
But there’s huge negative externalities when banks are blowing themselves up on the rest of the economy, and there’s certainly a lot of truth to that, right? But I think to some extent the unintended consequences, which people were pointing at the time, it certainly wasn’t a secret, but was that that led to much less intermediation happening in markets in general, right? Because really, the primary dealers are the biggest source of ability to intermediate markets, to take risks, to warehouse inventory when sellers show up and there aren’t broad buyers there immediately how to facilitate transmission and risk-sharing and so forth.
Benn Eifert:
And so derivatives markets started to work much more, to gravitate more to an agency-only type of basis. I mean that’s an extreme view, but where hedge funds certainly couldn’t show up and quote the kinds of trades that they used to and the kind of risk levels that they used to, and get the pricing that they used to. That I think caused the overall space on the buy side of relative value derivatives trading firms to face a lot of issues. That was a difficult transition for a lot of people to make. I think you saw returns in the space start to suffer after 2013-2014, but at the same time there was dramatic growth in some parts of the derivatives market driven by end users, but much more on exchanges, right?
Benn Eifert:
So risk was migrating away from OTC exotic types of trading by hedge funds into equity index and ETF option trading on exchanges where you started to see broader and broader participation in option markets by pension funds or fundamental equity managers for hedging or for customizing different exposures that they might want hedging out sector risks, moving quickly to overweight or underweight at the macro level. You started to see more recently heavy growth of single-name option trading among retail investors, and so if you look back over the last 10 years you’ve had actually very spectacular growth in liquidity and volumes on exchange in more vanilla securities, while you’ve at the same time had this kind of big fall-off in more of the exotic risk businesses.
Benn Eifert:
And those still exist, and there’s risk recycling out of banks, and you saw a lot of blow-ups in March related to that. But the fundamental nature of where the volume is and I think where the opportunity is in the market has changed a lot over that time period. So where 10 years ago we would have been trading 90% OTC securities, tons of volatility swaps and variant swaps and dividend swaps and correlation swaps, these days we trade primarily on exchanges using a lot of technology to drive the ability to participate in volumes on exchange, where we might run the same kinds of strategies and think about the world the same way. Understand from a systematic perspective what risk exposures that we want, where we want to be short, where we want to be long, where the dislocations are, but to actually express those trades and the management of those trades, in terms of working into and out of a bunch of option positions liquidly on the exchange, as opposed to recording banks on complex OTC structures.
Jason Buck:
Do you think it’s kind of analogous to when floor trading went away and we went to electronic trading, and you lost some … You actually quoted that when you were with the banks, they were able to put pretty tight spreads. My understanding, correct me if I’m wrong, was like the spreads may have been wider pre-GFC but we had more liquidity because you had the big banks’ balance sheets behind them. And now we might have tighter spreads, but if the market-makers withdraw those spreads right at the most inopportune times, it’s like you said, the perverse unintended consequences. But I’m wondering how you’d see the tradeoffs between both of them. There’s pros and cons to before GFC with the banks, and then there’s pros and cons now to having … Even though it’s liquid markets, you might still have more dealers or market-makers affecting the movements of the markets.
Benn Eifert:
Yeah, I think that’s right. I mean, I think to some extent the issues are that spreads tend to be tighter, certainly significantly tighter than pre-electronic markets days, right? Much tighter. Liquidity tends to be more fragmented and there are very large volumes in the markets, but if you show up into the market with a very large order that you’re trying to get done over a very short period of time, you might actually end up having more price impact than you would have earlier, right? So liquidity certainly is not just, how big is the bid offer on the inside, the forelot that’s sitting on the inside market? It’s depending on who you are and what you need to get done, it’s can you move big size over some moderately short period of time, and how much do you move markets in doing so?
Benn Eifert:
I think that certainly this environment, I mean our view is that from that perspective the ability to move large size over a very short period of time as a price-taker is much worse than it used to be. I think we very much try to never be in that position, where we’re needing to go execute a large trade over a short period of time as a forced buyer or a forced seller, because it puts you in a very bad position these days, where if you’re trying to quote banks, just the markets are very wide for the size. If you’re trying to work a very large order very quickly on electronic markets taking liquidity, market-makers are going to very quickly understand what’s happening and very quickly widen those markets and skew those markets against you.
Jason Buck:
That’s interesting, because we’ve had this ongoing discussion like, “Is the liquidity less or is it algorithmic order execution that’s happening, iceberg orders, et cetera?” But you’re saying in practicality, well, depending on if you’re a taker and depending on how badly you need to get out of that trade, that’s where you’re finding the illiquidity?
Benn Eifert:
Yeah. I mean I think for us, right, what it means is what you want to avoid doing is being in a position where you feel like you need to execute a very large order over a very short period of time, right? And I think if you think about your objectives correctly, there’s not that many circumstances or types of investors or situations they should be in where they actually need to, right? Very few investors actually have views that have very strong signals over the next five minutes, 10 minutes, half an hour, one day, right? If you’re an asset owner and you’re like, “Okay, we want to move from neutral energy to 10% overweight energy,” do you need to do that over half an hour? Do you need to do that over an hour? Can you do that over five days?
Benn Eifert:
Generally speaking, price impact on intelligently-structured algorithmic execution programs is pretty low. So we work into and out of positions that we want to, being best bid on the market for everything we want to buy and being best offer in the market for everything we want to sell and we have good systems around doing that. Generally speaking, we don’t incur any transaction costs trading that way. There obviously, different investors have different mandates and different needs, right? But I think part of it is just a mentality shift, right? It’s, you have a trade to put on. How do you think about the alpha from putting that trade on, the alpha from not paying transaction costs on that, and how should you be implementing that trade? Spending a lot of time thinking about what your execution setup is, and being patient and being passive in your execution, right? I think we see very large value in that.
Jason Buck:
It’s interesting to think about though, like as you think every business on the planet now is in the digital age and in the work from home, et cetera. It’s like you’re using fewer and fewer employees to do more and more things. So if you think about the pre-GFC, the banks and all their different separate divisions, you guys are having to do that in house with very few employees. You’ve got to get very good at coding your execution algorithms, things that probably would have been dispersed across different segments of the bank previously.
Benn Eifert:
Yeah, I mean I think it takes an emphasis on technology in your business, right? And generally speaking, if you’re just trying to execute a large equity order over time without too much price impact, you don’t need to start from scratch of like, “How would I code a low-latency DMA algorithm” or whatever, right? I mean, there are good technology businesses out there that provide the core platform that you can kind of customize to your needs. But it does mean you have to actually think about the problem that way and not just think, “It’s an afterthought. How do I execute trades? Here’s the 500 million dollars of stock that I need to buy. So I’m just going to kind of send that to my outsource trader at Jones, who’s just going to kind of lift the market for that and make his nickel of commission” or whatever. Not to pick on Jones, they’re great.
Jason Buck:
So let’s go back, like you just spoke about how the markets have changed and now we’re all these cash-settled futures and options markets. So tell us more about the impetus for starting QVR and what your overall theme was with establishing QVR.
Benn Eifert:
Yeah, absolutely. We saw I think at Mariner Coria, which we started just as all of the changes in the liquidity environment and bank regulations really were starting to bind. Certainly, one of my takeaways from that experience was it was getting harder and harder to do business the way that we always had, running our strategies the way that we had, trading primarily OTC, trading primarily with banks, trying to comp banks out and get into the risk that we wanted, right?
Benn Eifert:
There were fewer guys, fewer traders who would make the markets. They’d be twice as wide or four times as wide for a quarter of the size, and it was just harder to get risk on, harder to get trades on at a good price. So really, when we were building QVR what we wanted to do was to really mitigate that problem and still talk to banks and share ideas with banks, and get color from banks and trade with banks if there was a great ax that we really wanted. But to primarily focus our, restructure our strategies around just participating directly in exchange volume and having the technology to do that, and the portfolio management infrastructure to do that.
Benn Eifert:
So it’s a fairly heavy lift. It was something we were able to do, and it’s obviously a continuous improvement process. But it’s something we were able to do because we were building the firm from scratch, and we could sit down and say, “Okay, what do we need from day one? How are we going to configure this?” As opposed to trying to troubleshoot when you have a big portfolio and you’re trying to manage risk every day, and you’re already spending a lot of time on just keeping things moving. So that was really what we wanted to achieve, and the other thing that we tried to do was take some of the complexity back down from what we had done historically, where a lot of the portfolios that we had run historically might have had 50 sub-strategy line items, and been to some extent culturally felt a little bit like … Investors would look at the portfolios and just think, “This is really complicated, and I kind of just have to trust that you guys are really good.”
Benn Eifert:
There’s something to be said for trust, of course, but I think that there’s a lot of value especially these days, the way that institutional asset owners think about their businesses. They really want to understand what you’re doing and how it fits into their portfolio, how they can expect the different things that you’re doing to behave in different environments, and how they might complement or anti-complement things that they’re already doing. And so we really opted to start at QVR with our highest conviction, much smaller subset of strategy themes that we thought made a lot of sense in this environment, and then so very slowly build that out with new research efforts where it made sense, rather than running a very, very diversified portfolio across a lot of different, smaller opportunities.
Jason Buck:
Is part of that the idea that like simplicity is the ultimate sophistication? It might look cool to put on 50 exotic trades, but if you can do it in the cash-settle liquid markets in a much more efficient trade that’s actually a better implementation and is kind of taking your ego out of it? Or, how do you think about it?
Benn Eifert:
I think yeah, simplicity, you should always do everything in as maximally simple of a way that you can, that kind of meets the types of objectives and needs that you have, right? So there are times when there are good … The good things about a volatility swap for example is that you just … If you have a clear let’s say relative value view, you just buy this volatility at 20. If it realizes 21, you make a dollar and that’s all, and that has a nice simplicity to it at first. But what if it’s a single-name vol swap and then it actually comes with a cap, and then in a month it’s an aged vol swap with an aged vol swap cap, which is actually a really weird exotic thing? And if you want to unwind that and assign it to another bank, you have to get somebody to price this bizarro thing and argue over the cash flows and stuff.
Benn Eifert:
Versus if you’re trading listed option, the complexity is around the portfolio management aspects of it, so the path dependence of listed options, right? The fact that you’re rallying away from strikes, and therefore the risk dynamics of your portfolio is changing. You have to be able to manage that, but the products are very simple, very liquid. If you don’t like your portfolio, you can just take the whole dang thing off in a day or two, which with a large OTC portfolio it’s just a different world, right? So there’s a lot of advantages to that.
Jason Buck:
So going back, blank sheet of paper, you’re building QVR. What do you decide? What are the core pieces of the portfolio that you wanted to build around?
Benn Eifert:
Yeah, the core pieces of the portfolio that we really started with were all things that we had been doing for a long time in one form or another, and some of them that had to be re-imagined a little bit for the current environment or for the current implementation and [inaudible 00:22:57] strike. But I mean the investment process that we run and the thought process behind it has always really been the same. That’s thinking about and understanding how dislocations arise in the derivatives market, typically driven by the marginal market participants or the dominant market participant on derivatives markets who is an end user of derivatives, who isn’t some sophisticated arbitrager, is just a pension fund trying to do some risk hedging or a retail investor trying to buy a structured note.
Benn Eifert:
The derivatives markets are a little bit different than long-short equity for example, where in long-short equity you’re trying to be the guy who’s smarter than the other guy and buys the right stocks and shorts the bad stocks. It’s kind of a zero-sum game like, “I got it right. You got it wrong,” right? Whereas in derivatives markets, really these markets exist because of end users of derivatives. In some sense, all the market impact and transaction costs that the end users of derivatives are incurring in exchange for doing what they need to do, that sort of becomes a pool of alpha for relative value managers, right?
Benn Eifert:
And so our strategies are really organized around understanding some of those types of thematic dislocations in specific markets, in specific trading relationships, and then building a set of quantitative research around those, understanding their properties. How do you know if there’s a big dislocation or not? What are the signals you’d look at? How do you understand the expected returns and the risk properties of that? And so some of the areas that we focused one early with QVR, for example a strategy focused around identifying dislocations in short-data VIX futures, right? The VIX complex is a huge and highly liquid and very heavily trafficked area where most of the big transactions in the VIX market are not sort of sophisticated arbitragers, right? It’s huge real-money investors using VIX calls or VIX call spreads to do some portfolio hedging overlays, or huge hedge funds putting directional views on volatility, just buying a bunch of puts or put spread or something in VIX.
Benn Eifert:
It’s really those directional flows and the options that drive the VIX term structure. The futures and the shape of the futures term structure is more of a reflection of that, and used for delta hedging options, than anything else. And so we run and have run for a long time a strategy that systematically oriented around understanding, how do you know when something’s wrong at the short end of the VIX term structure when it’s way too expensive and way too cheap? And then how do you take a position there and then neutralize the market beta of that position in some other market so that you have hedge trades that aren’t making or losing money based on whether the market’s going up or down, but are really identifying and exploiting those dislocations. That’s an example.
Taylor Pearson:
Yeah, I just want to go back. I’ve heard you use the phrase like price-insensitive end user derivatives, meaning like structured products or pension funds. I was hoping maybe you could unpack that, because you hear it and it’s like, “Why would someone be price insensitive?” That doesn’t make sense, but obviously if you bought different [inaudible 00:26:15] structures. So yeah, maybe if you have a couple examples or just how you sort of think of that.
Benn Eifert:
Sure. Yeah, absolutely. So you think in the VIX market for example, the biggest player in the VIX market for the last many years is a large U.K. asset manager that people refer to as 50 cent, right? And they’re smart guys, but their job, they run mutual funds. They run equity long-only mutual funds, right? And they did some work, and they decided that they like hedging systematically in short data VIX calls, right? So they just buy the front-month VIX calls, and they buy whatever front-month VIX call trades roughly around 50 cents of premium, which is why the nickname is 50 cents, right?
Benn Eifert:
And it’s not that they wouldn’t like to pay a lower price or that they don’t look and see what strike they’re buying or whatever. But what they do is they just have a simple, systematic rule of thumb strategy where their longness … They go by every month some new front-month VIX calls, and they buy the ones that are around 50 cents. If those are the 23 strike or 26 strike or whatever, or what’s the shape of the term structure, or what exactly is the vol of all, they don’t care about that stuff, right? They’re humongous. They have to buy more VIX calls than God to kind of do their hedge, right? So they can’t be picky about this stuff.
Jason Buck:
And part of that too is then you think about, in our space as well you have risk transfer services, right? If you’re a large Canadian pension or a superannuation fund, and the consultants have been telling you for years, “You should be selling volatility and here’s a back test.” And then they start coming in at large size and they’re systematically selling volatility, a lot of times you have non-economic hedgers. Not even just price insensitive, but hedgers who may have a non-economic purpose because their book is really 200 billion dollars. And so you’re looking at those flows as well, right?
Benn Eifert:
Yeah, yeah. No, that’s absolutely right and that’s a great example, right? Where callover rate and cash-secure put sell strategies are very popular among really large institutions that are very slow-moving. It took them four or five years of consultant presentations and research and everything for them to kind of get organized to put on those programs. They generally don’t have sophisticated analysis of the decomposition of the performance of those strategies, and how much risk premium are they really capturing, right? A typical traditional callover rate program on a day-to-day basis is going to be dominated by the delta, right? Because you’re still your long stocks and you’re selling some options.
Benn Eifert:
And so you’ll hear more academically-minded people say things like, “Well, I mean but people aren’t dumb. If it wasn’t a good trade, they wouldn’t do it. If there wasn’t a risk premium, they wouldn’t sell it.” But how do they know if it’s a risk premium? They look at a 30-year back test, right? And when do they update that view? 10 years later when it’s a 40-year back test, right? And it’s just a realistic property of the world, so every Friday or every expiration, a couple days before expiration they come and they roll all these puts and they sell a bunch of new ones. That’s just what they do, right?
Jason Buck:
And so we talked about price-insensitive or non-economic hedgers. What phrase would you use for Asian structured products, and can you kind of tell a little bit about what Asian structured products are?
Benn Eifert:
Sure. Yeah, absolutely. I mean so in the U.S. we have this culture of retail investors owning stocks and picking stocks, and having IRAs where they buy ETFs or stocks. That’s somewhat idiosyncratically American. In a lot of European and Asian countries you have much less of a culture of stock ownership. A lot of Asian countries barring Japan, much less developed, like local equity markets in the first place, right? So there’s not really stocks to buy. What you have had develop over the last 20 or 30 years among other things are very big market, local markets in structured products that are notes that have different kinds of payoffs linked to different global equity embassies or baskets of equities.
Benn Eifert:
Particularly in the last 15 years or 13 years since the great financial crisis, we’ve been living in a zero interest rates world, right? So a lot of those products have really focused on generating yield, right? So the typical product that a retail investor might buy would be a three-year note or a five-year note, and it would have a 7% annual coupon which sounds awesome, right? Because what the heck can you do to get a 7% yield? But the trick is, the way you get it is you get it at lesser until any one of five different big global indices was to go down 35% from the initial level. If that happens, you’re just hosed and you lose 35%, and the note terminates and you’re gone, right?
Benn Eifert:
So those kind of products are pure play selling of long-term crash risk in exchange for yield, and these are typically super-complicated products from a derivative pricing perspective, like way, way more complicated than volatility swaps and variance swaps. Because you’re talking about it’s like there’s a basket of underlyings and it’s going to knock out, if the worst thing in the basket is down a bunch, but also by the way it can be called back if it’s up 10% after a year and whatever. So they’re these extraordinarily complex notes that obviously, I mean I would have to do a ton of work to feel like I had done a good job valuing and pricing and I still wouldn’t really know. The people who are buying them obviously have no idea, right?
Benn Eifert:
So how are you supposed to be price sensitive to like, “Is the skew of kurtosis pricing in this note correct?” You have no idea, right? They look at kind of, “All right. I’ve got a 7% coupon and I don’t know, 40% down. That sounds pretty good,” right? But that trading, right, the banks go out and hedge those trades because banks aren’t just owning the other side of the payoff when they issue those securities, right? Banks immediately are going to go out and sell that downside crash risk out in a basket of indices to hedge the other side. And so it creates these large impacts on derivatives markets, because these investors are coming in and effectively doing that trade. And then the question is, how’s it priced and where should it be priced? That’s certainly not a question that the investors buying those notes are really thinking about.
Jason Buck:
Yeah, that’s great. So going back to, you started with one of your core strategies being the hedge volatility. A lot of times we call it like an intermarket spread between S&P and VIX. We have some managers that look at that, especially just implementing that in the futures in like a short-short or a long-long trade. But I think you guys look at it a little differently and sometimes you’re using a basket of options or strips to maybe replicate that S&P or VIX futures decision. Can you talk a little bit about how your intermarket spread’s a little bit different?
Benn Eifert:
Sure. I mean in many situations we’re happy to just use the futures but the options give you the ability to customize the payoff somewhat, right? So a classic example would be, you can imagine a quiet but high-risk premium market environment where the VIX term structure is really, really steep. There’s a very large amount of carry available being kind of short the VIX term structure in the front, but things are quiet and vol is pretty low. There’s potentially outsized gap risk where if something just totally crazy comes out of the blue and happens and whatever, the S&P’s down 10%, like that VIX future could move massively and really outperform the beta hedge.
Benn Eifert:
So we’ll certainly think about things like that and say, “Well, in that kind of a scenario, do you want to own your VIX downside risk? Express the short vol view in puts or put spreads where you have limited loss and know how much you’re risking, and then have the short futures positioned against it in the S&P. On the long side, usually you’re not as worried about kind of a big negative asymmetry. Usually a long VIX futures position, of course you can lose money but it’s usually more of a positively asymmetric payoff profile in terms of returns over a short period of time, so you might just hold the long-long position in futures versus futures.
Jason Buck:
Taylor, sorry, did you have a question about that short-short trade historically, or …
Taylor Pearson:
No, I was going to ask if we can sort of unpack but I’ll summarize and Benn can correct me if I’m wrong. But short-short typically you’re going short, S&P short VIX futures because it again is a relative value trade [inaudible 00:35:29] long S&P, long VIX futures, and so just to clarify.
Benn Eifert:
Yeah, and the reason it’s short-short and long-long obviously, unlike if you had two stocks presumably you’d be long one and short the other one. But there’s a strong inverse relationship of course between implied volatility and equities, right? If equities are falling fast, VIX is probably going up and vie-versa.
Jason Buck:
I was thinking about, trading strategies come in and out of vogue, right, depending on what markets we’re in. Part of that short-short trade, some people thought it was starting to break down in ’18 and ’19, and then just did incredibly well in March. I’m curious to how you think about that as far as what’s an opportune market environment, and are you toggling based on what you view the market target-rich opportunities are, whether you’re short-short, long-long, or …?
Benn Eifert:
Yeah, I mean so that strategy, like all of our strategies for us, right? Much of the time we have no position because there’s no particular dislocation in that market and there’s nothing interesting to do. It’s not the kind of strategy where we have … We don’t believe in general and derivatives markets that there’s ever a trade you should just have on all the time, right? The world changes over time and certainly in that. Usually dislocations, large dislocation in the front end of the VIX curve are pretty regime-specific. Usually on the long-long side, usually that VIX future only gets way too cheap on a dislocated basis for brief periods of time. It might be days or weeks or something, but usually not for months and months on end.
Benn Eifert:
They way-too-expensive VIX futures sometimes can last a little bit longer. You can have runs of months because there have just been huge inflows from retail into VIX exchange-traded products for example, like VXX. So back in 2012 you think of … We had a regime for a good six-plus months where the VIX complex was incredibly expensive because there have just been huge inflows into, from RAAs and retail into TVIX and into VXX. But generally speaking, it’s a very dynamic strategy. If there’s a dislocation, we like to understand where it’s coming from and we’ll put on some risk. If it’s a smallish, moderate-sized dislocation we’ll put on a smallish, moderate position. If it’s a huge dislocation and we understand it, we’ll put on a big position. If there’s no dislocation we’ll have no position.
Benn Eifert:
And so generally speaking, all of our strategies work like that where we have a suite of strategy themes where we understand the particular type of dislocation, and how to identify whether it’s there or not, and how big is it? We’ll be allocating risk across those different strategy themes in proportion to what the opportunity set is. At a given time, we might only have meaningful positions in two or three strategy themes out of seven or eight, for example.
Jason Buck:
Great. Another one of your core VIX strategies, you call it VIX curve. I sometimes look at it like a calendar spread on the VIX term structure. Can you talk a little bit more about the VIX curve strategy?
Benn Eifert:
Sure, so we run a term structure strategy, again relatively systematic there. We’re looking for significant differences in relative value in the shorter end versus the longer end of the VIX term structure, which you can get because of big inflows into short or long positions at the front end of the VIX curve, so VIX, the front end getting very expensive in 2012 and 2016 with retail inflows, and then getting really cheap in 2017 with changes in theme of a lot of those retail flows, to trying to short VIX and buy XIV and so forth. The longer end often will be more driven by … There are ETPs out there but they’re smaller, like the XE for example. A lot of the longer end will be driven by hedging flows in the VIX options, so big asset manager periodically will come in and do very large trades in six-month VIX calls or call spreads. Tail funds will come in and left upside calls and push the back end of the VIX term structure around.
Benn Eifert:
Our whole modeling and thought process there is really, how do you assess the various quantitative factors that are highlighting to you potential dislocations between the front and the back, and then how do you pick a hedge ratio so that’s not a one-to-one vega trade, right? Because the back end of the VIX term structure is less volatile than the front, right? Typically when vol is moving, short data vol is moving the most, longer data vol is moving less, so you have to kind of think carefully about how to hedge that kind of position.
Jason Buck:
As you’re putting those trades on, I’m sure that’s part of your in-house algos and the way you look at the markets is like, are you constantly adjusting those ratios? Like there’s no set ratios, it’s more about what the market’s giving you, and then you’re thinking about, “How do I hedge those in a market-neutral fashion,” and those ratios are going to change over time?
Benn Eifert:
So I would say, hedge ratios usually don’t change too much for us. And that I would say, if it was … So the way you’re thinking about the world really is, a hedge ratio is really about risk reduction. So you want to say, “What is kind of the market-neutral trade package where tomorrow if the S&P is up a percent or down a percent, it doesn’t really tell me anything about whether my trade’s going to make money or lose money”? And generally speaking, you’ll certainly get shifts in market relationships over time and term structure dynamics, but usually they’re longer-term shifts.
Benn Eifert:
If you try to estimate some very high-frequency hedge ratio that’s changing a lot and very overly sensitive on recent data, it just tends to not do very well out of sample. So you’ll be like, “Oh, I’ve got to cut my hedge ratio,” and then but it was really just a short period of time and some random noise, right? So it tends to be that the positions that we’ll have on will be very dynamic, but generally speaking the way we construct those trades and the hedge ratios don’t tend to be highly, highly dynamic, at least over shorter periods of time.
Jason Buck:
And when you think about that VIX curve and you’re saying the front end of that curve being moved a lot by the ETPs and retail buyers, as some of these ETPs have cycled out of existence are you just cheering for new ETPs to come back on the market? You’re desperate for more flows and as the ETP grows, it’s just a more target-rich environment?
Benn Eifert:
Yeah. I mean certainly our strategies benefit from the existence of dislocations, right? And I think we don’t cheer for people to do dumb things in markets and lose money, by any means. But certainly, some of the great opportunities in some of our VIX strategies historically have been associated with very large flip positions in ETPs, both in 2012 and 2016, where ETP flows drove the VIX complex to be very expensive, and then again in 2017 and early 2018 where they did the opposite and drove that complex too be way too cheap.
Jason Buck:
And so rounding out these VIX core strategies, we’ve seen before intermarket spreads and calendar spreads. But what’s very unique is your VIX basis trade, so can you kind of talk about the VIX basis trade and what that is and how you implement it?
Benn Eifert:
Sure, so we run … Well, if you think about what a VIX future is, the VIX itself is the level effectively of a one-month variant swap. That’s kind of what the calculation does. And the VIX futures give you a forward curve of in some sense market-implied levels for the VIX in the future, right? Now, those things are all very closely related to the S&P volatility surface and to S&P options. You can, if you think pretty carefully about it, you can measure the relative value in S&P options and volatility, in the forward volatility over the same kind of maturity buckets and time range as the VIX futures. You can look at, how is that basis trading? How expensive or cheap is the VIX complex to the S&P complex?
Benn Eifert:
And those are again two very closely-related markets conceptually, but just from a fundamental markets point of view, they’re two different markets with different sets of participants and different flows at a point in time in those different markets, right? I mean, 50 cent might be over here lifting tons of VIX calls and pulling the front end of the term structure up in VIX and flattening it, and Bridgewater might be over here rolling their puts out from March to June, and steepening that part of the term structure. These are just two big flows that are disconnected and idiosyncratic, and that’ll be widening that basis relationship, right?
Benn Eifert:
And so that basis relationship is generally speaking pretty well-behaved. You know what range that pricing lives in. March certainly expanded our view of the range that that pricing can live in. Of course when things are really crazy, market relationships break down and get really wide. But so we range trade that basis very much the way that a fixed income arbitrage manager might range trade cash-synethetic basis relationships or something, right? Where there’s two closely-related things that should trade within some range to each other. When they get really stretched, you want to put on a compression trade on that basis and warehouse that basis risk. And really, it just highlights again what the role of absolute return and relative value arbitrage managers is in the space, right?
Benn Eifert:
I mean, those big boys are the end users of derivatives. They’re people doing stuff. From their perspective they need to do to protect their portfolio, but they’re not thinking about or just can’t think about it. They’re too big, those relative pricing relationships, and so they create these dislocations when they come in and trade in big size. The market needs participants that can identify that and warehouse that basis risk, and try to compress those relationships back into place.
Jason Buck:
Is part of that longer-term flow would be an example of, whether it’s a [inaudible 00:45:28] like a vision fund, buying longer-term equity replacement with calls and call spreads? Is that another example of that, or …?
Benn Eifert:
Yeah, that’s absolutely another example of that. So the big, big, big buying flows in long data vega in the S&P, that was obviously they weren’t buying VIX products. They were buying S&P products. There were other people buying VIX products at the same time, but all else equal that would tend to raise the price of S&P options, vega, further out the curve relative to the VIX complex, for sure. And yeah, I mean those flows in August, that was a very, very large end user who was very aggressive in markets and was a new participant, and was moving prices quite a lot, right? That touches a little bit on our dispersion strategy, which is a newer strategy for us because we didn’t think it was interesting really until March. Then it got really interesting, and we spent a long time really building a great technology infrastructure to manage it.
Benn Eifert:
But you think of, dispersion is really all about the relative pricing of index volatility versus the components of the index and their volatility. When the vision fund was in buying huge size in Microsoft and Google and Amazon and Netflix, it was raising the price of single-name volatility very dramatically relative to index, to levels that we hadn’t seen in a very, very long time. It got extremely stretched, and at that point the risk warehousing job of relative value arbitragers was actually to get long correlation, right? Because the effectively-implied correlation had fallen to extremely low levels because index vol was extremely high relative to single-name volatility.
Jason Buck:
Got it. Well, and I want to put a pin in dispersion and we can come back to it.
Jason Buck:
So thinking about all the VIX trades and the VIX trading sleeves, part of those trades that you alluded to, is there a relative value or a stat arb or a pairs trade? And as you alluded to in March, those can kind of blow out on you more than you expected them to, or maybe historically they have. It’s like, how do you think about managing that risk over an entire book?
Benn Eifert:
Mm-hmm (affirmative). Yeah, absolutely. So generally speaking, our approach to risk, so first of all we’re on a strategy-by-strategy basis, we’re trying to construct market-neutral trades. But then we’re very much thinking about the book together from a top-down risk perspective, and running a bunch of extreme stress test scenarios across all kind of risk factors, right? To make sure we understand how we think the book as a whole might behave in different environments. Now, the first and foremost thing I think that you’ve got to do, and when you run a portfolio like this, to make sure you’ll survive really extreme periods, it’s not to have this … We think we have great risk models. It’s not to have the slightly better risk stochastic volatility model that tells you exactly the right way that these things are going to behave relative to each other, because you have no idea, right?
Benn Eifert:
When March happens, even if you kind of had some inkling of how bad things could get, you had no idea of exactly what path it was going to take, exactly how different things were going to move, right? So what you want to make sure is that one way or another, you have enough convexity in some dimension in the book that if things get really crazy, that you’re going to have sources of strength that can offset any other potential sources of weakness that you didn’t see coming, right? So that’s certainly one thing, right? And if you run stress tests where the S&P goes down 20% in a day or a week or whatever, with a bunch of different assumptions about what happens to the volatility surface, you’ll suss out, “Do I really have big holes of like, if things go bad, go sideways, go upside-down the wrong way, am I going to get smoked,” right? So that’s one important thing.
Benn Eifert:
Another important thing is really to understand positioning and the behavior of market participants kind of in the regime that you’re in. So a great example in that, taking that basis trade as an example, in the environment pre-March, oddly enough when the market started to sell off and volatility started to spike, every time … Not every time. Most of the time in the prior few years, that basis between the VIX complex and the S&P complex would compress. VIX products would get cheaper relative to S&P. And the reason for that is, we were in a world where especially post 2016-’17, retail had discovered shorting VIX products. Hedge funds loved shorting VIX products. Lots of people liked shorting vol, and they especially liked shorting vol spikes, right?
Benn Eifert:
And so every time you had a little bit of a vol … And VIX products are the easiest way to do that, right? I mean, you can sell vol by selling S&P options. You can sell straddles. You can sell puts, but selling some VXX or buying some XIV is way easier, right? And way simpler from a portfolio management perspective. So we would always see that basis cheapen, because you’d have big inflows into trying to sell VIX products when you had a risk-off event. And March actually went the same way initially, where in late February the VIX complex actually got extraordinarily cheap and at the front end of the curve it got just totally ridiculous. That triggered actually our hedge volatility strategy to get very long VIX products at the front of the curve.
Benn Eifert:
But so understanding that positioning aspect where really the positioning risk in the market on the first leg down was market participants coming in to sell VIX and that spread compressing. So we actually, that spread was relatively wide in the pre-March environment. We had a big basis trade on. It came in a lot towards the end of February, and we got out of that trade because everybody was kind of coming in and providing us the liquidity we wanted to get out in a hurry. And then in March, eventually then at that point we understood the positioning which was hugely levered tail risk selling across the board, including in VIX products. Coming in in early March as VIX was up above 40 and you had a variety of funds we don’t need to name, but coming in to sell upside VIX crash risk in huge size thinking, “Okay. This is it, right? VIX is 40. VIX is 45. It’s going straight back to 10.”
Benn Eifert:
And so at that point the risk was, “Okay, this market takes another leg down and that stuff’s going to explode,” right? And then that is in fact what happened. The market did take another leg down, and you ended up seeing that VIX basis explode to an extraordinarily expensive level because you had so much of that short VIX call risk that had to get covered at auction when portfolios were getting liquidated, right? So really understanding which way positioning is, and in a bad event which direction those basis relationships are likely to move in, is really important. Like their basis relationships over long periods of time, they’re typically not directional. But at a point in time, they might behave directionally because of the nature of who the buyers are, who the sellers are, who’s on one side of that basis or the other, and who’s going to get blown out.
Jason Buck:
It’s one thing to kind of manage that basis risk in a massive selloff, like March. I’m curious how you think about it almost on the other side of September/October when vols are crashing back down and those relationships are starting to break a little bit, and they’re kind of wonky and moving all over the place. How do you actually manage that kind of risk?
Benn Eifert:
Yeah, so actually VIX basis, that particular basis risk, it’s remained pretty elevated. It’s come down some from the wides, but really the way to think about it is that basis is all about relative supply and demand in the VIX complex and in the S&P complex, right? And most of the types of funds or traders who like to sell upside VIX crash risk and be short VIX futures, they didn’t make it, right? March was rough. They’re not here with us anymore, and so the market lost a lot of supply of VIX crash risk, of VIX upside calls and of short VIX futures positions. And VIX products have always been popular from a hedging perspective, right? I mean, you’ll see investors like to go buy call spreads or calls in decent size as sort of easy-to-manage hedge portfolios.
Benn Eifert:
So that basis, it’s definitely been volatile but in general it’s kind of been high and started to come in, even when volatility started to get crushed. That basis has come in, but it’s been kind of a slow and steady trend. Managing those portfolios, a lot of the work is really around, again in the old days in OTC markets, we would have been able to trade forward vol structures in the S&P that really replicated very closely the structure of VIX contracts but were based on the S&P, and that didn’t require dynamic management. It was this kind of, as long as you could do that trade you could just put in the portfolio and watch it and take it off when you wanted to.
Benn Eifert:
Now we’re synthetically replicating that type of risk in S&P with a very large number of options, and a lot of the [inaudible 00:55:55], the problem or question of management is really managing the path dependence and higher-order risks of that portfolio, making sure that as markets are moving we’re moving strikes, we’re moving maturities to stay, to keep that risk exposure really well-balanced.
Jason Buck:
Yeah, and you alluded to it earlier. What’s fascinating to us about VIX relative value or VIX absolute return is that you can structure the portfolio market-neutral, but then you’re also buying cheap tail protection. And so you could still have almost like a long vol or tail risk bias when you have a market-neutral book. Can you talk just a little bit how you think about buying cheap tails? Because I’ve even heard you say before that it’s not the same as directional long volatility. What do you mean by that?
Benn Eifert:
Yeah, absolutely. I think often you’ll see here people say things like short vol or long vol, and there’s a very, very broad spectrum of things that could fit into that bucket, right? Here’s an example of the distinction between long vol and long tails in an absolute return context. We talked about Asian structured products, one type of position that we had on coming into March on the back of that flow, right? So that Asian structured product flow led to a very large dislocation where long-term index skew was way too low. And by skew, we just mean the relative price of the far out-of-the-money puts was much cheaper than you would have expected. Usually those puts should trade at a pretty steep premium to at-the-money vol because tails are fat, right? And they should be fat. The left tail is fat. There should be a lot of skew in the market. Deep out-of-the-money puts should cost you some money.
Benn Eifert:
And that just came again from this one-way selling of those deep out-of-the-money long data puts, right?
Jason Buck:
Yeah, it’s a great way to own those teenies, for example. So you brought it up earlier, and so you also look at very opportunistic trades as well, as far as different trading strategies in your sleeve that you’re always tracking and seeing, is it coming back into vogue where you want to trade that strategy? The one you just brought up earlier was dispersion trading. So can you start with just a definition of what the dispersion trade is, and then why do you think it maybe in the last few years hasn’t been good for dispersion and now you think that may be coming back around?
Benn Eifert:
Sure, yeah, so correlation and dispersion generally speaking refers to the relationship between single-name volatility and index volatility. And in particular you can figure, “Okay, the index has a bunch of components and each one has a weight in the index.” Okay, so Apple’s a really big weight and GE is a really small weight, and you can kind of buy the weighted basket of single-name volatility and sell the index. For example, that would be a short correlation trade and the reason is, right, the volatility of the weighed basket of names will always be higher than the volatility of the index, right? Because there’s a diversification effect in the index where some names are going up, some names are going down, and so that washes out at the index level. But if you own all those individual-name options, you’re benefiting from that, right?
Benn Eifert:
As correlation approaches one, that weighed average single-name volatility will start to look almost the same as the index volatility, if everything is just moving together, right? And a dispersion strategy at least to us, so again we’re dynamic managers. We think that there can be dislocations on either side. You might want no trade. It might be that index vol is too cheap. It might be that single-name vol is too cheap, and you’re going to over time have different trades on depending on what’s going on in the world. Now we didn’t think it was … Historically, we’ve been very, very involved in that space. I would say in the old days it tended to be the case, let’s say the five years after the credit crisis, index volatility especially in the S&P did tend to be pretty expensive. That was because everybody remembered how bad the credit crisis was, and how bad it was to get shortcut convexity or without a hedge.
Benn Eifert:
And S&P was the really easy, obvious go-to liquid hedge, right? So there was a lot of hedging flow going into the S&P, and it tended to be attractive to be long those component names and short the index. Now, short volatility became kind of a super-popular en vogue trade across lots of segments of the market, call it after 2016 and then through into 2017. There was a huge collapse in term premium in the level of S&P-implied volatility, not just at the front of the curve but even kind of six months out, a year out. And our view was that there wasn’t really any interesting risk premium left on that side of the trade at all, and if anything you probably wanted to have the trade on the other way, where you were long the index and short the single names.
Benn Eifert:
But in general, we just thought it wasn’t that interesting. It was over-trafficked and no risk premium. In 2017, 2018, 2019, you saw most dispersion strategies struggle through that period. It depended on, there’s a lot of different choices you get to make when you’re setting up a dispersion strategy and how you run it. Some people did okay. Some people didn’t do too well. But in general, it wasn’t a super opportunity set. I think the thing that changed that in March was a couple things. So first of all, the prevalence of concentrated short volatility and index got blown up and went away, right? There was a lot of hedging inflows, and at least from time to time there’s much more expensive index vol.
Benn Eifert:
And then on the other side, single-name volatility, single-name realized volatility has exploded for a couple reason. I mean, one is you think of the huge factor and sector rotations that we’ve had over the last six to eight months post-COVID, right? I mean, COVID was a huge fundamental shock that affected different markets, different companies, different sectors in different ways, right? Think about like the stay-at-home basket versus the vaccine basket, and longer lockdowns so Zoom is rallying 20% because we’re all using Zoom. Then it’s like, “Oh, we’re going to go back to work and we’re going to start flying again, and Airbus is up 20% but Zoom’s down 20.” So you had this huge realized volatility under the surface in factor rotations, and that’s very beneficial for long positions in single-name volatility.
Benn Eifert:
And then the other thing that you’ve had has been large non-traditional market participants in volatility and in single-name volatility. So we talked about the vision fund earlier, causing huge price swings in the relative pricing of single-name vol and index vol. Retail has also been involved, more on the shorter end of the curve putting Wall Street into big concentrated short option positions that they have to hedge, which creates some squeezy gamma dynamics. And so in general, the realized volatility environment in single names has been super. So now we think it’s a very interesting opportunity set. It’s still a dynamic one.
Benn Eifert:
It doesn’t make sense to have a dispersion trade all the time. Sometimes you want to be long correlation because the vision fund has just taken it to some crazy price. But what we’ve spent a lot of the last six months doing was building a technology infrastructure that could apply our approach to the markets to dispersion, and to be able to be simultaneously out there working many, many thousands of option orders in low latency, effectively making markets in the direction that we’re trying to get into or get out of.
Jason Buck:
I’m going to come back to that, that making markets. But one of the other opportunistic trades that you’ve had on is European dividends. What did you see this year in European dividend trade?
Benn Eifert:
Yep, so you know dividends are a really fun market. That’s a market I think not a lot of people know about unless you’re specialized in the space, right? So there is markets globally, although historically they were biggest in Europe, where you can buy or sell dividend futures which effectively pay you. They pay you out. They settle at maturity based on the amount of dividends paid in the underlying index, by all the stocks in the underlying index over the prior calendar year. So if you buy a 2021 Euro stocks dividend future, you just count up all the dividends that got paid in 2021 by Euro stocks companies and that’s the settle price, right?
Benn Eifert:
And it’s like, “Oh, why would you trade that? Why does that market even exist? That’s weird.” The reason it exists comes back to those structured products that we were talking about, where almost all of the time when you buy a structured product that say pays you that 7% coupon unless one of the underlying indices goes down a lot, the reference is always to the index price level, not to the total return series of the index, right? So effectively, there’s no dividends in that product that you’re buying. But when the dealers go out and they hedge the delta on the other side of that, they’re buying sticks that have dividends in them. And so effectively that creates this risk to dividend exposure that banks then need to recycle back into the market, and that’s what gave rise to dividend futures.
Benn Eifert:
And so a lot of the … So they settle in a very fundamental way, right? How many dividends got paid. We count them up and that sounds like a thing for guys who know balance sheets and how many dividends are these guys going to pay? But dividend futures trade in a way that’s very heavily driven by the hedging of those structured product portfolios and the complicated stuff that goes on there. So in March, you had huge blow-ups in the space where effectively the French banks got long a tremendous amount of dividend risk exposure all the way across the term structure, because of how fast those markets went down and how the structured product’ weighted average lives extend when markets go down.
Benn Eifert:
And the result of that was that the risk managers eventually forced the traders to hedge those positions. They sold short data dividends primarily, which are more liquid, to hedge their entire portfolios so effectively putting the bank positions kind of net short at the front end of the dividend term structure one or two years, and then keep holding onto those net long positions at the back because they’re just too illiquid to sell in the size that they had. And then a lot of hedge fund portfolios were taking a lot of pain and getting liquidated on the back of those moves, so we know those markets very well. Again, we hadn’t been involved the last few years because we didn’t think there was anything interesting to do. But all of a sudden now, there were these massive dislocations triggered by this exotic desk hedging under stress.
Jason Buck:
Yeah, my first question and you touched on it would actually have been the liquidity. Obviously this is a function of the futures indexes are not stripping out the dividends, so that’s why all the hedging comes in. And so the index futures have a lot of liquidity, but what kind of liquidity do you see, especially like the Euro stocks dividend market? But I guess as a smaller player, you can be more nimble in that space and so it’s also nice that it’s a capacity-constrained environment or …?
Benn Eifert:
Yeah, exactly. So they are big markets. I mean there’s billions and billions of dollars of open interest, but that said it’s better if you are as active as we are in that market, you can’t be huge. So we might be moving millions or tens of millions of dollars a day in dividends futures contracts. But if you’re trying to move hundreds of millions of dollars a day in dividends futures contracts, you’re going to move those markets a lot, and which of course is what the French banks did when they had to unwind there. So you do see bigger players involved in that space, but they’re typically involved in a much more static way where they work their way into a position and then they just wear that position for a very long period of time.
Benn Eifert:
In our view, that was part of what amplified the risk in the dividends market was that there were a lot of tourists in the space before March 2020. There were big asset managers and big hedge funds that just viewed dividends as an alternative beta and just bought a bunch of them, and then panicked and tried to sell some of them when things were going down, at the same time the French banks were trying to sell them. So yeah, our view in general in this space is that running a capacity-constrained strategy where you are nimble enough to move risk around and to be able to be in when you want to be in, to get out when you want to get out, and to be able to provide liquidity in a meaningful way when there’s tons on the other side, and air pockets of liquidity I think is the right way to be. You don’t want to be so big that you end up just putting on positions and being totally stuck in them.
Jason Buck:
You’ve touched on throughout this conversation from the beginning, middle and all the way through, this idea of part of your alpha is in your trade construction and execution. You’ve said before, this idea of being a one-sided market maker. Can you talk a little bit about, what does that actually mean in reality, trying to be a one-sided market maker?
Benn Eifert:
Yeah, absolutely. So if you think about the traditional way that hedge funds would have executed trades, and we would have executed trades five or 10 years ago, you’re a liquidity taker in the sense that you have a trade you want to do. Maybe you want to buy a vol swap or whatever it is, so you quote eight banks. You say, “Hey, can I see a market in this vol swap?” And then they all come back with bids and offers, and you hope there’s a good enough offer. If there’s a good enough offer you lift it, right? And you know, hopefully you measured where you thought mid-market was and how much transaction costs you pay, but you’re removing liquidity from the market.
Benn Eifert:
In our case, again where we see this growth in exchange volume in liquidity and participation, what we’re trying to do is effectively put on the positions that we want, and get into and get out of risk, but providing liquidity and effectively participating in that exchange volume until we built the position that we want, and then as we manage those positions, participating in the exchange volumes to do it, right? So what that looks like is, we’re not going into a broker and saying, “Hey, this is the trade I want to do. What’s the price?” What it looks like is we are continually … We’re sending out a set of orders into the market, right? Which say, “Here’s what I want to buy. Here’s what I want to sell. For the things that I want to buy, I want to be bid continuously no more than 0.05 volatility points below theoretical mid-market on a real-time basis in randomized trades, batch sizes between one and 10 lots. I want to …”
Benn Eifert:
Which is effectively what a market maker is doing, right? They’re saying, “Here’s where I’m bid. Here’s where I’m offered.” But a pure market maker, their whole business model is that spread, right? And it’s trying to get hit on their bid, which is by buying below mid and then getting out of it closer to the offer side, right? We can be better bid than Citadel or Susquehanna on the things that we want to buy, because we want to buy them, right? Because we’re trying to work into a position, and we want that risk and we’re in principle willing to pay up to theoretical mid-market to get it on. Whereas they need to get paid enough edge to make it worthwhile to take on the inventory, right?
Benn Eifert:
And the drawback of that or why a lot of people don’t do that … Well, obviously it’s a lot of work to build the systems. But also, it means you don’t just quote the trade that you want to do exactly how you want to do it, and then put on the whole trade all at once, right? There’s uncertainty. How long is it going to take me to get into this position? How am I going to manage the legging risk getting into this position to make sure I’m not just getting filled on all my long vol side and not my short vol side and so forth, right? But the advantage of that is, when we do our transaction cost analysis looking at everything that we do, we earn a small amount of money on transaction cost attribution, right? So we don’t pay transaction costs. We collect them. Not a ton; that’s not the business. That’s not how we make our returns, but if it was zero we’d be happy, right?
Benn Eifert:
Because that means in a world where it’s expensive to transact, we’re getting into and getting out of the positions that we want to and the sizes that we want to without paying transaction costs. We’re able to do that again by just sourcing liquidity where it’s available, being bid there. Not saying, “I have to lift the offer,” but being bid there and waiting for somebody to come.
Jason Buck:
But by trickling out and pinging the market like that, you’ve got to be getting an interesting feedback of information. Do you ever put that back into your models as far as, maybe we should or shouldn’t be putting this position on in size?
Benn Eifert:
I mean, you certainly can identify quickly when there’s a big seller in the market, for example, for something that you want to buy, right? Because you’ll go out into the market and sometimes there will be a slow trickle of fills and sometimes there will be a flood of fills, because somebody has identified that there’s a source of liquidity and they’re trying to get done. A lot of times we expect that to be the case, right? Because we see a dislocation. We might not totally know where it’s coming from, but we might have some idea of the type of thing that’s going on, and there’s a dislocation there because somebody’s selling it, right? I mean, that’s why it’s there. That’s what we expect.
Benn Eifert:
And so when we go out in the market to buy and we see kind of aggressive flow coming in, for sure. One area where it does become relevant, like think about dividends for example. When we were starting to put on those positions in March, when obviously the world was very hairy and the French banks were just liquidating those positions, fire sale, and hedge funds too, those were think markets in that environment. And so you’re very much relying on market feedback in terms of how aggressive you want to be as a buyer, right? Because if we … The day that we decided to start doing those trades, if we were just really aggressive and we said, “We’ll buy everything that somebody’s willing to buy right here,” we would have bought it all and then they would have dropped another 10 points, right?
Benn Eifert:
What you’re trying to feel for is, how aggressive are these sellers? How much more is coming? You can put a five or 10 lot out and then they immediately hit that bid and crush it down another 50 cents. That means you want to really piece into that slowly. You want to chisel into the size. You want to see how far people are willing to sell it down. How desperate are they? And then you want to get really aggressive as soon as it feels like that’s actually stabilizing, and then the massive wave of selling isn’t coming anymore. Now it’s like, “Okay, this is a huge liquidation. It went way too far. But now it feels like it might actually be done. Let’s get aggressive.” And even if then you end up coming out and pushing the market a little bit to get into your big size from that point, it’s better than kind of being the guy who raises his hand and says, “I’ll take that trade” like 20 points earlier, right?
Jason Buck:
Exactly. I get this question often from retail traders who are looking to be maybe newbie options traders. They’re always like, “How does somebody like Benn know where these structural flows are coming in and everything? What are they looking at? What’s on their screen?” And I’m like, “I don’t mean to be coy but it’s like from building two decades of experience and relationships with other traders in the markets at major banks and major institutions,” right? I mean, there’s just no other way to really get a good feel for that.
Benn Eifert:
Yeah, for sure. I mean, I think a lot of that type of stuff, one is just understanding who the big participants in the particular market that you’re looking at are, and that just comes with time and experience. It’s not rocket science typically, because there are very large organizations. You think back over the last three years and some of the really big trades that were happening, you know who’s doing it very quickly because there are certain flow patterns and signatures and flow that all of the dealers obviously know, and all the brokers obviously know. There’s no anonymity when you’re big, right?
Benn Eifert:
It’s interesting. People think, “Oh, trading OTC makes it anonymous,” or “Trading with a broker makes it anonymous” or whatever. It’s ridiculous, right? I mean, because when Harvest Volatility Management back in 2018 is rolling its iron condors it’s like, “Well, there’s one …” And UBS was, well, I mean there’s only one guy who rolls 20,000 lots of eight-legged iron condors. That’s UBS, and then the guy that rolls 10,000 lots, that’s Harvest, so you know exactly what’s happening, right? And I think the same is true even in the more niche-ier spaces where some of those exotic risk transfer trades are going up, and who’s positioned how? Those are just things that you understand in the market based on knowing all the senior people in the market and knowing what everybody’s doing.
Jason Buck:
Good. Taylor, do you have any other questions or something you want to touch on before I ask my final question?
Taylor Pearson:
No, take it away.
Jason Buck:
So I have a very difficult, exotic hedge question for you.
Benn Eifert:
Okay.
Jason Buck:
So if people follow you on Twitter, they’ll understand this. Maybe this is like your Friday trader question, all right? So my question is a bit different, though. How do you hedge your exceedingly convex water bill if your son keeps hosing down your neighborhood to protect the rest of the neighborhood from wildfires?
Benn Eifert:
That’s just theta, man. You just pay the theta, and sometimes it feels like a lot of theta but you’ve got to own the convexity, and it’s just worth it, and that’s it. I actually rolled out in my head, I have a mental accounting bucket for child care costs and that number is astronomical. I just wall that off. I have no emotion about that, because if I think about it it’s mind-numbing. So if you just think about it as $1,000 a month of extra child care costs, then that’s a little easier to bear.
Jason Buck:
So it’s just a pure upside call on entertainment, then.
Benn Eifert:
Exactly. That’s what it is. It works out okay.
Jason Buck:
Got it. Benn, thank you so much for coming on. We appreciate it.
Benn Eifert:
All right, guys. It was a lot of fun. Thanks for having me.
Taylor Pearson:
It was great. Thanks, Benn. Thanks for listening. If you enjoyed today’s show, we’d appreciate it if you would share this show with friends and leave us your view on iTunes as it helps more listeners find the show and join our amazing community. To those of you who already shared or left your view, thank you very sincerely. It does mean a lot to us. If you’d like more information about muni fund, you can go to munifund.com. For any thoughts on how we can improve this show or questions about anything we’ve talked about here on the podcast today, drop us a message via email. I’m taylor@mutinyfund.com and Jason is jason@mutinyfund.com, or you can reach us on Twitter. I’m @taylorpearsonme, and Jason is @jasonmutiny. To hear about new episodes or get our monthly newsletter with reading recommendations, sign up at mutinyfund.com/newsletter.
