In this episode, we talk with Tim Jacobson, founding member of Pearl Capital.
Before starting Pearl, Tim worked with a family office and designed Pearl to add a much needed form of diversification to their portfolio and discovered many other investors have the same need.
We talk about common mistakes investors make in evaluating their risk. We then get into the details on why VIX futures is the best instrument to hedge against equity market volatility and why the absolute level of the vix is not as important as the fluctuation in the VIX, the volatility of volatility. At the end, we also get Tim’s take on what the post-Covid-19 world looks like.
I hope you enjoyed this conversation as much as I did.
Listening options:
- Listen on Stitcher
- Listen on iTunes
- Listen on Spotify
- Android users can grab our RSS feed here.
- Listen on YouTube
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 15:
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.
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’re 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 Tim Jacobson, founding member of Pearl Capital. Before starting Pearl, Tim worked for family office and designed Pearl’s investment program that had a much needed form of diversification to their portfolio. In the process, he discovered many other investors had the same need. We talk about common mistakes investors make in evaluating the risk of their portfolios. We then get into details on why VIX futures is the best instrument to hedge against equity market volatility in Tim’s opinion, as well as why the absolute level of the VIX is not as important as the fluctuation in the VIX, the volatility of volatility. At the end, we get Tim’s take on what the post COVID-19 world will look like. I hope you enjoy this conversation as much as I did.
Taylor Pearson:
Tim, you previously worked at a family office, maybe just start a little bit of background about your career up to that point. And then for listeners that aren’t familiar, what is a family office exactly? And how does that environment work?
Tim Jacobson:
Great. Yeah. Happy to be on the podcast today. So, yes, I started my career at Franklin Templeton out of undergraduate way back in 2004. So, I’ve been in the industry now over 15 years, 16, 17 years. And after I left Franklin, I did a couple of things in the hedge fund space, mainly researching hedge funds and in particular quantitative hedge funds. Because when I was at Franklin, I really fell in love with that space. There was a quantitative team that I was a part of and we were building out systematic, trend following strategies.
Tim Jacobson:
And so, when I left Franklin, I always carried with me that passion and that new found curiosity in that whole space. I equate it to scuba diving for the first time. You don’t realize that there is this new world or this different world that exists that you’re not really aware of. Coming out of college, I always wanted to be a stock picker, but given the opportunity that I had, I fell in love with it, totally different style of investing. And I’ve never looked back since.
Tim Jacobson:
So, when I eventually hooked up with this family office in California, our job with my partners Lawson and Alexandra, our job was really to build a d correlating portfolio. Portfolio, in other words that was going to do, perform differently than any other asset class. It was going to perform differently than equities. It was going to perform differently than credit or real estate. And it was meant to add some stabilization to their holdings.
Tim Jacobson:
And so, a family office is really just, it’s an investment vehicle designed specifically for a single investor. So, it’s usually a family that has significant wealth and they’re large enough to where they can employ a staff. Our model was a little bit different. Every family office does things a little bit differently, but our model was a little bit structured differently. But that’s the basic idea, is that the family has large enough assets to where they can employ their own advisors and professionals to help them either do the whole thing or a piece of it. And in this case, our job was to just handle this piece of the family’s assets.
Taylor Pearson:
And tell us how did you get to that piece of a d correlated assets in volatility? What was the journey? What was the idea, may so to speak, of how you got there?
Tim Jacobson:
Well, that’s why I give the backstory of my professional background is because I’ve always had a passion for quantitative strategies, researching them, building them, selecting them, building portfolios out of them. It’s always been something that’s been very interesting intellectually to me as well as academically. And so, when the opportunity came to do that with my partners Lawson, Alexandra, we were excited to obviously to do that. So, we had known the family for several years prior to us launching Pearl, to do that for the family. And so, it was just a perfect opportunity for us to do what we enjoyed to do and also make a living doing it.
Jason Buck:
Coming from quant background, and quant is one thing, but why VIX and the VIX trading? Was it just that you were by looking for those uncorrelated trades or way to de-risk or lower the volatility of their portfolio? That’s what led you to VIX trading or why specifically VIX?
Tim Jacobson:
Yeah. Fantastic question. So, that goes to the second half of 2014. Listeners may or may not be aware of this, but in 2014, there was an interesting trend that emerged in particularly in the dollar. And if readers want to know a little bit more about that, I’d direct them to our website, and in our publications tab, we just published a paper a couple of weeks ago called Free Lunch and Trend Followers are Buying. So, free lunch is a reference to the famous adage, that the only free lunch that exists is diversification. So, we wrote this paper to talk about the benefits that CTA, it’s trend followers have in portfolios.
Tim Jacobson:
Well, in 2014 there was a strong move that the dollar made that set off a chain reaction in all other commodities priced in dollar. So, gold made a move, oil made a move, agricultural commodities made a move, all in conjunction with this dollar trend. And the paper that I referenced that’s on our website, discusses that in a much broader picture and makes the case for why trend followers ought to be included in that diversified portfolio, and why they should specifically not be looked at as crisis alpha solutions, leave that to folks like us and Mutiny. But that moment in 2014, highlighted and underscored that dynamic, that these trend followers provide investors a certain kind of return stream, but it is not necessarily crisis alpha, and it is diversifying against equities, but it does not overcome the challenges of investing in equities, which are periods of at times of significant volatility.
Tim Jacobson:
So, as we took a step back, we wanted to understand, is there an asset class that can provide us true diversification against the volatility of the equity markets, right? Not just something that behaves differently or gives us a different return stream or a different look, but we wanted specifically something that could directly benefit from increases in equity market volatility. And VIX is a fantastic instrument to do that. If you also go to our publications page on our website, we also have another article called Effectiveness of Commonly Used Hedges in US Equity Markets, or some really long title like that. But basically we go through and we look at various instruments and ways that people have tried to get diversification and crisis alpha against equity markets. We look at gold, we look at treasuries, fixed income, CTAs, even looking at safe haven currencies, like the Yen, things like that.
Tim Jacobson:
And really the VIX futures is the best instrument to deliver a real hedge, natural hedge against equity market volatility. I mean, hands down, it performs the most consistently against equity market volatility. It provides the most magnitude in terms of the ability to cover the volatility that comes to you from equity markets from time to time. So, really the VIX instrument stood out to us as something that was truly an opportunity to fulfill that particular need. So, the long story short… I love it when people have a very long explanation and then they end it with, and the long story short. We ended up building our own program to suit our own particular needs, which was an asset class based investment, which could stabilize the portfolio, but also have the dual benefit of capturing returns during moments of equity volatility.
Taylor Pearson:
Yeah. It’s a long and short of relative, right? I guess, we could probably talk for six hours without the extra to that question. So, it was a short answer in a certain sense. And I’d love you to expand the VIX, the volatility index, people aren’t familiar. How do you explain the VIX? Maybe there’s someone that’s not familiar with it. And then just tie to why, maybe intuitively why does it make sense as a hedge? What is the VIX and why does it make sense to be a hedge to equity market volatility?
Tim Jacobson:
Well, great. Well, I hate for this to turn into a shameless plug of all of our publications. But if you also go to our website under the publications tab, you’ll find another paper we wrote called VIX Twain and Magic Mirrors. So, what we’re saying in that paper is exactly the answer to that question, what is VIX? VIX is nothing more than a mirror reflection of the amount of volatility that the markets are generating in that particular moment in time plus or minus supply and demand forces that the market participants are creating.
Tim Jacobson:
So, in other words, if equity markets are volatile, the VIX will reflect that. If they’re not volatile, the VIX will not reflect that. And what really prompted us to write that paper was fourth quarter of 2018. So, in the fourth quarter of 2018, and in that December month in particular, the market sold off 9%, which is a really horrendous month to be involved in equity markets, to be down 9% is a difficult month. Well, volatility, I don’t even think got above 25% or 25 on the VIX. Maybe we got to 30 on the VIX. But certainly on the VIX futures, we didn’t get above 25.
Tim Jacobson:
And people who aren’t necessarily familiar with volatility and how it reacts, volatility does not necessarily mean market goes down and volatility spikes, that is a misnomer. Volatility is a function of the magnitude up and down and on a daily basis of the fluctuations and the movements of the price action in the S&P 500. So, if the daily moves are up and down and they’re very large then volatility will go high, right? What we just lived through in March, 2020 is a perfect example. There were a number of days in the middle of March, where we were plus and minus over 10% in a single day, and not just one day, but that was a two or three day stretch. That is significant volatility.
Tim Jacobson:
If the markets are just selling down 1%, 2% at a time, yet your end result could be a minus 9% month on the S&P 500, but it didn’t come with significant volatility. And that’s a very, very important concept for people to understand, is that negative returns do not equate to high volatility. High magnitude moves in the S&P 500, equate to high volatility.
Tim Jacobson:
And so, what VIX is, is it’s basically just looking at the amount of volatility that’s happening in the market through the eyes of the options market. But really the eyes of the options market are glued to the amount of volatility that is being generated in the market already. So, in a way, VIX is basically just looking at itself in the mirror. It’s looking at what the market volatility is doing and its pricing and the options, people who are trafficking the options are basically taking that information and feeding it back into the way that they price options, and what price they’re willing to buy and sell and trade them. So, really, it’s just volatility looking at itself in the mirror as the way that I would categorize what the VIX is doing.
Jason Buck:
And a couple of add on to that one is, we always like to point out that, yeah, volatility is doesn’t mean it’s only when the S&P goes down, you can have volatility if the S&P is spiking higher. You point it out, it’s the magnitude of the moves. It just so happens, the magnitude is usually on the downside, the whole stairs up elevator down scenario.
Jason Buck:
We’re probably going to get this anyway, but I like that you guys talk about the echo of volatility. And it reminded me when you brought up December Q four of 2018. Talk about how you think about the echo of volatility and how that affects volatility trading.
Tim Jacobson:
Yeah. Super.
Taylor Pearson:
And let me then, just do-
Tim Jacobson:
Go ahead.
Taylor Pearson:
… quick definition, Tim, I’ll get you to explain a couple things. You mentioned the VIX and VIX futures. The VIX itself as an index, it’s not a tradable product over the futures that are tradable. Could you maybe just explain a little bit how that works? And then I think what you mentioned the VIX spiking to 25 or 30, I think you can correct me. I’m sure you know these numbers better than I do. But historically, the VIX average is something around 20. And then maybe in that the most recent low volatility period, 2012 to 2019, the averages is somewhat lower than that, 12 or 15, or what sort of, just for people to calibrate.
Tim Jacobson:
Okay. Yeah. So, what’s the difference between the VIX index and VIX futures? We’ll tackle that one first. So, VIX index is not something that people can invest in. It’s a reading, right? So, Myron Scholes or Fisher Black Myron Scholes came up with the Black Scholes option pricing model years and years ago. And what that does, it’s a theoretical mathematical model for understanding how an option should be priced. And it’s quite technical, but at its core, what it looks at is the strike price, the price of the underlying security, in this case, the price of the stock or the S&P 500, the due dividend rate and other things, but there’s about five or six variables.
Tim Jacobson:
The one thing that you don’t know, but which you can solve for algebraically is implied volatility. So, it’s an ingredient in how much an option should be priced, and what level the option should be priced. So, VIX index is nothing more than taking a reading based on the basket of options on the S&P 500. It’s going to look at the prices and the characteristics of those options and it’s going to impute or compute the level of implied volatility that’s implicit in the way that those options are priced.
Tim Jacobson:
So, VIX index is basically just a barometer or a thermometer that’s measuring the amount of implied volatility that is priced into the market. Well, because you can’t trade it, but because it is a very valuable, if you could trade it, that would be a very valuable instrument to be able to have.
Tim Jacobson:
So, CBOE, Chicago Board of Options Exchange, CBOE was very smart. And they said, well, let’s create a VIX futures contract, which would fall along the term structure of the VIX index. So, the term structure, of course, is you have the VIX index as its anchor. And then every month out, you have a series of expirations, and that’s what creates, that’s what we call a term structure, where you have a series of expiring contracts. And those prices, if you were to connect them with a line would create a curved term structure. So, you can trade the VIX futures. And that’s basically a way that you can get exposure to the VIX index synthetically or a derivative of it, if you will. So, the VIX futures are not going to always track exactly the VIX index, but it’s probably the closest thing you can do to get an expressed view on the VIX index.
Taylor Pearson:
Great. And then, yeah, maybe talk a little bit about what are historical norms for the VIX? What is the VIX historical average? When people are calibrating a VIX of 10, a VIX of 40, how should people think about it?
Tim Jacobson:
Sure. So, one of the calculations within the VIX, is they times it by 100. And really what they’re trying to do there is just make it into a usable, readable index. But why are they timesing it by a hundred? What if you were to divide it by 100, what are they talking about? Well, if I were to line up a series of returns, daily returns in a spreadsheet on an asset, say the S&P 500 in this case, I could in Excel, and this is a very basic thing that any of us can do. We can go equals STDEV, open parentheses, grab whatever time series of daily prices that you want, close parentheses, and times it by the square root of 250, for 250 traded days. And that right there is going to give me an annualized standard deviation of market prices.
Tim Jacobson:
In other words, in industry terms, we would call that the volatility of the market, right there over that time period measured, where we’re capturing and calculating a very basic style of market volatility, right? So, when we talk about standard deviations, what we’re really talking about is volatility of the market, how much magnitude up and down the market is moving. And if I were to take that number and times it by a hundred, I could then put it on an apples to apples basis with VIX, right? So, if I’m in an environment where the standard deviation of daily price returns of the S&P 500 equals 0.08, and I times that by a hundred, I’m basically saying 8% is my standard deviation of the market, is my volatility of the market. Well, then I just have to reference what VIX is telling me, and now we’re on equal terms, if that makes sense. Right?
Tim Jacobson:
So, if you have the 0.08 realized volatility reading that we just calculated, and then you times it by a hundred, that would be eight. Well, VIX, a reading of eight on the VIX, which we’ve never seen before, eight on the VIX will correspond to the eight in the calculation we just did. So, that’s how the two are related, VIX, implied vol, and realized vol, they’re related. Now, obviously there’s usually always a gap in those readings, not always, but a lot of times there is, especially in those lower levels.
Taylor Pearson:
On average, the historical VIX is something around like 20 or 15 to 20. Is that right? Do you know what the roughly what it adds [crosstalk 00:22:04] over the last-
Tim Jacobson:
Yeah. Historically, the average VIX is right around 20. But what we need to understand is that it’s not an average that has always held to. In fact, VIX is a bit bi-modal, meaning it has two averages that it likes to cluster around. So, when you’re in a low volatility environment, VIX actually likes to cluster around an average of around 15. And when VIX is higher in a higher volatility regime, VIX likes to fluctuate north of 20. And I think it’s around 25, if my memory serves me correctly. So yes, on average it’s 20, but in reality, depending on the regime that you’re living in, VIX will tend to cluster around that regime’s mode or average. So, in the years 2013 to 2019 that’s why we saw VIX spiking and coming right back down, VIX spiking coming right back down, is because VIX was doing a mean reversion around its lower regime average.
Tim Jacobson:
But now that we’ve transitioned to a higher volatility regime, and again, another shameless plug, if you go to our publications tab on our website, we’ve published two papers in the last 18 months where we’ve talked about this transition of VIX and volatility to a higher regime. And it does that, VIX will move low to high, from high to low, volatility does that as well. So, what we’re now seeing really since February 2020, people have noticed that volatility has stayed higher. It’s not like it used to be where VIX spiked and then came right back down. VIX has spiked and it’s staying there. And that should be a signal to everybody that we are likely in a higher volatility regime, much like we were in say 2000 to 2002, or actually really ’98 to 2002. And then also from 2008 to 2012, where volatility stayed elevated for quite some time. It’s our view that that will be the case, that volatility will likely stay within the 20 to 40 range with movements here and there outside of those ranges.
Tim Jacobson:
But historically when VIX or volatility gets higher into a higher volatility regime, it tends to want to cluster around those ranges. We could be dead wrong. It’s not like we’re saying that that’s what is going to happen, nor are we suggesting that people trade around what I just said. That’s just for us. And an interesting thing to observe and something that we think is helpful as a guidepost for people that follow our program.
Taylor Pearson:
And then Jason, you asked about echo volatility, I think this transitions well to that.
Jason Buck:
Sure. Maybe yeah, I always tend to get ahead of us a little bit too much, but I think you guys have written a great paper on the echo of volatility. And I think maybe we can jump ahead and talk about it in terms of what happened during the Volmageddon in February, 2018 and how maybe that leads to an echo of volatility during Q four of 2018, like you’re saying in December, if we’re down 9%, but the volatility is not picking up, how it’s almost an echo of volatility going to that October, December event of 2018. But let’s maybe backtrack and talk about Volmageddon in early February, 2018, what happened there and then how that echo volatility affects later on throughout that year.
Tim Jacobson:
Sure. Well, it’s always fun to talk about February 2018, because it’s such a watershed moment for a lot of folks in the industry. As I mentioned just a moment ago, we were in a low volatility regime from 2013 to 2019, call it, but 2018 obviously falling inside that. And that was really an environment where people realized that you could just short the VIX or short to VIX ETFs and make fantastic returns year in, year out. And so, everybody came on to that idea. And it’s the old adage of, wake up and sell volatility, right? So, everybody and their uncle was coming into the markets every day and selling volatility and it was getting to be an extremely crowded trade. 2017 record low volatility. We have to go all the way back to 1964 to see the same level of low volatility that the market saw. But even then, in terms of the number of days we stayed below certain levels, was a record. So, that just goes to show how crowded that trade was.
Tim Jacobson:
And we saw some shots over the bow, shots across the bow in 2017. There were a couple of really key days where people should have woken up and understood, “Hey, maybe it’s time for me to not get on the short vol bandwagon.” One of them was in May, 2017 when Trump fired Comey, the VIX really had a big move that day relative to the amount of selling that happened in the market. In other words, it wasn’t a move. The VIX didn’t have a move that was really merited by the amount of the sell off. But I think what happened was, you had some people that were shorting volatility, there was a move that was large enough that then forced people out of their positions. And so, that was a warning shot.
Tim Jacobson:
So, the next day was August 2017 when Trump and North Korea got into a Twitter fight about who had the bigger button, if you guys remember that, that was the whole rocket man meme that Trump was on about. I think the market sold off about 3% that day, but the VIX went ballistic. It was just a very, very strong move in the VIX relative to the amount of selling in the market that day. Again, another shot across the bow, that those that were in this crowded short trade maybe ought not to be playing that trade anymore.
Tim Jacobson:
Well, fast forward then to January and February of 2018, that was really in the beginning stages of concern about the trade war with China. And I think for the first time, the market woke up to the potential for a trade war. And on that February 5th, 2018, the market sold off 5%. Well, at that point the entire VIX complex, the entire short VIX complex basically had to unwind and XIV and other VIX ETFs, because VIX doubled in the day, which is the largest percentage return we had ever seen in the VIX. We had never seen the VIX more than double in a day. When they had to then roll, when they had to, basically people redeeming out of that. It was a forced liquidation and then it fed on itself.
Tim Jacobson:
So, with about 15 minutes to go, we were seeing the VIX was up about eight points that day. But by settlement, 15 minutes later, it had doubled again to over say a 17 point move in the VIX, which was the largest we had ever seen up until that point. And unfortunately, there were a lot of casualties that day in the marketplace and something that nobody should take lightly. That’s a very concerning thing and something that we never liked to see. But that is the nature and the risks of markets. Right?
Tim Jacobson:
So, VIX had it’s probably, it’s largest move since August of 2015 on that one day. And at that point we thought, “Okay. Well, maybe volatility is here to stay.” But again, we were still in the middle of a low volatility regime. And so, VIX was really wanting to come right back down. And so, that’s exactly what it did.
Tim Jacobson:
Well, fast forward then to the fourth quarter of 2018, we started to see a little bit more volatility, same idea with the trade war and some concerns about that, as well as the fed wanting to raise rates maybe a little bit faster than market was prepared for. So, a lot of different variables and factors coming into the scene. And so, it sparked a sell off. But what happens is almost like how a day trader might have different levels and place to stop losses at different levels in the market, and basically what drives support and resistance in markets. So, if the market sells down to a particular level where a lot of traders are sitting with buy orders, you can hit that level and then the market bounces right off of it. In a similar, not the same way, but using that as a metaphor, there are things baked in, not baked in, but there are some elements that get reflected in the way that volatility also behaves as it then makes a secondary move.
Tim Jacobson:
So, we all know what an echo is, right? We can echo, and then you get the sound back and it’s softer, it’s an echo, but it’s still a voice calling out. Well, when market sold off and in February 2018, that was the primary move. That was the first amount of volatility we had seen in a long time. And it was a strong move. Well, when we came to the fourth quarter of 2018, it was a strong move, but it wasn’t, it didn’t come with a lot of magnitude. It was a fizzling down. It was almost like the market was daring itself to cross certain thresholds.
Tim Jacobson:
And so, and we see this a lot actually. We see this in March of 2009. We see it in January of 2016. That you have a primary move in volatility like October of 2008, August 2018, February 2018. These are these primary moves in volatility, where for a first time in a long time or first time in a while, you have a massive move in the market that is unexpected and there’s panic in it. And there is concern in the price action. You can see it and it drives volatility higher. And everybody can feel that emotionally as that’s happening.
Tim Jacobson:
Well, things then tend to calm down or stabilize and consolidate. However, the markets decide they want to do that. And then there’s usually a secondary move. So, March of 2009 that was the final leg down in the crisis. January, 2016 there was another leg down to the same levels. And then fourth quarter 2018, same kind of idea. You’re getting a secondary move back to these levels. And they usually just don’t come with the same amount of volatility. There’s not the same amount of panic. The initial shock is worn off. And so, when selling does occur, you don’t get the same amount of panic and fear that you got in the primary move. And so, therefore it tends to be a volatility move that is much like the echo that you would get from the primary move.
Jason Buck:
So, to think about it, yeah, and in other ways, like you said, February 2018 reminded people that VIX and volatility is a thing again, because everybody had been complacent. So, then in Q four it’s only, in October it’s only eight months later. So, when that move happens people are, it’s fresh recency bias that volatility can happen again. So, and that echo that move is much less than that Volmageddon in February 2018.
Jason Buck:
But then what I find interesting is how the different time cycles is then in, throughout 2019, maybe it’s because of fed policy in queue for 2018. 2019 vol becomes so suppressed again for a year plus that are very almost like forgets about volatility or assumes fed intervention is never going to bring back volatility. So, then in March of 2020, what we just experienced February, March, is that volatility spikes so dramatically because there’s no echo before it, because of maybe government intervention, and then the immediate unbelievably suppressed volatility 2019. So, we get that spike in so far this year, but then how do you think if we have another, like we bounced back, obviously we had to be recovery or whatever we’re going to call it. How do you think of that? Echo of volatility if we have another leg down in Q four this year, is the same, or you think it’s going to be a muted echo that softer vol move, or how do you think about that?
Tim Jacobson:
Well, yeah, let me use a different metaphor. I probably should have done this first. Imagine you are on a battleship in the middle of the Pacific and your job is to look at radar and you’re looking at it day after day. And it’s just the most boring job on the planet, because nothing is showing up on your screen. In a primary vol movement, all of a sudden there are a thousand red dots or one giant red dot and it’s headed dead center and it’s going right for you. And all of a sudden your adrenaline hits and you’re afraid. And everybody on the ship scrambles, right? That is the primary vol move. And now you’re going to deal with that. Now, you’ve got to deal with that crisis. Now, you’ve got to deal with that situation.
Tim Jacobson:
Well, let’s say, it turns into a battle on the battleship, and guns are blazing and everybody’s dealing with that situation. But if that battle rages on for four or five days, or in this case, let’s say it rages on for four or five months, you’re looking at radar and nothing is new. You’re dealing with that situation. And now you’re in the mode that that is the current vibe of the market. And so, there’s not the same panic, there’s not the same adrenaline flowing, you are dealing with that situation. I think volatility, I should say is very much the same sort of idea, that it only surprises you when it surprises you. And then when it’s on the radar and you’re dealing with it, there’s no more real surprise, it’s going to take…
Tim Jacobson:
Now, imagine if you had dealt with that crisis on the battleship, and you’ve made those thousands of red dots dwindled down to a hundred, but then all of a sudden you see a thousand more come and they’re coming from a different direction. Well, now that’s a new primary volatility regime, right? That’s new panic. That’s new, a fear that you’re going to now have to deal with. So, I look at it that way. I look at volatility like a radar would. And if anything is coming at you that wasn’t there, that’s coming at you all of a sudden coming to you dead center, that’s a primary vol movement. If it’s still on your radar and you’re dealing with it, even if it comes closer to center, that’s likely to be more of an echo vol or a secondary vol movement.
Jason Buck:
Got it.
Taylor Pearson:
It makes me think of, as your target, so you get the reading accounts of the Battle of Britain, when the Nazis, the Luftwaffe was bombing London, there was that, that first week or two it never moves, freaked out as you would expect to be when your city is being bombed. But I think within a few weeks, right? Everyone is just like, “This is what happens, right? We’re getting bombed by the Germans and the-“
Tim Jacobson:
It’s new normal.
Taylor Pearson:
That’s how I proceed. And I still have to eat lunch and I still have to-
Tim Jacobson:
Keep calm and carry on.
Taylor Pearson:
That’s right. It’s interesting how that human psychology works.
Tim Jacobson:
That’s exactly right.
Jason Buck:
And that’s where that phrase comes from, keep calm, carry on. Exactly, from that time period.
Tim Jacobson:
Exactly.
Jason Buck:
We’ve all experienced it recently with coronavirus of like the initial panic. It was just, your adrenaline is rushing and now it’s become the new normal, and that’s how we adjust to it. But going back to-
Tim Jacobson:
Jason, just interject on that, I mean, what we’re all reacting to early in March was the case count, right? A case count was raging higher and markets were selling off in relation to that and people shutting down. Well, today on June 25th, we’re in the same situation. We’re getting record case counts and the market is up 30 points today, 40 points today.
Jason Buck:
That’s a good point.
Tim Jacobson:
Right. It’s the exact same thing. People get accustomed to the new normal. Now, let’s say that the situation changes and all of a sudden we get a dollar crash and the Europeans decide that they don’t want to be invested in US equities anymore. They’re going to bring assets home and the dollar crashes. And then the dollar crash begets the Europeans pulling more money from US equity markets. Now, that’s something new. Now, that’s something we all need to be concerned about. That wasn’t part of the Corona virus pie. Right? That’s another pie in the face that we’re going to have to deal with.
Jason Buck:
Exactly. And so, earlier you referenced there’s almost, it’s a bifurcated or to regime VIX market where it’s either low vol or high vol. And we can cluster at this high vol for extended periods of time or years. So, we can get into how do you play that environment. But maybe we should take a step back for a minute and talk about, you guys specialize in what we colloquially called the VIXR or the relative value VIX trade between the VIX and S&P. So far, we’ve only primarily been talking about the VIX, but let’s talk about VIX and S&P. And how do you think those two interrelate and then how do you trade off or the relative value pairs trade between VIX and S&P?
Tim Jacobson:
Yes, super. Well, as we spent probably too much time talking about earlier, already, the relationship between realized vol and implied vol, meaning the volatility that the market is actually generating, we went through that thought exercise of doing it, that in Excel. And then we talked a lot about how the VIX is calculated using the implied vol from the options market. Well, we also talked about how the two of those two volatilities are very closely related, and how it’s like VIX is looking at itself in the mirror through the eyes of the realized volatility. So, the two volatilities are very highly correlated. You can calculate some very basic measures of the two types of volatility and chart them using different time periods and look back periods. And what you’ll find is that there’s a very strong correlation between the two types of vol. But it’s not a constant.
Taylor Pearson:
If I could interject quickly, I’ll give my very simple explanation of realized versus implied volatility. You can-
Tim Jacobson:
Go for it.
Taylor Pearson:
…. correct me where I’m wrong. But realized volatility is a measure of, as you were talking about doing the Excel and the standard deviation, you’re looking at changes in price of some underlying, the S&P, whatever it would be, and you can calculate how much volatility actually occurred. And then implied volatility is based on the price of options. And generally the logic would be, if people think something very bad is going to happen, they’re more willing to pay a higher premium to have the protection offered by options. And that implied volatility it’s being implied from the price of that option is that higher.
Tim Jacobson:
Exactly.
Jason Buck:
Or simply put, realized volat is historic look back and implied is looking forward.
Tim Jacobson:
People talk about it that way as well. We think that they’re concurrent because you don’t get implied without realized, knowing realized first. You have to have a reference point. So, it’s a bit circular and a bit of a feedback loop there. But that is the way that a lot of people talk about it.
Tim Jacobson:
So, yes, the two types of volatility are very highly correlated, but it’s not at a constant relationship. That relationship is constantly in flux. Why? Because people have emotions, market participants have emotions. Even people who build systematic strategies, build them with their emotions in mind of what they’re willing to accept in terms of risk and return, what they’re going to value in terms of how they want those traits to behave. So, there’s a human element throughout all of markets, whether it’s systematic or discretionary trading. And so, there are the emotions of fear, greed and complacency that govern much of the price action. We believe this is very much a behavioral dynamic that exists between implied and realized volatility. It is governed by human emotion.
Tim Jacobson:
And so, when people get concerned and they’re fearful, that’s going to push implied volatility to a particular relationship with realized. When they get complacent, that’s going to push it to a different relationship. And when people get greedy, that’s going to push implied volatility to a different relationship as well. So, you can actually see if you were to chart the two types of volatilities against each other, you can actually see the emotion and the sentiment of the market and how it’s shifting and dynamically breathing and ebbing and flowing. And it’s fascinating to see that.
Tim Jacobson:
And then to also overlay that onto the price action of the market, you actually begin to see an interesting picture. And that is that implied volatility tends to trade at a discount when markets are in panic mode. And implied volatility tends to trade at a premium when markets are rising. Why would that be? Right? Why would that be? Well, it’s our view that, and it’s one explanation and there’s probably others as well, but it’s our view that if you’re driving along in your car and you knew that you were not going to get into an accident, and you were very confident of that, you were feeling greedy or complacent, you would want to be a seller of car insurance, because you’re going to collect a premium and no one’s going to get into a car accident, and you’re going to pocket that premium.
Tim Jacobson:
But if you knew beforehand that you were going to get into a car accident, you’d want to be a buyer, you’d want to shell out a little bit of a premium to get a larger payout, right? You’d want to be a buyer of that insurance. So, why implied volatility acts like the buyer or the seller of insurance versus the outcome, which is the market. And so, it’s that dynamic, that same behavioral dynamic, which governs the reasons why people purchase insurance and other markets, we believe is a very similar dynamic governing why people would want to purchase or sell insurance in market insurance.
Taylor Pearson:
[crosstalk 00:46:38]. Go ahead, Jason.
Jason Buck:
We both like the car analogy. That was a good one. But thinking about that’s your overlay on how you think about implied versus realized, but then let’s talk about how maybe it gets expressed in that trade, what we colloquially call short, short or long, long. Let’s talk a little bit about what that means when you’re short VIX, short S&P or long VIX, long S&P, and then how you ratio those trades. And then thinking about what this overlap of implied versus realized volatility.
Tim Jacobson:
Yeah. So, in moments when you have a view that implied volatility is higher than realized, you’d want to sell the more expensive asset, right? And you’d want to purchase the cheaper one. And then you’re trying to collect on the difference or the convergence between the two types of volatility. So, yeah, in moments when implied volatility is higher, you’d want to be a seller of the more expensive, which we claim would be the implied volatility, you’d want to sell the VIX. But we don’t want to sell the VIX naked, meaning just sell the VIX and have that be our only position. We would want to sell that and hedge that completely with the other leg of the trade, which in our, the way that we structure the trades, we’re trying to use the E-mini as our proxy for being long, the volatility.
Tim Jacobson:
So, Jason, earlier, you said, yes, it’s true, volatility can go up as markets go up, or volatility goes up when markets go down sharply, as that stairs up elevator down. And yes, it’s true that volatility typically increases when markets go down. Right? But not always. So, it’s not a perfect trade, but it’s a very good natural hedge to want to go short the market against a short VIX. Because what you’re effectively saying is, if volatility spikes more often than not, it’s going to come with the market going down. So, I’m effectively long or synthetically long realized volatility when I’m short the market. And so, VIX and S&P are naturally inversely related to each other. So, if I’m short one, and I’m also short the other, because they’re negatively correlated, they move inversely to one another, you’re effectively hedging that position.
Tim Jacobson:
And again, it’s not a static hedge. It’s a dynamically moving target as to how much E-mini for a unit of VIX that you want. And that’s also part of the science and the art behind what the trade is about, is understanding what hedge ratio do you want to set against those two assets. And then the same thing is true, when you have a view that implied volatility is cheaper. When you want to go long that VIX, you want to go along the cheaper asset. And then I want to synthetically short realized volatility. Well, if I’m long the market and volatility spikes more often than not, not always, but more often than not, that spike in volatility is going to be markets going lower. So, me being long the E-mini is effectively being short realized volatility. So, I’m going to go long implied by going long with VIX. And I’m going to go short realized by going long with S&P.
Tim Jacobson:
And again, that relationship is going to be influx and needs to be dynamically adjusted, to always maintain market neutrality. So, that’s one way that you can structure a relative value market neutral trade between implied and realized vol.
Taylor Pearson:
Going back to your car example, it made me think, I think that statistics, something that the majority of accidents happen, I think within five minutes or five miles of your home. I mean, some of that is due to like base rates, right? Like most of the time you’re driving a lot, you’re in that area a lot. But part of it is you get overly familiar, right? Like I took a road trip with my wife recently. We were driving through Florida, via drive through the tropics. In the summer, you have those huge rainstorms where it just down and it’s just like blinding rain for 15 or 20 minutes. That’s obviously a dangerous situation. But my guide is very aware, right? I turn on my flashers and I got both hands on the wheel and I’m paying a lot of attention.
Taylor Pearson:
Whereas, when I’m two minutes from my house, I’m just, I’m more likely to reach in the center console and see if I can find my audio Jack. And I’m thinking like, “Oh, this is fine. I drive this road all the time.” And I guess that was an interesting, if that’s the scenario where I’m close to my apartment or close to my house, I’m overestimating, or excuse me, I’m underestimating a volatility. I can go, “Nothing’s going to happen because I’m nearby.” When I’m far away, I’m in some new environment, now I’m overestimating. Right? Because I’m hyper-vigilant and I’m hyper-aware.
Tim Jacobson:
You’re perfectly describing complacency.
Taylor Pearson:
Right.
Tim Jacobson:
Right? And that I think is what was the undoing of so many in February of 2018, is the complacency. And I think that a complacent environment is way more dangerous than a volatile environment. And because as you just said, in volatility, we know what to do. We can put two hands on the wheel. We increase the speed of the wiper blades. We slow down and we move to the right. Right? We all know what to do in volatile environments. It’s the inflection point. It’s when we’re complacent and we’re feeling like nothing can go wrong, everything’s going our way, that’s when you need to be very, very careful.
Jason Buck:
I think going back to this relative value trade between VIX and S&P, the majority of the time, for lack of a better term, you’re going to be in that short, short trade, short VIX, short S&P. Because part of that trade, one of the secret sauce is getting the ratio right of contracts and VIX versus S&P. And everybody has their own way of looking at that. But part of that trade as well is the roll-down premium in VIX when you’re short the VIX. We brought up the term structure earlier, but can you talk a little bit about that roll yield or roll premium and the VIX when you’re in that short, short trade, which allows you to be market neutral, but maybe collect some of that roll down premium.
Tim Jacobson:
Yes. That is something that could potentially be playing into returns, although we’ve done some analysis to where we don’t believe that we’re correlated to that roll-down yield, but it is a factor that does need to be accounted for and can be, as you just alluded to something that is a tailwind at your back, given how you’re positioned. So, as we talked about the term structure of VIX, meaning you’ve got, so right now the July contract is the one that’s set to expire next. And then after that you have the August contract, September, October. Well, right now, it’s a pretty flat curve. But in a normal environment what you would see is, July would be priced the lowest, August would be priced a little bit higher, September a little higher than that, October a little bit higher than that. And of course, VIX index being priced the lowest of all of those.
Tim Jacobson:
And so, this idea of roll yield is that as contracts come into expiration, they’re going to tend to want to converge to what the VIX index is, so that on expiration day or at the mode of expiration, they’re effectively working towards being equivalent to VIX index. And there’s reasons why that doesn’t occur, but that’s a much longer discussion. But it will tend to converge to the price level of the VIX index. So, that’s what that roll yield is.
Tim Jacobson:
And so, if you’re short the VIX in an environment where it’s converging from high to low, well, you’ve got something that’s in theory a tailwind at your back because it’s naturally wanting to go lower towards the VIX index. And so, you’ve got something that’s built in to maybe help you get there on a short, short trade. But we do not view what we do as anything to do with the roll yield. We use the front month contract to express a view on implied volatility. But we are not using it because we believe we’re trying to capture some sort of roll yield, but it could be something that helps you in the trade.
Jason Buck:
Yeah, it’s excellent, the thing to point out is that this is why people will get carried out on a stretcher on VIX, because I think historically they look at that roll yield and everybody’s trying to capture that roll yield. And at times they’re going naked, short VIX to capture that roll yield. And then when VIX spikes, they get their face ripped off and they’re out of the game. So yeah, it’s a dangerous game. But like you said, it can be a tailwind or a headwind, depending on what trade you’re in and then what the ratio is. And it’s just, maybe it’s just another factor in the game overall. And whether that implied and realized is expanding or contracting, it’s a very, like you pointed out earlier, it’s always undulating, it’s dynamic. And it’s just interesting to watch on a daily or intraday basis for us.
Tim Jacobson:
Yeah. I think that’s why for us it’s so important to understand the valuation between implied and realized, that is for us, the most important thing to understand. Because roll yield is high or low that it has something to do with it, but not really at the same time. VIX, the term structure can move on you, and if that’s your only input, if that’s the only thing you’re looking at, then that’s a problem or that can become a problem.
Taylor Pearson:
Now, I was just going to add, I mean, I think that the term structure and futures can be a bit confusing. But at least in the context of VIX, it makes an intuitive sense. If we’re in a low volatility regime and let’s say the VIX is at 15, as you go out into the future one month, two months, three months, the next contract might be at 16 and 17, and 18 because the feature is uncertain. So, they should have a premium there. And then, if nothing changes and stays stagnant, that 18, three months from now is going to converge to 15, it’s going to drop down. So, if you’re short the VIX, you’re able to make money on that trade.
Taylor Pearson:
Obviously, as you said, it’s that a lot of, you are looking at, they’re like, “Oh, this is great.” They can, if you looked at some of those short volatility indices that bowed in 2018, they look just this perfectly steady returns stream for five, every month they were making 1%, it’s like, “Oh, this is like free money.” Right? It just always goes up 1% every month, they level. I’ll tell them then, they lost all of that in a single day.
Jason Buck:
And I just remember something else I wanted you to touch on real quick, Tim, is that as we transitioned to a higher volatility regime, a lot of times that can hurt options traders because they’re now they’re paying up a higher price for implied volatility. They could still do well, it just reduces maybe the complexity of an options trade. But that’s totally different when you’re trading like VIX and S&P, is you can tailor your trades to a high volatility environment and do exceedingly well in a high volatility environment, or even a high volatility of volatility environment as volatility starts to whip sewing around.
Tim Jacobson:
Yeah, really it comes down, for us what we like to see is oscillation. If prices are stagnant, it’s very difficult to capture any sort of relative value, but if there’s oscillation and there’s maybe even confusion in the marketplace as to what the proper valuation is, and there’s great debate among market participants about what the valuation should be. That’s a great environment because now you’re going to get larger opportunities by virtue of that greater oscillation. Greater price moves, equal greater opportunity. So yeah, the level of the VIX is not as important as the fluctuation in the VIX.
Taylor Pearson:
And Tim, I think those are the main things we were hoping to cover with you. So, thank you very much for your time. And that was a great conversation.
Tim Jacobson:
Well, if we can do an appendix to this session, I think listeners may want to know about the first email I ever got from Jason.
Taylor Pearson:
Yeah. Now, let’s do the appendix.
Tim Jacobson:
Okay. Well, so I grew up a Brigham Young University football-
Taylor Pearson:
I’m actually slightly terrified of this, straight away, because I don’t actually know the back story. But I do know, Jason is very, there’s a great volatility in his emails. So, there’s a lot of ways this could go. Sorry, go ahead.
Tim Jacobson:
No, that’s all right. So, I grew up a BYU football fan, right? And I’m a child of the seventies and eighties. And BYU football was in its absolute glory days during that time period. In 1980, we had Jim McMahon is our quarterback. A lot of people don’t realize he went to BYU. Jim McMahon is a BYU guy, world. Everybody needs to understand that. Then we had Steve Young. Some people may recognize that name. Steve Young was our quarterback in ’83. And then in 1984, we won the national championship. Just, I mean, things could not get any better for us as fans.
Tim Jacobson:
Around that time, there was a guy named Jason Buck, who was our defensive end on the team. And he’s got an amazing backstory. He actually grew up on a farm in Michigan and his father lost the farm. And for a while, as a child, he and his family lived under a tarp or basically a makeshift house made from a tarp and the side of their car. He worked his way through high school and got a job to save money for college and eventually joined the junior college team at Ricks College up in Idaho. Just an amazing backstory. I mean, this man is such a hero in my eyes and for a lot of different reasons.
Tim Jacobson:
So, Jason Buck, eats quarterbacks for lunch. He goes on and has a great career in the NFL. He’s a famous alumnus for BYU football. And I get this email from Jason Buck, saying he’s interested in our investment program. And I’m just thinking to myself, I cannot, I mean, somebody pinch me. I must be dreaming that Jason Buck wants to hear all about what we’re doing. But turns out it’s a different Jason Buck, with an equally interesting backstory. And I don’t know, if the listeners don’t know Jason’s backstory, maybe I should turn the tables and ask Jason his backstory.
Jason Buck:
I was going to say, it’s quite the opposite. I’m so sorry to disappoint. I think even also just as interesting is the first time we met in person, we actually ended up being seated next to each other at this highfalutin Italian dinner in Miami. And it’s a classic line of a Mormon and agnostic, sit down for dinner and talk about Amazonian tribes and their beliefs in afterlife.
Tim Jacobson:
Yes. I’ve actually read that book. What is it? Don’t Sleep, There are Snakes.
Jason Buck:
Yeah. Yeah. We ended up talking for hours about the origins of language and whether we’re a tabula rasa or not. And it was one conversation I won’t forget, and I enjoyed it thoroughly. But it was one of those things where on first meeting, three, four hours later where we’re still talking about the existence of God or the ontology of the world we live in. So, it was fantastic. Our first meeting very different from usual first meetings. But also I highly encourage any listeners to, as you heard Tim bring up many times, there a lot of the content they put out on their websites, it’s fantastic. They’ve written tremendous white papers. And lately on a lot of your newsletters, you’ve been referencing or overlaying the Hoover era for what we’re going through now. And those have been just tremendous. Have you guys turned that into a paper at all yet? Or is that part of the newsletters and can outsiders get access to that, or is that only been internal thus far?
Tim Jacobson:
On our website we’ve published a paper called, Echoing the Times of Hoover, that you’re talking about. And yes, there are a number of parallels between 1929 and today. It’s a good read. I mean, we’re not calling that this is a great depression, but we’re just highlighting the parallels that were then and now. And there’s other parallels as well. I think others in the industry have also picked up on the parallels and we’ve since seen some people talk about the global travel industry as a parallel.
Tim Jacobson:
So, for those that don’t necessarily know what I’m talking about, really is from World War One, Europe wasn’t able really to produce its own food. And so, here domestically, there was great demand and higher prices to support it for US farmers to produce and export agricultural products. And so, it induced a lot of the independent and family farmers to take on debt, buy land, buy farm equipment, expensive tractors, so that they could boost yields, boost output at higher prices and do very well. Well, when the war ended and Europe got back to producing their own agricultural products, it took the floor out of US demand. And over the next decade, we know the story. I mean, even before the 1929 crash, Congress did a lot to try to hold up and prop up the agricultural industry.
Tim Jacobson:
So, one of the parallels we draw to that is the US oil industry, in that it relies on elevated prices in order for them to be able to produce at a profit. I think another one might be global travel. There’s Airbnbs, Ubers, Lyfts, lots of people making their careers around those types of things. Airlines, I mean, there’s a lot to do with the global travel industry as well, which I find another manager bringing that point. I think that’s very interesting.
Tim Jacobson:
But yeah, there’s danger to when prices fall out, there’s danger to look to those industries that are levered, that have borrowed. I mean, if you bought Airbnbs and you’re planning on filling them up, and now all of a sudden there’s not demand and there’s not… Well, what are you going to do? You don’t have demand. You don’t have revenue, and you’ve got to service that debt. That’s a scary situation. If you’re an oil producer, you’ve gone out, you’ve got expensive fracking equipment to be able to explore and harvest oil in the shale industry, that requires a high price in order to service that, and price falls out. What are you left with?
Tim Jacobson:
So, there’s a number of parallels of the lead up to both situations. COVID just simply was the catalyst much like the market crash in 1929 was a catalyst to waking everybody up to it. But then you had the fed coming in huge in 1929. The only other time in history that Central Bank balance sheet expanded to the same level was, you have to go all the way back to the early 1700s to the War of Spanish Succession. Which by the way, if you’re going to name a war, I highly recommend the War of Spanish Succession as a name for a war. I think we should name all of our wars this way.
Jason Buck:
It’s Like the War of Northern Aggression that [inaudible 01:06:31].
Tim Jacobson:
Yeah. War of Northern Aggression. Exactly. That was on the back of it. So, and then in 1709, you had a frost that killed prices and harvest, and in England as well. So, you had this global upheaval all happening at the same time. Well, you have to go all the way back to 1700s before you see the Central Bank balance sheets expanding to the same level as did in The Great Depression at the same levels that they are now, even more so than ’08. And we’re on track probably to see the fed’s balance sheet expand to upwards of 40% of GDP possibly by 2028. We’re on track. I haven’t checked it in the last few weeks, but I wouldn’t be surprised if we’re closing in on 30% or 30% plus on balance sheet exposure to GDP.
Tim Jacobson:
So, also the response from Hoover was they wanted to do everything they could to keep people’s jobs. They wanted to support wages. We have PPP. There’s just a lot of parallels to the buildup, the reaction to the moment, the response to the fed, response of governments, all very similar. I would say that because we’ve learned our lessons, hopefully, maybe won’t be as bad. But I don’t think that people can deny the severity of the situation that we’re going through now. I don’t believe it’s over, I have a hard time. Now, people need to understand we trade everything systematically. We’re not discretionarily doing anything.
Tim Jacobson:
But I look at these things and I form my opinions on them. I just don’t see how the world goes back to normal. Let’s pretend today, July or June 25th, that COVID does not exist. Lets pretend it does not exist. Is the economy at 100% what it was six months ago? No. And so, I don’t believe that all of a sudden, just because we find a solution to COVID or people get back to work, that that means that markets are going to go on to all the time high. I could be dead wrong. That’s the beauty of what we do, is we’re agnostic to market direction. But in my view, I just don’t see how it’s possible given all that we’ve seen for things to just “go back to normal.”
Jason Buck:
I think that’s a perfect place to end on that polymathic crescendo. Thanks Tim, for being on our vlog. We’re definitely, we’ll circle back to doing another podcast when you release some of the new, great products you’re working on, but thanks again for being on it. And we hope everybody enjoys. And please check out his website as you heard on this podcast, the papers are fantastic.
Tim Jacobson:
Thanks, Jason. Thanks, Taylor. I really appreciate 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 @Mutiny Fund. And I am @TaylorPearsonMe.
