Long Volatility Strategies, George Lucas and Dennis Rodman
In this episode, we chat with Chris Cole, founder and chief investment officer at Artemis Capital Management. Chris is an expert in long volatility strategies and has a knack for coming up with analogies to explain them.
We talk about why Dennis Rodman is arguably one of the best basketball players of all time despite scoring less than eleven points per game and what investors and individuals can take from that in terms of how they think about diversification.
We also discuss why George Lucas may have been the greatest volatility trade of all time, why forgoing gains in a long volatility strategy in the first leg down after markets drop 3,4,5% is a better long term strategy and what Chris thinks about fixed income like government bonds as a hedge against market crashes going forward.
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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 7:
Taylor Pearson:
Hello and welcome. I’m Taylor Pearson and this is the Mutiny Podcast, brought to you by Mutiny Fund, a multi-strategy long volatility fund designed to give retail investors a way to insure their portfolios against volatility, tail risk and black swan events. 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.
Taylor Pearson:
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.
Taylor Pearson:
Due to industry regulations, participants on this podcast are instructed to not make specific trade recommendations, nor reference past or potential profits. And 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 chat with Chris Cole, the founder and chief investment officer at Artemis Capital Management. Chris is an expert in long volatility strategies. He has a knack for coming up with great analogies to explain them. In this episode, we talk about why Dennis Rodman is arguably one of the best basketball players of all time, despite scoring less than 11 points per game, the lowest of anyone in the Hall of Fame, and what investors and individuals can take from that in terms of how they think about diversification.
Taylor Pearson:
We also discuss why George Lucas may have been the greatest volatility [inaudible 00:02:02] of all time, why foregoing gains in a long volatility strategy in the first leg down after markets dropped three, four or five percent is a better long-term strategy, and what Chris thinks about fixed income by government bonds as a hedge against market crashes going forward. I hope you enjoy the episode.
Taylor Pearson:
So, Chris, you’ve written about Dennis Rodman and how some of his history’s misinterpreted. He’s arguably one of the 20 best players of all time, despite being the lowest player. Why is that and what is the lesson you take from that in terms of portfolio construction?
Chris Cole:
Well, Rodman’s a fascinating basketball player in the sense that his skillset is dramatically undervalued by the market in a classic Moneyball sense. So let’s recap about who Dennis Rodman was as a basketball player. I think everyone remembers, when they think of Rodman, they think of this guy who was wearing wedding dresses, married Madonna, was hanging out with Kim Jong-un.
Chris Cole:
But a long, long time ago, Dennis Rodman was a basketball player and a really good basketball player who won multiple championships, both with the Chicago Bulls and the Detroit Pistons. Rodman was the lowest scoring inductee in the Basketball Hall of Fame. He never averaged more than 11 points a game in a season. He was not even a scoring threat beyond five feet from the basket. The guy could not score. When you played with Dennis Rodman on your team, you were effectively playing four on five on offense.
Chris Cole:
So something really weird happened, though, when you put Dennis Rodman on your team. He has one of the highest wins over replacement values in NBA history. His teams went from average to good, and from good to great when he joined them. And his teams offensive efficiency jumped through the roof when he was on the floor. So what was it with this guy?
Chris Cole:
Well, Dennis Rodman did one thing and one thing exceptionally well, which was rebound the basketball. When other teams missed … When your offensive players missed their shots, Rodman would get the rebound, and he was so good at getting second chance opportunities at scoring, he was a six standard deviation outlier in rebounding compared to anyone else in the league. No player in NBA history has achieved that degree of statistical separation from average in any other stat than Dennis Rodman.
Chris Cole:
So, Rodman did for rebounding what Michael Jordan did for scoring. So something really bizarre would happen when you put Rodman on a team of even average scorers. You have a bunch of average scorers, they miss a couple of shots, Rodman’s able to get them second, third or fourth chance opportunities. And this resulted in tremendous improvements in offensive efficiency and wins over replacement value.
Chris Cole:
Rodman is a classic anti-correlated asset. He’s very similar to the role that volatility can play in the institutional portfolio. Most other asset classes … And this is true if you’re investing in equity, it’s true if you’re investing in corporate credit, it’s true if you’re investing in VCs and start-ups, it’s true of corporate profits. Most of your portfolio is long GDP in some format.
Chris Cole:
And the problem is that when you go through a scoring slump in your portfolio, that tends to transmute through everything to the performance of start-ups to tax receipts to the cross asset classes. Everyone suffers at once. So there’s very little in the institutional portfolio that’s anti-correlated. That, in essence, can rebound the misses of the other asset classes.
Chris Cole:
Well, long volatility as an asset class is very similar to Dennis Rodman. During these long periods where there’s high scoring in markets and markets doing really well, long volatility does not look very impressive. A good long vol fund is merely being static during these periods, or maybe even losing a little bit of money during these periods.
Chris Cole:
But if you’re able to get tremendous performance when there’s a change in the business cycle from your long volatility fund convexing on linear performance, meaning that for every one point of loss you’re getting two or three points of gain from your long vol, that’s giving you second and third chance opportunities that over the business cycle will result in additional wins for your portfolio.
Chris Cole:
So a really strong anti-correlated asset like long volatility that’s anti-correlated to the credit and business cycle peppered into your portfolio can have massive gains for the institutional portfolio when you look at it as a composite whole. Very similar to the role Dennis Rodman played on the three-time champion Bulls, or the two-time champion Detroit Pistons.
Chris Cole:
So to this point, when you take long volatility and you pair it with a simple equity portfolio, over the business cycle you get over two times the risk adjusted performance that you get in a simple equity portfolio. If you look at that combination, that simple portfolio of long vol with the S&P compared to the average hedge fund, that has beaten the average hedge fund by over 90% since 2005, and it’s quadrupled the risk-adjusted return.
Chris Cole:
So the numbers are quite powerful, yet very similar to Rodman, long volatility is not a popular strategy. It is not something that people really understand the value of until there is that shift in the cycle, until you need that rebounding.
Taylor Pearson:
Speaking about volatility, I think the idea of long vol, long volatility isn’t super intuitive to someone that hasn’t spent a lot of times in the markets. I know you talked a little bit about George Lucas as an example of a great vol trader. Why is that? How does George Lucas … or how did he think about volatility and how does that influence how you think about it?
Chris Cole:
It’s interesting because some of the … You guys come from a world of venture capital, and it’s interesting that long vol and VC investing have some similarities. I’ll get to the Lucas dynamic in a second. But really, when you’re investing in long vol, you’re making a number of small bets that often times don’t pay off. They often times don’t pay off. But the one out of 10 or one out of 100 times that they pay off, they pay off really, really big.
Chris Cole:
The difference between venture capital and long volatility is that, in a classic long vol portfolio, those payoffs occur during periods of dislocation and change. So where the VC portfolio follows the business cycle, the long vol portfolio is going to make most of its gains in a period where there is sustained turbulence and crisis and change in markets.
Chris Cole:
That could be a period like 2007, 2008. It could be a period like 1928. It could be a period like 1998. And most importantly, we can see payoff on either end of the tail distribution. Volatility can pay off on a left tail where there’s a big crisis and things drop. Or you could have massive payoff and volatility in the event of some sort of a currency debasement that leads into a melt up in stock markets and asset prices, like was experienced, for example, in Germany in the 1920s, or in the late 1970s in the United States.
Chris Cole:
So volatility can pay out, but what vol needs to pay off is change. You need massive change in the system. When you’re making a bet on volatility, you are making a bet on change and you’re going to lose a little bit of money in the event that the status quo prevails. So in that sense, it has some similarity to venture capital with the added benefit of being anti-correlated to the business cycle.
Chris Cole:
So the discussion about George Lucas, I always say that Lucas is a brilliant options trader and a brilliant volatility trader. A long time ago, what happened is that George Lucas was making a science fiction movie. And, at the time, science fiction was not a very popular genre for studios. There was no precedent for a blockbuster science fiction genre film.
Chris Cole:
So obviously the film I’m talking about is Star Wars. And Lucas, his salary at the time, he was coming off a lot of success directing a movie called American Graffiti. He was able to command, at this point in the 1970s, a salary of about one million dollars. And what Lucas did is he said, “Look, what I’m going to do, don’t give me a million dollars. Pay me 150 thousand dollars. But I want to own the merchandising and sequel rights to my new movie, Star Wars.”
Chris Cole:
And, at the time people look back and they think of that as some sort of a radical idea that Lucas did. It actually was not that radical. The studio at the time, they had taken bets on merchandising and sequel rights from a movie called Doctor Dolittle that was done in the 1960s. The studio executives had done this movie. They had tremendous hopes for selling toys and doing sequels. And Doctor Dolittle was a complete bomb. They pretty much bribed the Academy to get it into the Oscars that year, and they ended up writing down 200 million dollars of plush llama toys.
Chris Cole:
So at the time, in the 1970s, remembering the disaster that was Dolittle, the studio didn’t think there was much ability to sell toys, licensing tie-ins, sequel rights. These things were not valued appropriately. Well, Lucas took a little bit of his carry, his salary, actually, a decent amount of it, said, “I’m going to make a bet on these higher order, non-linear gains.” So, to this extent, for this bet to pay off for Lucas, Star Wars needed to be more than a moderate success. It needed to be a game-changing type of success.
Chris Cole:
For things like sequel rights and merchandising rights to pay off, Star Wars had to be a big hit. And, of course, it was. And essentially, for the cost of about 850 thousand dollars, he was able to purchase an option that paid off over 45 billion dollars, and it’s still paying off to this day.
Chris Cole:
But that is very similar to the philosophy of long volatility. You have some carry in good times. You’re taking in money. You’re making money on your equities. You’re making money on all these VC things paying off. You’re making money on a variety of different asset classes in a bull market. And what you’re going to do is say, “I’m going to take a portion of that aside and I’m going to use it to bet on change in the business cycle in an anti-correlated fashion. I understand that this will not pay off if the status quo is maintained, but if the status quo is maintained, the rest of my income streams will be fine.”
Chris Cole:
It’s the game-changing shift in the current market paradigm where long vol pays off. And very similar to the Lucas bet, pays off in an asymmetrical fashion. So I think what long volatility funds like Artemis try to do, we find ways to structure these non-linear bets that allow you to take risk responsibly. We are trying to provide an ability to create opportunity from change and allow our clients to take risk responsibly, knowing that they have this non-linearity in their back pocket, a Dennis Rodman to rebound the ball in the event that markets change in a dramatic and unpredictable fashion.
Taylor Pearson:
I think that diversification across volatility, yeah, it makes a lot of intuitive sense when you explain it that way. I think one of the places people get hung up, and I’m curious for your thoughts, is that the long volatility return profile can be confusing because it doesn’t really have a one-to-one correlation with volatility. Particularly smaller movements, a two or three or five percent decline in markets. But as you mentioned earlier, it has that non-linear convex returns as you go deeper into a bear market. How do you explain that? How do you think about that?
Chris Cole:
This is such an important point to make, because volatility investing is a bet against status quo. It’s a bet on change. So a lot of times, people will come up and say, “Oh wow, the VIX jumps up or volatility jumps up to 20. The S&P goes down five percent. This must be really, really good for you.” Not really. Not necessarily. That is not a change in the status quo. That may or may not be good for us.
Chris Cole:
Often times, we’re seeing those types of moves as an ability to enter into trades, to get into an opportunistic position. Because it’s not the five percent down or five percent up that we’re trying to monetize. That’s within one standard deviation. That’s within the normal boundary of things that occur all the time in markets. What we are looking to do is to use that period as a set-up so that we can monetize the down 50% period, when the market is crashing like in 2008 or in 1987.
Chris Cole:
Or, alternatively, when the market’s up 100 or 200% and the currency is being devalued, that is another period. It is the extreme changes where we make non-linear gains, not these intermediate vol spikes or these very small, one standard deviation moves. We’re looking for the three, four, 10 standard deviation move in either direction.
Chris Cole:
And I think that’s very, very difficult for people to understand, particularly because most people, after long periods, have a recency bias, and they actually forget how volatile markets can become during periods of change. Last year, volatility left up to, on average, about 17. So it jumped from the low teens to about up to 17. And people were saying, “My goodness, what a volatile year this is. Volatility is up so much. There’s so much volatility.”
Chris Cole:
And I think most institutional investors, most people who do this for a living, are actually shocked to learn that last year’s volatility level of 17 was actually several points below the long-term historic average of vol, and that vol can average upwards of 40 or even 50 during periods of sustained turbulence. So we are really there. This is the same concept, to go back to Lucas, Lucas was not betting that Star Wars was going to be a modest success. His merchandising, his sequel rights were not going to pay off if Star Wars came to the box office and it made a little bit of money and it came and went. That’s not what those merchandising and sequel rights are for. Those merchandising and sequel rights are for a film like Star Wars to be a game-changer.
Chris Cole:
And when you’re placing non-linear bets, that’s what you’re trying to monetize, something that truly changes the regime. And the game plan is to put lots … to not just bet on one Star Wars but lots of different films or lots of different periods of potential change in an intelligent fashion so the one that breaks through can pay for all the losses.
Taylor Pearson:
I’m curious how you think about what’s going on in the market right now and market structure right now and how that plays out. I know you wrote a paper. I think in maybe 2016, 2017, you said the market was underpricing or was underestimating very low volatility in the short-term and very high volatility in the long-term, and I think 2017 was one of the lowest volatility years in 40 to 50 years. As you mentioned, 2018 was below historic norms. What is the market dynamic that you see that makes you think that?
Chris Cole:
Well, I mean, the market dynamic that makes me talk about where volatility has moved is simply just math, because we have hundreds of years of volatility measurements. So when I’m saying that volatility is returning to average, I have years and years of data to be able to look and back that up.
Chris Cole:
But right now, when I look at the landscape right now, I actually feel quite uneasy about it. Quite uneasy about the direction that we’re moving. And a lot of times, people would sit back and they would say, “Okay, you feel uneasy about markets, but I actually think we might be moving towards something that … not only a regime shift in markets but a regime shift in the very social fabric.” So I think that gets pretty interesting.
Chris Cole:
But let me throw out some stats right now. We use a lot of different techniques to understand when the probability of volatility’s rising. We look at hundreds of thousands of data points. We run them through pattern recognition algorithms. But at the basics, volatility can be decompressed into three main indicators. One would be liquidity. One would be credit conditions. And the other would be cross asset relationships.
Chris Cole:
So let’s talk a little bit about where we are in the business cycle with each of these factors. We are currently in a debt [inaudible 00:22:07], let’s say. 47% corporate debt to GDP. The highest levels ever in the United States history. And sovereign debt globally has exploded. But corporate debt in particular in the United States, which is highly correlated to the business cycle, we have currently the highest levels of corporate debt as a percentage of GDP ever.
Chris Cole:
You throw onto that fact the idea that 2.5 … The dominant percentage of that corporate debt, which is about 2.5 trillion dollars, or approximately over 50% of the investment grade market is now at the lowest [inaudible 00:22:56] of investment grade. So any business cycle, we are likely to see a large portion of what is now in … A business cycle shift. We are likely to see a large portion of what is now investment grade debt downgraded to high-yield debt.
Chris Cole:
If only approximately one third of that triple B rated investment grade debt gets downgraded, it will overwhelm the high-yield market. And many buyers, many pension systems will be forced to sell, because it’s not longer investment grade. So this produces a potential powder keg of volatility since rising credit spreads and OEF spreads are intrinsically linked to higher vol in equity markets.
Chris Cole:
So one might sit back and say, “What is driving … What are corporations doing with all of this debt? Why are they issuing all of this debt?” Well, it’s not going to capex. In fact, for the first time in history, we have seen the amount of share buybacks eclipse capex. So what companies are doing with all of this corporate debt is they are using it to buy back their own shares.
Chris Cole:
And this is producing a dangerous cycle of volatility suppression. And I’ve compared this to a snake eating its own tail, where you have record low interest rates, a tremendous amount of corporate debt issuance, the stock market is literally consuming itself. In a very literal fashion, US companies are buying back their own shares. And this has been reducing liquidity.
Chris Cole:
So if we go back to the set-up of what can lead to higher vol, where you have over-leveraged companies, you have potential for poor liquidity because the only marginal buyer of the equities is the S&P, are those companies themselves buying back their own shares, which is a trillion dollars this year. And then on top of it, if you have just even a basic business cycle retrenchment, this will cause a potential unwind in this leveraged monster. And these are all massive drivers of volatility, potential drivers of volatility over the next three years.
Chris Cole:
And we are seeing major divergences in where equities are going to today verus where bond markets are going. And obviously the Fed is appearing to want to stem off this potential liquidity avalanche.
Taylor Pearson:
Yeah. The volatility suppression example, I always think of … I think this is a Nassim Taleb line was something like, “Jumping off a one foot wall 100 times is not the same as jumping off a 100 foot wall one time.” In a sense, you’re falling 100 feet but that suppression of mild to moderate volatility, jumping off a one foot wall or a three foot wall, can sometimes create conditions for higher levels of volatility that has that non-linear either payoff or downside in the long-term.
Chris Cole:
Yeah. It becomes quite … There is an additional non-linearity that occurs by the fact that … I mean, Wall Street … And I think Jim Grant said something to this effect. I’m trying to remember his exact quote. But you have a good idea on Wall Street, and it starts out as a good idea, and then it becomes the institution. Everyone is doing that idea and that idea actually becomes a source of risk.
Chris Cole:
So in 1987, there was nothing wrong with portfolio insurance. There was nothing wrong with portfolio insurance, but when suddenly it becomes a dominant institutional strategy, it becomes a source of risk that becomes reflexive. In the same vein, share buybacks done responsibly as a tool to repurchase shares when a stock price is undervalued can be a responsible tool. When those share buybacks are being funneled with ultra-low interest rate corporate debt that’s shoveling on debt onto corporate balance sheets, and then the only marginal buyer in the stock market becomes the companies of the stock market itself levering up their shareholders to the extent that then that is producing … With the share buybacks, you have a price insensitive, buyer supporting markets, which is then incentivizing all these algorithmic strategies to short volatility and buy dips.
Chris Cole:
This actually creates a concentration of non-linear risk that is very difficult to fully quantify and understand its impacts. In my 2017 paper, we put that quantity at about two trillion dollars worth of short volatility in share buyback strategies a year. And to put that in perspective, portfolio insurance that led to the collapse in 1987 was only about two percent of the market cap, and currently these strategies have about eight percent impact on the market cap of the S&P.
Chris Cole:
So this really is a snake eating its own tail. And that can be nourishing for a while, but there is a natural end game to that. And that end game occurs when a natural recession or a spike in credit spreads, causes the party to end.
Taylor Pearson:
I was reading that paper getting ready for us to talk, and I remember it popping into my head, I’m not sure if you’ve heard of … I think it’s Goodhart’s law or [Goodurt’s 00:29:16] law, but it’s when a measure becomes a target and ceases to become a good measure?
Chris Cole:
Yes, yeah. It’s really interesting because volatility … I had this analogy about volatility. If you go look at … And it’s a classic example of this. If you go read CFA textbooks or an MBA textbooks, they always talk about volatility as this measurement of risk. And it implies that volatility is this statistic that is somehow outside of markets to measure the risk of an investment.
Chris Cole:
But today, volatility in a world of ultra-low interest rates where the entire German and Swiss yield curve is now negative, volatility is being actively sold and harvested as a form of yield, in many different ways. So when volatility becomes … which used to be a simple statistic, becomes a proxy for taking risk, when all of these strategies use volatility as a measurement to allocate risk, all of a sudden it introduces a tremendous self-reflexivity. Volatility has ceased to become a statistic that is observable and is now an active participant on the playing field, affecting the game, and that’s leading to a dangerous reflexivity that I think many market participants do not fully comprehend or appreciate.
Taylor Pearson:
On the volatility front, I think one … When you talk to a lot of investors about … maybe not volatility, but certainly diversifying against a market crash, one of the things people often say is, “High quality fixed income, usually in the form of government bonds, has historically been considered a hedge or maybe a long vol strategy.” I know you’ve done some research. How do you think about that?
Chris Cole:
Yeah. If you go back and look at previous cycles, I mean, you don’t have to go back very far. Even to the mid 2000s, go back to the late 1990s, we see instances where the Fed is able to cut interest rates by five to six percent. So, okay. People forget there’s a convexity or a non-linearity or a gain that is non-linear when rates decline. So it’s not a one-to-one. If rates go down 100 basis points, bonds do not necessarily have a one-to-one gain on that. There’s a convexity that is driven from that, both in the price of a bond and in the economy.
Chris Cole:
But today, if the Fed wants to lower interest rates, I mean, they can, but to get that same power, they’ve got to go to negative two, negative three percent. That could be quite destabilizing. So your upside on your bond portfolio is not what it used to be back in a period where rates were at six and seven percent.
Chris Cole:
And we’re constrained in that way. And Europe and … Just as Japan has been constrained for a decade and the way Europe is constrained right now. So in a best case scenario, you get marginal pick-up in a bond portfolio. I mean, in the US you have less than 200 basis points to go here.
Chris Cole:
But worst case scenario, if we see some sort of inflationary environment or there is some sort of a currency debasement problem, you could see a scenario where stocks and bonds decline together, and that certainly has happened historically. We saw that in a period like the early 1900s. We saw it in a period like the late 1970s. In that scenario, your bonds, which you think are a defensive asset, you think your bonds are serving the role of Dennis Rodman, actually begin to actively miss shots on your behalf.
Chris Cole:
And when there’s a correlation breakdown between stocks and bonds, that could be disastrous for the institutional portfolio. So that’s one of the major reasons to have a long vol asset. Everyone tends to think of volatility as being something that you want to hold in the event of a deflationary crash. Certainly if there’s a crash on the left tail and stocks drop 50%, your payoff on your bond portfolio is not what it was even as recently as 2007. There’s just not that much more of interest rates to cut.
Chris Cole:
But on the flip side, if we have a regime where there’s some sort of debasement and you have some sort of stagflationary result … And I’m not making predictions here. I’m just stating potential outcomes. If we have that stagflationary bond vigilante outcome where stocks decline and bonds decline, the classic 60/40 stock bond portfolio is going to be remarkably harmed to a point of potential pension insolvency. And that’s a great reason to have volatility in your portfolio as well.
Taylor Pearson:
You mentioned Japan and what’s going on there. Have you looked into maybe the past 20 or 30 years of Japan’s history in financial markets? I know some people have made comparisons, maybe the US today is similar to where Japan was in the ’90s. Is that something you’ve looked into at all?
Chris Cole:
Yeah. I mean, absolutely. I think Japan is one of those … It’s kind of that litmus test for where the US could go, particularly as baby boomers begin to retire and they go from a net accumulation phase to a phase where they’re selling off assets. And that’s a massive deflationary type of trend.
Chris Cole:
So it is our job to do the worrying for our clients and to think about the myriad of potential different outcomes, and certainly history in other countries provide that guide. And in looking at that, it’s our job to find ways to make payoffs in a non-linear fashion regardless of what direction the market leans towards.
Chris Cole:
So definitely Japan is one of those models that I think we’ve looked very seriously at as that complete deflationary spiral that is led by demographics. It’s definitely an outcome that we pay a lot of attention to and are very serious about.
Taylor Pearson:
You’ve written something as well about one of the challenges with long vol funds historically has been that they tend to bleed. If you look at the CBOE tail risk index, I think it’s down something like 50% from 2012. You typically, if you’re buying options, you’re paying that premium upfront hoping that the eventual payoff compensates for that, that bleed. How do you think about that and how does Artemis think about managing that or doing that?
Chris Cole:
Well, it’s our job to find ways. I actually look at Artemis and I see that our strategies are intended to be alpha givers. So I don’t think of Artemis as a classic tail risk fund, and I don’t hold ourselves to that standard. If we’re bleeding out 50% over a period then we’re not doing our job.
Chris Cole:
So I’m looking for ways to … If it’s the Vega fund, I’m looking for ways to carry that exposure neutrally. And if it’s some of our other funds, our new Hedgehog fund, we want to be positive through the market cycle by playing both tails. But at the same time, by being true to our mandate.
Chris Cole:
And so, we’re going to use every tool. We have different tool that we use to do that. Artemis Hedgehog, we use a lot of data and regime detection to dynamically buy options. I think the common misconception is that a guy like me buys an option and sits on it. We buy a tail risk option and we bleed and we wait for the world to end. That’s not true at all. We are actively looking at hundreds of thousands of different data points and we’re using those data points to strategically understand when we should be buying either a right or a left tail option that can profit if there’s volatility. To the upside or volatility to the downside.
Chris Cole:
In one of our more classic funds, the Vega fund or [inaudible 00:38:45] fund, we’re trying to carry neutrally by using those types of techniques in addition to finding opportunities where we can own convexity in a positive carry, or when we can own some carry that funds tail risk convexity.
Chris Cole:
There’s numerous ways to do that but they all involve a staff of nine people and multiple PhDs and tremendous professionals working together around the clock, being focused. There’s no one silver bullet that enables you to do that. It is a very, very active process.
Chris Cole:
But certainly I will say, even from some of our peers in the long vol index, that strategy over a business cycle, it should be evaluated over a business cycle. It’s very similar to Dennis Rodman. If your team’s on a scoring streak and Rodman’s not scoring, the foolish coach would be like, “Why is this guy in the game?” And the even more foolish coach would take him out in the fourth quarter saying, “Hey, I’ve got a 10 point lead. Why do I need this guy?”
Chris Cole:
Or, “Hey, I’m playing soccer. We’ve got a four point lead. Let’s take out our goalie.” Right? “We don’t need goalies. Let’s take out our goalie and put another offensive player on the floor.” And that’s unfortunately the way most investors think. And there’s a tremendous behavioral bias and a FOMO because people have trouble encapsulating all the elements of the portfolio into one. And to think about it truly in a portfolio context instead of in an individual component.
Jason:
Chris, you just said one of the things we’ve been thinking a lot about lately and that’s actually the business of long volatility. So, when Taylor and I look at a lot of things, we use the entrepreneurial lens, right? And so, if you think about short volatility trades, whether it’s just buying an index, a 60/40 portfolio, a real estate [inaudible 00:40:53], everything, let’s be honest, it doesn’t take much just to hit that buy button.
Jason:
And so, if we think about … People like to talk about passive income or passive investing, and we don’t believe that exists. There’s a business or a person behind each one of your investments. So therefore the idea of passive investing or passive income, those short vol trades, we’ll see how they play out over a business cycle. But what I’m getting at is when you’re talking about long volatility, it’s incredibly dynamic, 3D chess and it requires an incredible amount of active management.
Jason:
In a world where everybody’s been pushing for passive and lower fees, we feel that only long volatility has this really active component to it which requires an incredible amount of PhDs, in-house talent, algorithmic machine learning. It’s a very energy intensive business. And therefore, it’s much more entrepreneurial and needs to be run as a business.
Chris Cole:
Yeah. I completely agree. And what’s fascinating is that it’s an extremely difficult business that’s not appreciated. It’s funny because a lot of large, well-respected hedge fund managers who are in more classic strategies tend to have a long vol guy on their staff doing this non-stop. So it’s the everyday investor who has no access to that expertize.
Chris Cole:
At the end of the day, it is a tremendously active process, and you need a team of people focusing around the clock on specifically that task. And it’s a thankless job, because during the times when you need a long vol manager the most, the times where the markets are most risky is when those long vol participants are least popular.
Chris Cole:
And I say this quite sadly. I’ve seen friends who have shops, competitors who have gone out of business, a number of different funds go out of business at this stage in the cycle. And it’s because it becomes difficult for investors to stay with strategies. And that fear of missing out leads people to make the wrong investment choice at exactly the wrong time.
Chris Cole:
So long volatility managers tend to be most popular when the crisis has already happened. In our Vega fund, we receive calls … When the VIX spikes to 40 or 50, the phone rings off the hook. But it’s too late at that point. That’s not when you need to be thinking about making an allocation. And I talk to my peers, it’s the same thing. Everyone is interested in long vol when it’s hitting the media and the market’s already down 30%.
Chris Cole:
But the time to be thinking about these investments is at the time when the party is still going on. The party’s still going on, the leverage is still being applied, the market’s up. But you need to figure out a way to get home and you need to line up your designated driver before the party gets out.
Chris Cole:
And that gets harder and harder every single time the Fed spikes the punchbowl at that party. But we know how this story ends. We know how it ends. And if you’re waiting to pick up that ride at 4:00 in the morning when everyone’s already drunk, your chances of getting home safely are greatly diminished.
Jason:
Yeah. And I can’t remember who said it, but it’s, “You’re going to look like an idiot. Do you want to look like an idiot before the bubble bursts or after the bubble bursts?” So that’s kind of a nice way to look at it. But you already alluded to it, but why do you think that … Like you said, if you just look back historically over multiple business cycles and a mix of short vol and long vol can actually beat 90% of hedge funds, why do you think they’re not doing it?
Jason:
I mean, going back to even Alfred Jones’ original hedged fund, we’ve gotten away from that and do you think that’s just the advent of, like you said, FOMO, or just going out the yield curve, or you have to invest in short vol because your institutional allocators want that? They don’t want that drag at the hedge?
Chris Cole:
Well, I think your average institutional allocator looks at the Sharpe ratio of something over the last three years. And they sit back and say, “What is the Sharpe ratio over the last three years?” So guess when tail risk and long vol were most popular last?
Taylor Pearson:
2010.
Chris Cole:
That’s right. That’s exactly right. Exactly. If you went to a volatility conference in 2010, 2011, everyone was talking about long vol, tail risk, hedging. Everyone was bending over backwards. Everyone was all part of the program. They’re going to bleed and blah blah blah. And then you fast-forward to today and those same conferences are all about yield enhancement and short vol.
Chris Cole:
So it’s incredible. I’ve actually been at a conference where I’ve watched the head of a massive pension system proudly say that he would not invest in anything that didn’t have a tremendously positive return over the last three years. Any hedge fund or active manager. And, to me, that’s like saying, “Hey, my team hasn’t missed a shot. We’re on a hot streak. So I’m going to take out my defensive player.” Or, “We’re up five goals. I’m going to take out my goalie. Because what is my goalie doing? My goalie hasn’t done anything over the last five minutes. Why do I need a goalie? Why do I need defense?”
Chris Cole:
And this type of behavioral bias is what drives it. So everyone’s … Come 2009, 2010, everyone had this traumatic experience in ’08. Everyone has read The Black Swan. And everyone is all in on anti-correlation and CTAs and tail risk and you name it. And fast-forward to now and, “I don’t know. Why don’t you monetize when vol hits 20? Why do I need this? It’s too expensive. I could get an extra two percent yield over here.” So this is the way these cycles work.
Chris Cole:
You go back, it’s the same thing across history in the late ’90s. There were numerous guys. Julian Robertson, Warren Buffett. There was an article in Barron’s in 1999 saying, “Has Warren Buffett lost his touch? The old model of investing is done, and should the Fed be taking into account the new economy metrics in a more powerful way to understand the power of these new evaluation techniques?” I mean, you can read this across history.
Chris Cole:
So nothing is new under the sun. The same cycle repeats itself over and over again. And this is why, at a certain point, doing the right thing is actually a business risk for various people at different points in the cycle. And that’s why these opportunities exist.
Jason:
And you spoke about the three forms of vol. I just want to dig a little bit deeper into liquidity, credit and cross asset relationship. How do you think about the relationship between vol and liquidity? Is it a chicken and egg problem, which comes first? Is liquidity just the accelerant or it exacerbates volatility? How do you look at the nuance of that relationship between vol and liquidity?
Chris Cole:
Yeah. Well, I think it’s really, volatility is the brother of credit and leverage. So when you have an ability to access capital, and when there’s ample credit then there’s an interplay between liquidity and you have a situation where the market can continually go up and things can be sustained. But there’s a tremendous interplay between liquidity, duration and credit.
Chris Cole:
The way that I would phrase it, let me give an analogy. It is very much like leverage is a fire. So say you have your office and you’re sitting there in your office and there is a barrel of nitroglycerin sitting in your office. And I come into your office and I say, “Guys, what is that barrel over there?” And you’re like, “Oh, it’s a barrel of nitroglycerin.” I’m like, “Oh my God. If that blows up, that could blow up three city blocks.” And you guys are like, “Oh, it’s no big deal. I can store it here and I get a yield by storing it here.” Like, “Okay, that’s interesting. That sounds scary, but so be it.”
Chris Cole:
So that barrel of nitroglycerin can sit in your office for years on end and never have a problem. But what ends up happening is it takes some external fire. Say an electrical fire over there catches the carpet on fire and then that fire reaches that barrel of nitroglycerin and then there’s a massive explosion.
Chris Cole:
Well, the barrel of nitroglycerin is like liquidity. It’s like liquidity. It amplifies and causes these jumps in volatility. And the fire is like credit stress in business cycle shifts. So what starts as credit stress, what starts as a credit stress fire in a period of bad liquidity can be amplified into an explosion. And then the two will interplay with one another. That leads to more fires and more failure.
Chris Cole:
So if you’re looking … To me, when I’m looking at volatility, and there’s numerous data points that we’d take a look at, but if you break it down to it, you’re really looking at this dance from when difficult leverage conditions and difficult credit conditions feed into low liquidity and can lead to these air pocket jumps and explosions.
Chris Cole:
And we have, not to be alarmist, I’m just kind of stating the data points out here. But there is a potentiality for that right now. We have the highest corporate debt to GDP in history and volume levels on the S&P 500 are at where they were in the late 1990s as the market has moved to passive indexation and has literally consumed itself through share buybacks.
Chris Cole:
So you have the combination of potential liquidity and credit stress. And it should be no shock that every single time we begin to see credit stress in markets, the Fed suddenly jumps in to go [inaudible 00:52:19], to tame that fire. But there’s only so much they can do at zero bound.
Chris Cole:
And eventually, one of those fires is going to break through. And the more they try to tame and suppress that volatility, in essence … I always said this, you can’t destroy vol. You can only transmute it through time and source. So you can take volatility at one standard deviation and push it out to the tails. You can take volatility today and you could push it out to the future. Or you can transmute volatility and it can be transmuted through things like social unrest and income disparity, that manifests itself in ways that are maybe even more dangerous than a 10 or 20% decline in markets. And this is truly the quandary that central bankers and policymakers find themselves at today.
Jason:
Just a side question, in your personal life, I know how much you enjoy rock climbing. How do you think about the relationship between short vol and rock climbing?
Chris Cole:
That’s funny. Well, I am not a free solo guy, we’ll put it that way.
Taylor Pearson:
Lots of ropes.
Chris Cole:
Yeah. And I do a lot of my climbing in indoor gyms with big mats. But the rock climbing that I have done outside, absolutely, you take as many precautions as you can. And that’s right. It’s like this. Just because you’re aware of risks, it’s about being aware and knowledgeable of risks. So I’m not saying climb under a rock and buy gold and buy guns and never invest in anything. The point, at the end of the day, is that you’re aware of the potentiality of risks. You educate yourself and you take responsible risks.
Chris Cole:
So I train in a gym before I get out on the actual rocks, and I’m using the right ropes, and I’m going with people who I know are better at it than I am. And in this sense, you surround yourself with an understanding of that risk so you can take intelligent risks. And that’s what our role is is we worry about all of these potential outcomes so we can be the rope and we can be the trained climbers so that people can take smart risks that enhance their life. So that’s probably my same philosophy when I go rock climbing. No free solo-ing for me.
Taylor Pearson:
That’s a good note to end on. Chris, thanks for joining us. This was really fun.
Chris Cole:
Thanks, guys. It’s been a lot of fun. I enjoyed it.
Taylor Pearson:
Thanks for listening. If you’d like more information about Mutiny Fund, you can go to mutinyfund.com, or better yet, drop us a message. I am taylor@mutinyfund.com and Jason is jason@mutinyfund.com, and we’ll get back to you. You can find us on Twitter @mutinyfund and I am @taylorpearsonme.
