Animal Spirits Podcast - Talk Your Book: Anti-Carry

Episode Date: June 25, 2021

On today's show, the guys talk with Paul Kim of Simplify on how to sell vol and not get run over by the proverbial steamroller.    Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Simplify. Go to Simplify ETS and learn how they're helping advisors build better portfolios. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holtz Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritthold's wealth management. This podcast is for informational purposes only and should not be relied upon for investment

decisions. Clients of Rithold's wealth management may maintain positions in the securities discussed in this podcast. So February 2018 is an underrated day. A date that would live in in infamy. I think it was February 6th, maybe I was looking it up. That was an underrated day in finance Twitter history. That was the day that XIV went under, which is very bizarre because it, It was like a 10 to 12, maybe 15% correction at the most.

And this strategy that had just been going gangbusters because there was no about, especially remember 2017, I think the S&P was up 30 plus percent and the biggest drawdown was maybe three to five percent. It was like the least volatile year in a long time. You know what's annoying that you can't find like historical tickers that like go cabloy? You can't find the chart of XIFE. You can find it if you Google search images.

This goes away. Wouldn't it be neat to just type into any. of the services, like a chart of Lehman or Enron? Yes. You know, if you would have put $10,000 in Enron in blah, blah, blah. Anyway, so why are we talking about XIV? Today in the show, we have Paul Kim on for his third time to talk about ETFs from Simplify. And what was XIV?

XIV was a strategy where you were selling volatility, which I said to Paul is like picking up pennies in front of a stimulus. That's what people say selling volus. It's the widow maker trade. So his whole thing with this new strategy that we're going to talk about today, called S-FAL is taking what XIV did right, which was, yes, you do want to, over-the-long-term, sell volatility because that makes sense. Most of the time, the market is not all that volatile. Most of the time, it's fairly calm, but also not take as much exposure as XIV did and hedge

out the tails when the market's invariably blow up because they always do. It's an interesting strategy. We learned new terms today. Yes. We've heard about the carry trade before. We've never heard of the anti-carry, which I think anti-carry could be a very good villain on an Avengers movie. What do you think? All right. Anyway, every time we talk to Paul, I feel like I learned something, and they are doing, we talked to them a little bit before we started, and we said, are you creating products that hedge funds would have created in the past? And this is probably a strategy that some hedge funds do, but most of the stuff they're doing is also using beta, but also adding some overlays.

It's very interesting. The stuff that they're doing, and I think this is really cool of a lot of the niche and thematic ETF players is they are trying different stuff and they are giving investors stuff that they never would have had access to before

in a low-cost tax-efficient wrapper. I think I haven't really given this too much thought, but I think I'm more bullish on products like these than the thematic ones where it's just like electric vehicles, for example. The timing on those strategies, is much more important. You have to catch it just at the right time.

And some of those are always going to blow up and get a ton of assets because they happen to hit that theme at exactly the right time. But I feel like a lot of the themes, they maybe come out after the fad has already passed. It's just about timing. Well, not anymore. Not anymore. I feel like now people are so much quicker to react.

I think with SEC regulations being a little bit looser, it's easier to get the market quicker. All right. Well, we've talked to Paul once every, his company was formed in early 2020. We've talked to him three times. And every time we talk to him, they have a new fund out, which shows how much easier it is to get a fund out these days

once you have that infrastructure in place. Yeah. But yeah, every time we talk to him, I learn a lot. I think he's a really sharp guy. And I think they're doing some really cool stuff. So here's our interview with Paul Kim from Simplify ETFs. We are joined the end today by Paul Kim, CEO and co-founder of Simplify. Paul, thanks for coming back on today.

Thanks for having me again. looking forward to this conversation. This is your third time on the show, correct? Put you in rarefite air with, I think, the exact prints of BlockFi as are only three-time guest. All right. Does it end at three? Like, are you banned after that?

Just want to start off by congratulating you guys. I saw that you passed half a billion dollars in assets, and not that long. So how long has it been? Just about nine months, very, very fast growth. We are also launching a lot of ETFs. That helps, but I think it speaks to sort of the big problems that we're trying to solve with our ETFs, and we're trying to get our

awareness out. And as that awareness level goes up, we're seeing a lot more traction across all of our ETFs. So I think there's a lot of opportunity because, I mean, with indexes, how many more index funds can be launched? We get it. They're all out there at this point. We have multiple flavors of each index. There was an article in Bloomberg yesterday talking about the rise of thematic ETFs, and there's been way more active ETFs or thematic ETFs. I can't remember than indexes this year. Again, it makes sense. All the juices have been squeezed there. But it's still, even though it's growing, it's a big dollar amount. It's only about, I think, three and a half percent of all ETF assets. So the big dollars go to the cheapest, most vanilla betas out there.

But in terms of revenue, it's definitely much more interesting of a mix. And then in terms of issuance patterns, you're seeing a lot more active ETS-1, which a lot of these thematic ideas are often active, or certainly what Eric Belchino's likes to call the shiny ETS, sort of the differentiated stuff that most of our ETS comprise. I think there's a demand, and that's expected. So initially, the ETS solved a lot of portfolio challenges, giving you cheap beta exposures, but now that people are comfortable with ETS and have essentially created an entire ETF portfolio,

they're looking for more satellite and niche exposures, and there's a lot of suppliers of those exposures now. Do you think that prior to the ETFs, like when your strategies have been in a hedge fund wrapper? So prior to some of the regulatory changes, particularly the derivatives rule that came out October of last year, and even just lifting of the moratorium on derivatives and ETFs back in 2012, you wouldn't have been able to create the type of strategies that we are offering today in an investment vehicle or ETF. So the question is, would they have been compelling enough as a hedge fund strategy? Perhaps not, because a lot of our strategies combine mostly beta exposure with sort of modifications around them. And I would say hedge funds tend to deliver much more sort of specific or absolute return oriented exposure.

So probably not the perfect comparable, but the same underlying securities and derivatives, options, and futures that are very popular in hedge fund vehicles are now available. in ETS like ours. That's a good lead into the Simplify U.S. equity plus GBTC. So that's your SPBC ETF. And so this looks like it already has 100 million assets, which is great. So this is using the S&P 500 along with an overlay to the gray scale Bitcoin Trust, which is pretty much the only way to get access to Bitcoin in one of these fund structures these days. So that is the breakdown, is it 9010? Or is it 110? What is the breakdown there, those two? So it's 100% SMP, and there's a reason for that, we wanted to make sure as people try to fund their Bitcoin exposure, where is it coming out of? And our solution is saying, well, the largest bucket in most

portfolios are the equity or risk asset budget. And so can you pull a percent out of SMP and put it into this ETF? So that's 100% SMP, mostly through IVV or third-party ETF, SMPETF. some of that exposure to your futures, that combination is 100% SMP 500. And the futures allows you to then take some of that uninvested cash backing that future and go out and buy a 10% slug of GBTC as a way to get exposure to Bitcoin. Which is that rebalanced occasionally, I assume, back to those weights? So it's going to be rebalanced at minimum quarterly or whenever you see the gray scale portion come up to 15%, we'll rebalance it back down to 10. If you ever see gray scale

dip to 5%, we'll rebalance it back up to 10. I imagine there was more than one rebalance in the recent weeks, or not necessarily? Not really, actually, because even though Bitcoin fell about 50%, a lot of that came before this ETF was launched. And even a 50% drop would by itself barely hit that rebalancing point. I think the rebalancing is an important feature, though, because because Bitcoin is such a volatile asset class north of 50% volatility, rebalancing it inside an ETF means you could take advantage of the in-kind reductions, push and defer out taxes tied to that. So it's a very sort of operationally and tax-efficient way to sort of get that rebalancing built in. And that feature, arguably, the tax advantage of the ETF wrapper arguably could

pay for the entire expense ratio of that exposure. So that's an interesting value problem. opposition. So do you think a lot of people are looking at this as they're toe in the water to Bitcoin and wanting to get just a small allocation to it? And this is a simple way to do it. Exactly. I think others, including Rick Edelman, basically get off zero. So dip your toe, address some of the FOMO or sort of desire to get some exposure. And even a skeptic, you could argue, Bitcoin or Crypto broadly is a one and a half trillion dollar asset class. and in a $400 trillion global investable asset class, that's something close to half a percent of exposure as a pure skeptic, i.e. total market investor. And so in that world, especially if the

upside potential of something like this can be 10x or more, if you believe some of the crypto fans out there. So even a skeptic would justify something non-zero. And then if that is the case, as an advisor, DeSherry or portfolio allocator, how do you want to get that exposure and does it make sense to use something like this ETS? Where are your flows coming from? I know it's hard to tell with the ETFs, but do you think that it's predominantly driven by advisors because these are more on the exotic side? It's really hard to tell.

There's no 13F data yet, but given sort of the size of the flows, we suspect it's an asset manager of some sort professional asset manager. Did you see in flows yesterday into SPBC? or do you not have any insight into that? We have not seen inflows every day, but we're getting fairly decent volume for a brand-new ETF, and it's been lumpy. But again, all new ETFs tend to look like that,

where you have a lot of sort of smaller tickets most days, and then you get these larger allocations when you get an asset manager or an RIA to sort of put on a trade. Because there are no Bitcoin ETFs yet in crypto is still relatively hard to do for an advisor, GBTC is kind of your only option right now to use it in this sort of structure. How do you view when this thing trades at a premium or discount? Do you take that into account in your moves here?

Are you just still trying to keep it more static? So we're keeping ours at the market price. So our nav is struck and our portfolio has rebound on whatever GBT's market price is. But I think that's a net positive. One, because it's trading out a discount right now, which means you're effectively getting greater exposure for the same price. So you're getting a discount of, call it about anywhere from 10 to 15% is as low as the 20% discount. So from that regard, it's a positive. And then the other feature is as an ETF, we would be considered an accredited investor. And so if it ever went back

to trading out a premium like it's done for most of the time the past few years, we'd be able to create new shares at NAV and basically ARB that difference. So if it's a discount, account, arguably, this sort of structure benefits because you're getting more, quote, Bitcoin exposure for cheaper. And if it's at a premium, you still benefit because now you have this potential arbitrage because you could still create shares at NAF. All right. Let's talk about Sval, the simplified volatility premium ETF. I've always heard that selling volatility has been compared to picking up pennies in front of a steamroller. How is Sval a different type of strategy than what most people hear about?

So I think particularly back in February 2018, picking up pennies was the perfect sort of metaphor here and people got steamrolled. Selling volatility is like investing in anything else where you want to make sure the sizing of your investment is appropriate. And volatility, as we call it, which is the VIX futures. So VIX has an asset class, which is the volatility of S&P 500, is effectively a hundred VAL asset class. So if you're going to buy that, make sure you're not levering up because one, the whole

underlying volatility of that is very high. But if you're going to go inverse, 100% volatility instrument, make sure you have the right amount. And so clearly 100% inverse was too much exposure for 100 vol asset. And again, February of 2018 with XIV, perfectly illustrated that. And now there are ETFs and ETPs out there. that offer 50%, which is better in that it would not have gone to zero back in 2018. We did a lot of back tests and studying sort of the optimal exposure, and we found that a 25%

position is actually a pretty good sweet spot where just that exposure avoids some of these big historic VIX spikes. It makes it a lot harder to have a permanent loss of capital, but it still takes advantage of this massive carry in this sort of vix curve. The weird thing about XIV to think to a lot of people was it wasn't like a 40 or 50% market crash that took it down. It was like a 10 or 12% correction. It wasn't even a huge blowout. So what do people underestimate about a volatility product like this where that product could go to zero in a 10% correction? So 10% correction in the SMP, 1 is a big deal, especially when you think,

about the asset class having a historic volatility of somewhere around 18%. That's a big deal. And so for VIX, which is a 100% volatility exposure, those are not going to be percent by percent correlated. It's going to be essentially levered volatility of S&P. And so, again, a 10% drop in S&P with approximately 100% pop in VIX, not that surprising. And it's all about sizing sort of that exposure. So again, we found that 20%. 25% is a much better long-term beta to VIX futures. Separately, also what makes this strategy unique is that we've paired the carry of selling volatility with the anti-carry of buying calls on volatility.

So if you invest a little bit of money, we're talking a percent or two a year in calls on the VIX, and you pair it and you fund it out of this massive carry engine by selling the VIX. That combination is even more powerful. So what kind of sort of carry already talking about? The VIX curve today, if you had 100% short that curve, if you're shorting the front month's contract, generates a annualized yield of 100%, north of 100%, actually. So even getting a 25% exposure to that means you're generating,

you're starting out the math at 25% yield. If that curve just stays... Can you walk us through the structural dynamics that make that so? So why is their contango? Why is this a feature and persistent feature? It's insurance. It's basically, if you think about what is the VIX. The VIX is the cost of buying calls and options on S&P 500 names.

So when there's more volatility, the price of those calls and puts go up, the option premium, and that implied price is the calculation used to back into VIX. So when VIX is high, it means people. have a demand for call and put options, and it positively slows because there's greater uncertainty as you go forward in time. So a one-day put is always going to have a relatively skinny implied vol relative to a 30-day or a 60-day put because more stuff could happen. That's essentially like a play on behavioral human nature, basically, that people are just worried the further you go out and they just don't know. Yeah. So the longer the time period, the greater

the uncertainty. So that's what gives this curve a natural positive slope, i.e. it's called contango. But it's not always the case because every now and then something hits the fan and people freak out. And the short term puts and calls become very expensive. And all of a sudden, that curve snaps and the front end snaps up. That's a volatility spike, i.e. like back in 2018, in that situation, selling ball is a negative carry. But fortunately, that's a, That's not most of the time, 80 to 85% of the time, it goes back into this normal-looking positive-carrying curve, and it's a very persistent thing. If you look back 15 or 16 years, the average curve looks a lot like the curve today.

It's a little steeper today. So instead of the 100% yield you're getting potential today, you would have averaged about a 45% or 50% yield over 15 years. So that's the base carrier. But, of course, the path to hell is littered with carry. That's sort of like a bond adage. So every now and then a year or two, it blows up and people get their faces ripped off. And that's where, again, the anti-carry, having some insurance by buying calls, you pair that

together, funded out of that massive carry potential. And all of a sudden, you have a very, very interesting income strategy that could still deliver double-digit carry potential with a lot less downside risk. That's all we've done. We've combined the carry engine with the anti-carry, put overlay or call overlay, and that combination is very, very interesting today. I think the strategy is intriguing. I'd be curious to know about the 100-year storm that happens every 12th to 24 months.

What does that do to this type of strategy? How bad does it get? So, again, without the call options, we looked at the past and looked at just a 25% exposure to this VIX without any protection in one of our case studies. And that on an annualized basis over the past 15 years would have gotten you somewhere in the mid-5% sort of annualized return. So you survived that because at a quarter, 25% exposure, even March of 2020 or February 2018 did not stop you out of the market and you were able to sort of benefit from the long-term carry. So that's a naked sort of exposure. 25% works really well.

Well, 50%, which is the most popular in ETFs today, keeps you in the game, but you have a permanent loss of capital during an event like March. A hundred percent, as already shown, will get you out of the game because that's too much exposure. So instead of 50, the 25 is already a pretty strong beta. But if you layer on this sort of protection for those every two-year storm, all of a sudden you do much, much better potentially than that beta would. I've done, which is already a pretty strong number. Is that tail risk that you're putting on there? Is that fairly static too? Or is that something that has to be managed and massaged and changed depending on the

volatility characteristics of the market? It's pretty straightforward. All we're doing is, let's say today, if you had a 25 exposure to the VIX curve, you're starting with 25% carry potential. We're taking a percent of two of that and buying calls on the VIX, and we're just spreading it out over every month. And that's it. And that's enough of an hedge to mitigate a lot of the downside.

Again, if you repeated a March type episode where VIX went from the teens to 82 in a very short period of time, having some call options on the VIX would actually have been a profit source in that environment. So not only are you protecting the downside, a VIX move that quickly would have actually added to your returns. And that's the interesting part where when you combine carry with anti-carry, you get really interesting outcomes. It helps the downside, but often pulls you up to the upside as well. This sounds a little free lunchy. Where does this break down? Where does this go wrong? What type of market environment is mad for this?

It would break down very long term if you throw behavior, human behavior changes overnight. We all wake up one day and we go. Further down uncertainty, like a month from now, I'm more certain than I am. next week. So if that contango. That's not a real risk. We know that's not going to happen. What type of market environment is bad for this? But that is literally the only time it would happen. If you have a long, multi-month period of time where that contango turns into a backwardation and your carry goes reverse. But again, I'm with you. It feels like, okay, humans are not going to change overnight and it shouldn't see that behavior. But that's the exact environment this would do

poorly. In most environments where you have, again, a positive carry, it's going to do very well. And then the rare environment, when you have a VIX spike, it depends how violent that VIX spike is. If it goes up 20, 30 percent, is that enough to make your calls useful? No, you'll lose a little bit, but it's not a horrible sort of downside. If it spikes a couple hundred percent like it did in March of 2020, that's a fantastic time to have these calls on. And so sort of the middle ground or this persistent change in human behavior would be the only situations in sort of my view. I assume that those hedges then those calls are much cheaper and don't cost you as much. So it's not that they're cheap. People who buy those calls for the most part are going to have a loss. It's a cost of

insuring. The reason it works so well is because it works when we needed to work. When you pair it with the carry and anti-carry, the fact that it works when your main carry engine is suffering makes that hole better than each of the part. But if you're just buying puts on S&P, you're going to be in a pretty tough shape most of the time. If you're buying calls on VIX, most of the time you're going to lose money. Every now and then you'll get lucky, but it's that pairing of the two that make it so powerful. What does this look like on a daily basis? What's the involvement with this type of strategy? And I imagine it sort of marches to the beat of its own drum. Does it look sort of like the VIX or the opposite? Like what is this over a regular, I know there's no regular year,

but generally speaking, what is this going to look like? What's the return stream going to look like? If you are again, assume this curve sort of stays persistent for a year, that's about a call it 20 to 25 percent carry potential. You divide that by 12 months. You're going to generally least get about a 2%-ish-looking yield each month. And every now and then, you're going to get some noise when VIX goes up and down. But over a long period of time, you're going to expect to get something closer to carry. It's like all fixed income. You could have day-to-day noise, but the majority, the vast majority of your returns in fixed income is the yield. And similarly here, we think the vast driver returns will be this shape of the curve and the carry. You're going to have

day-to-day noise, but having 25% notional exposure means that that noise isn't too dramatic each day. And then having these calls on VIX means no single day or two is going to sort of get you out of this carry position. You're looking at this carry. An investor could look at this as a yield or an income strategy. Yes. I mean, I'm not smart enough to know what's going on here, but 2% a month, even if it's not quite that, again, it sounds, it just sounds, a little free lunch sheet to me. How about this, Michael? Who's on the other side of these trades? Who is taking the other side of these that's along this to happen? I mean, is it mostly hedge funds? Is it individuals who are trying to hedge banks? Who is taking the other side of these

trades against you? Everyone who's, well, volatility vix in this case is a measurement of the implied vols on calls and puts. And we know the appetite on both calls and puts have gone up significantly in the past few years. So everyone buying calls and puts on an Amazon, an Apple, a Microsoft are really the other side of this. And so the entire industry that are starting to make greater use of options on either tail, that embedded premium in the options is the underlying carry engine here. So as long as option demand is strong, and as long as that view, that uncertainty is higher a month or two ahead of time than it is tomorrow, you're going to have a really interesting source of carry. And that's it. It's basically the other side of this

VIX trade are buyers of options. When you are talking to advisors about this product, where does the conversation go in terms of how this fits into a portfolio? I think it starts with income and stays mostly with income. Every advisor today, I think, has clients that have an income need. And given how skinny yields are in every other asset class, this premium here, and you could think of any source of income as a risk premium. The volatility risk premium is a relatively attractive one today because, again, on the other side of that are buyers of insurance, whether calls or puts, and that demand has grown significantly. So the other side of that trade would be sellers of Vol vix. And again, that is a richly sort of rewarded premium right now. It has been for the past 15 years. Michael, maybe already

kind of asked this, but I'm going to ask it another way. So this strategy probably isn't highly correlated to any typical asset class. Probably at times it is, but most of the time, it probably doesn't have much correlation to anything else, right? So noise-wise, like on a day-to-day, it correlates with VIX, which is a risk-on-risk off. But longer term, again, as carry is the dominant driver here, it's going to be relatively uncorrelated. It's more behavioral.

It's that sort of uncertainty, the price of behavioral preference for that uncertainty. demand for calls and options. And so, yes, longer term, carry is a very good diversifier to a lot of portfolios. During events, what happens? Does the price fluctuate more than it normally does? Does the income get squeezed? What happens when there is market events? For example, if VIX futures position goes up by 20%, i.e. there's a VIX spike, our holdings, which is short that position, would go down 25% of that, 2.5%. That's the basic math of it. But Vick spikes tend to be very mean reverting over very short periods of time. It tends to come back down to about the 20 level, give or take. So a lot of things drive it back to sort of that mean reversion. And again, it brings out that carry

of that curve shape is the predominant driver. So you may get some noise day to day, but your dominant source of returns if you hold this long term will be whatever that carry is offered. So all of the new retail that's been jumping into the options market for the last 15 months or so, that's a good thing for this strategy. Yeah. So people often call the VIX the fear gauge, fear index, but it's really, again, it's a two-sided calculation. So if there's a massive demand for calls, especially single-stock calls, that actually can inflate VIX because of volatility implied vol of both the calls and options are factored in. And so if the price of calls go up because the demand is up, it means implied vols on the call side that's used to calculate the VIX goes up.

That's what you're seeing is sort of that noise on either direction can impact VIX. All right, Paul, last question from me. If this product has success in terms of gathering assets, would you consider a more aggressive when you consider the 50 or is 25 as far as you're going to push it? We think the 25, again, we backtested the raw beta. The 25% is the sweet spot from our perspective in giving you exposure to the attractive carry without as many occurrences of sort of permanent capital loss. Because if you have 50% and this thing spikes 100%, you're going to lose capital permanently. Not all to zero, but you're going to lose a chunk of it. And that's what happened to some of the popular 50% exposure ETS back in March.

And so that's just a raw beta. We think the 25% is a better sweet spot than the 50. And then on top of that, if you throw on the options, we think that combination is really, really interesting. If I'm marketing this, this is Jeremy Siegel stocks for the long run plus Taleb, the turkey is going to get his head cut off eventually. More or less, this is in 100% exposure, yes. that turkey's been proven to have gotten his head chopped off.

And a 25% exposure, we've never in history seen anything that would have chopped it off. 50% we've seen instances where the turkey was threatened and bloodied a little bit, but it lived. But if you throw on some calls on the VIX, mathematically becomes harder to sort of kill that turkey. Essentially, the idea is most of the time markets are not very volatile, so you're taking advantage, but sometimes they're very volatile. Yes. That's it, right? Yep, and to make sure you survive through those infrequent but important bouts of volatility, you want to, again, think about carry is your main source of returns here,

but how can you protect that carry engine from times when things don't work out so well? And so when you marry a carry with an anti-carry, that combination is more robust and, in our view, long-term, better. All right, Paul, we're going to leave it there. Thank you so much for coming on today. Cool. Thank you so much. Thank you.