Odd Lots - The Market's Big Bet on Low Volatility

Episode Date: December 10, 2018

The past couple months have seen the return of volatility in markets. On this edition of Odd Lots, we speak to Chris Cole, the founder of Artemis Capital Management and a long-time watcher of volatility. Cole has argued that a lot of the investment strategies we take for granted in markets essentially amount to a giant bet that volatility will remain low. So what happens when vol starts to come back? See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLoth on Amazon Music. Hello and welcome to another episode of the Odd Thoughts podcast. I'm Tracy Alloway. And I'm Joe Wisenpaw. So, Joe, it's that time of year again. You know, we're getting close to the end of 2018 and that means everyone is starting to talk about what 2019 might have in store for markets. Truly the most wonderful time of year, I think, is the season right about now. It always warms my heart. And that's when you start getting analyst notes from sell-side shops, talking about what their 2019 forecasts are for all asset classes, stocks and bonds and currencies. I truly think it's really like the most heartwarming time of year for that reason.

Right. Okay. Don't you? Absolutely. The most wonderful time of the year. indeed. But there's a little bit of a difference this year, I feel. And probably it's because December is coming off the back of November and October, which, as we've discussed on the All Thoughts podcast before, have been pretty painful months for a lot of investors. Yeah, that's true. And of course, people always update their forecasts, basically to some extent, extrapolating on what happened in the

recent past. So I think the fact that we got this sort of October, November, intense bout of volatility has caused people to say, oh, suddenly we see all these new risks on the horizon, whereas if you would ask them at the end of September, they would have been much more sanguine about what the future had in store. Yeah, everyone's sort of rushing to retool their risk forecast for next year. But there's one person who has been consistent in forecasting a very similar set of of risks for many years now. And that person is going to be our guest on the show today. That's great. I'm looking forward to this because, A, it'll be nice to get an alternative viewpoint from the always sort of, you know, somewhat rosy outlook of the mainstream

investing class. But it's also interesting to talk to people who are contrarians because while it's true that, you know, it can pay to have a different view. In the meantime, when markets aren't blowing up. It can be a costly view. So how you reconcile that is always very interesting. Yep, absolutely. And I have to say, I've been a fan of this particular person's work for a very, very long time. So I'm quite happy that we're going to have him on the show and that we'll get to put these questions to him. So without further ado, our guest for this episode is Chris Cole over at Artemis Capital Management. Chris is the founder and CIO of Artemis Capital. And he's writing about the markets and specifically volatility for many, many years now. Chris,

welcome to the show. Thank you. It's a pleasure to be here. So, Chris, maybe just to get started, you could give us a little bit about your background and how you got to Artemis and what exactly it does, because it's a little bit unusual, I feel. The question of Artemis is to really create opportunity. Normally when there's volatility in the marketplace, that's a bad thing, big equity drawdowns, it impacts people's portfolio in a negative way. Our job is to turn that volatility into something that's positive. And the history of the firm actually comes out of an old school hedge fund story. I used to, I was trading my own proprietary capital throughout the period of 2007 to 2010. and really turned 2008 into something that was quite profitable and tried to develop strategies that paid off in the event that there was a tremendous amount of volatility, but it didn't bleed uncontrollably or lose a tremendous amount of capital if the market continued to do well. And that was how Artemis was founded.

It was founded out of a bedroom. And today we have institutional clients all over the world. So is the goal of Artemis to be, or even the goal of their sort of framework to be profitable over the long term, or is it as some other funds are positioned to essentially allow people to take more risks during the good times while ensuring that when the bad times hit unexpectedly that they don't suffer a massive negative shock, basically? How you want to use the, you know, we're a hammer. You can use this whatever we'd like to. I think we have clients to look at it in both ways. But the goal at the end of the day is that throughout the business cycle, we want to deliver returns that show access alpha,

that are on par with what you'd expect from an alpha-genering hedge fund. But the difference is that we want to create most of our returns when the overall market is suffering the most, when there's the most volatility. So instead of where most of the class, The classic hedge fund structure, the classic portfolio has these long periods when there's a bull market and people are doing really, really well. But that's when we're just trying to stay static and not really make or lose a lot of money.

But when we end up having that 20, 30, 40 percent drawdown, 50 percent drawdown in market crash, that's when we want to really shine and do particularly well. And so to that effect, you can think of us as a hedge, but we like to look at ourselves as a hedge that pays you to own it through the business cycle. Right. So you mentioned creating value out of chaos. I'm trying to think how to phrase this question, but why did chaos or volatility become your thing

or your area of expertise or focus? No, I did a program. I worked at Merrill Lynch in my early days. And I, like most people, began starting out in value investing. And I looked at all these different strategies, like value and momentum and all these different financial products. And I really kind of looked at them the way that an alien would, looking at different return streams.

Whether you're talking about credit or value investing, these are mean reversion strategies. And then there are strategies like global macro and CTAs that make money off of trend or divergences and change. So I came to this conclusion that really there were only two asset classes in actuality. long and short volatility. There's people that say, is volatility the asset class, they say, well, you know, volatility is the only asset class.

Because in a crisis, people have all of these different strategies in their portfolio. But in a crisis, these strategies end up looking a lot like a short volatility strategy, a strategy that ends up doing particularly bad during drawdowns. And all of these different diversification ends up being correlated with one another. and then you end up having a strategy that is particularly fragile to change. So institutional investors, individual investors, in essence, kid themselves into believing that they have all these different asset classes. When actuality, they're just crowding into strategies that are fragile to change in the market. And that the true diversification is actually finding strategies that are long volatility or strategies that make money from change.

And that when you look at the world in this lens, There's really only one asset class, and volatility is the only real asset class in a sense of replicating returns. Chris, in theory, this idea of having assets or having diversification that could pay off in both long, heightened and reduced volatility is the premise behind a lot of sort of do-it-yourself at-home portfolios, like buying a lot of stocks and buying a lot of bonds, buying treasuries that, you know, maybe pay off. a little bit, a little bit extra money during the good times, but in bad times, bid up and are a safe haven asset class when we get a surge in volatility. This arguably has worked well for the last few decades. Do you think there's a reason that that won't work in the future and that the assets that seem to have thrived in the past during heightened volatility won't do so in the future? topic to bring up because for the greater part of 30 years, people have looked at the stock bond

anti-correlation and have said, you know, why do I need to be invested in something like long volatility or something that is exposed to change when I can just be invested in fixed income? Because I know that bonds will go up when stocks go down. And that has been true for my entire life. but if we take a longer history and look out 100, 120 years, and I presented this evidence as far back, it's become a popular thing to talk about now. But if you look at some of Artemis' research dating back to 2015, 2014, we talk about this at length. Stocks and bonds have actually spent more time correlated with one another than they've spent anti-correlated.

There's been multiple periods in history where stocks and bonds have dropped together for two to three years at a time. This includes the early 1900s, periods like in the 50s, and periods like in the late 70s. So if I go to an average financial advisor out on the street and I say, you know, I have $100,000, what should I do with my money, that person's likely to say, well, you put it in 60-40 stock bond split. And then the bonds will protect you when your stock's too badly. And if I have a little bit more money, I can go to a very expensive financial advisor, and they'll say, you know what? We want you to lever the bonds against the stocks because that's better on a market with risk reward, framework, efficient frontier.

That's something called risk parity. But if you look at these portfolios, they performed very, very well over the last 30 years. But if we look at over 100 years, there are multiple three-year periods where these portfolios would have had massive drawdowns, massive drawdowns. In some instances, for risk parity, even career-ending drawdowns. So this assumption that stocks and bonds will always be antacorrelated is a very, very dangerous assumption. And I think all of one has to do to prove this is look across history. Now, if yields were all the way up at, you know, 10, 12 percent, as they were in the late 70s, you could sit back and say, well, there's room for bonds to perform in the event stocks drop.

But if we think about what it would take for treasury bonds to perform as well as they did during the last recession, we'd have to have treasury yields go all the way down to negative 2%. Now, I'm not saying that that's not possible, but I'm just saying that's highly improbable. And this is the baseline assumption from which trillions of dollars of assets, of assets, asset allocation decisions are made upon. This assumption of the stock bond at a correlation. So this makes alternative forms of defense, like volatility, like smart global macro, very, very important at this particular juncture in the cycle.

I think it's very important that people understand that the stock, the assumption that bonds can be a form of defense for you is particularly dangerous at this stage of the market cycle when most yields are at their zero bound. Right. So the argument here is that when most people talk about being short volatility, there's an assumption that they're explicitly short volatility by, for instance, you know, buying VIX related exchange traded products or something like that. But you're saying that there are big parts of the market that are implicitly short vol through an assumption of existing relationships like the correlation between bonds and stock. Are there other things that you think are implicitly short wall in the market? Papers, I talked a little bit about the short-vall trade as being like an aurboros or the classic image of a snake devouring its own tail.

And this is how I like to visualize modern markets today, this financial alchemy driving markets higher and volatility lower. The global short-vall trade now represents an estimated $2 trillion. in financial engineering strategies. And these strategies that I deem as short volatility simultaneously exert influence and are influenced by volatility. This includes what I would deem about $60 billion of explicit shortfall exposure and another $1.4 trillion worth of implicit.

So what do I mean by the difference between explicit and implicit shortfall? Well, as explicit shortfall tends to be the weak hands at the table. These are traders or their institutions that are actually shorting volatility. This is where you're actually going out and shorting a VIX future, or you're actually going out and you're rolling, or you're doing a buy-right, over-write program. You're actually shorting calls or you're shorting puts to earn extra income. It involves actually selling a derivative. I think most people are aware of this, but this is actually the smallest component of the short-fall trade. The much, much,

bigger component of the shortfall trade. The trillion-dollar-plus component of it is what I call implicit shortfall. When you are shorting an option, you are taking on the assumption of stability, and that assumption of stability expresses itself through various risk profiles that can be expressed in these esoteric Greek terms that we use. But But long story short, you're taking the assumption of that volatility in markets will be stable. You're taking the assumption that there's not going to be any jump risk. This is something we option traders would call gamma. You're taking the assumption that there's not going to be rising interest rates.

And you're taking an assumption that there will be stable cross-assic correlations. These implicit shortfall strategies replicate the payoff of a portfolio of short options. by creating these similar exposures. So these would include strategies like ball targeting funds, which are short gamma in the market. They're short volatility and their short gamma. These would include strategies like risk parity, which are implicitly short gamma and short correlation.

So even though these strategies may not be directly selling volatility, they are implicitly replicating the exposure of a portfolio of short options. And you know what one of the greatest examples of an implicit short-ball trade in history was? Actually was the portfolio insurance debacle of 1987. Portfolio insurance was implicitly short some of these exposures of a short-option portfolio, even though it was never actually shorting a put-or-call option. So I think many of these strategies ranging from the financial engineering of share-bu backs, to certain risk premium strategies, to certain vault targeting strategies,

to certain risk parity strategies, which are comprising a very large portion of the institutional flows in equity markets today are replicating the payoffs of a short straddle. And this presents a layer of embedded and very hidden risk that people aren't fully taking into consideration. Canadian women are looking for more. more out of themselves, their businesses, their elected leaders, and the world are out of them. And that's why we're thrilled to introduce the Honest Talk podcast. I'm Jennifer Stewart. And I'm Catherine Clark.

And in this podcast, we interview Canada's most inspiring women. Entrepreneurs, artists, athletes, politicians, and newsmakers, all at different stages of their journey. So if you're looking to connect, then we hope you'll join us. Listen to the Honest Talk podcast and IHart Radio or wherever you listen to your podcasts. Chris, I don't want to get too philosophical here, but whenever I think about this, my mind starts to drift beyond mere financial markets. And I always think about like, isn't life and living in a society implicitly short volatility? I take a job. There's no guarantee that that job will last.

But as long as sort of things more or less function as they are, I keep my job. I buy a house. There's no guarantee that there's not going to be some freak fire or war in the area. But if there is, then, of course, that's completely potentially destroyed. Like, isn't, aren't we all always going to be as long as we're functioning members of a society, sort of all implicitly short volatility? I get asked this question a lot because I actually wear a watch that counts time backwards to my death. So it's a.

So that gives some perspective. I don't know you see the world, I guess. That's right. I look at myself as a call option, you know, and there's a element of time exposure that's ticking off. We are short time, and that's a form of shortfall. There are ways in our lives that we make ourselves, and, you know, certainly by education and by learning and reading and continually educating yourself, you are making a long-volvelling. volatility trade. By meditating and taking care of your health, you're making a long volatility

trade, by having lots of meaningful connections in your life and knowing a lot of individuals that can provide good contacts and good healthy relationships, these are ways to be long volatility. But almost certainly, most of what we do in life has an element of short-val exposure. And the biggest one, of course, being time. That is the only true currency. and the most fragile one. So is the implication here that overall people should think about the role of financial markets in investing sort of differently than they do? Because I think like basically people see they go about their lives and they make money from their jobs. And then to some extent, the role of investing in the market is to augment that and to turn their savings into even more and to make even more

money than they would just get from labor income. It sounds like the implication is that for you, since most of our lives are going about being short vol, that to some extent we should really rethink what the purpose of investing money is and that it should be more like a general life hedge. The look at savings is to make yourself anti-fragile to turbulence, to give yourself options. So, you know, it's amazing that the U.S. is probably one of the only cultures in the world where we assume growth. I think my friend Jared Dillian has made this point really well, that it's always assumed that the stock market should always be going up. It's always assumed that earnings per share should always be going up. Now, that's been a fantastic assumption to bet on over the last 50 years.

It may be a wonderful assumption to bet on over the next 50 years, but it's a wonderful assumption to bet on over the next 50 years. But it's actually important to understand that it's quite unusual in the history of most nations. Most people don't have that philosophy. So the concept of being able to provide a sense of savings is not necessarily to lever up your lifestyle, but it should be to give you an ability to be your highest self. The money and savings should be a form of anti-fragility. Cash itself provides optionality. So I want to be an in-the-money call option.

That's how I'm going to start thinking of myself. So I want to get back to that short volatility idea because, of course, in February we had this Valmageddon occurrence where we saw a lot of explicitly short vol strategies like VIX-related exchange-traded notes and products blow up. And there was a theory that when they blew up, they basically had to hedge. so they started pushing up the VIX index itself, and that kind of caused investors to get even more nervous, and then the VIX would go up even more,

and the exchange-traded notes would have to hedge even more, so you had this feedback loop that ended up making the whole thing really, really painful for a lot of people. I think you mentioned $1.4 trillion for your implicit shortfall strategies, so I'm wondering, could we, we get a sort of self-reflexive feedback loop in implicit shortfall strategies, and if we did, how bad would that be for the overall market? Well, billions of dollars in central bank stimulus, share buyback, systematic strategies are based on market volatility as a key decision

metric for leverage. So what we think we know about volatility is pretty much all wrong. You know, the Markowitz modern portfolio theory conceives volatility as some external measurement of the intrinsic risk of an asset. And this is a highly flawed concept, even though it's widely taught in MBA and financial engineering programs. Because it views volatility as an exogenous measurement of risk. To this extent, it's sort of like the way a sports commentator sees strikeouts and shots on goal. It's sort of a statistic measuring past outcomes of a game to keep score, but that somehow exists externally from the game. But the problem is that volatility isn't just keeping score. It's a player on the field now, massively affecting the outcome of the game itself in real time at a level that's never been seen before.

The last time we saw something like this was leading into 1987. And back then, the short volatility dynamic of portfolio insurance was really only about 2% of the market. Today, today, these short volatility strategies comprise upwards of 10% of the overall market. Now, that doesn't mean that we're likely to have another 1987 type of 20% crash in a day. But it does make the probability of some event like that much, much greater. These short volatility strategies are like a barrel of nitroglycerin sitting in your offices. Now, I can walk over to your offices in Bloomberg, and I can sit back and say, hey, guys, you know, Joe Tracy, what's in that barrel?

Be like, oh, it's just some nitroglycerin. Isn't that highly explosive? Couldn't it blow up several city blocks? No, it's not a big deal. It's been there for years. In fact, we've been adding to the stockpile of it for years. The banks pay off a healthy year. yield to store it here. And I'm like, my God, this is scary. This could, this could blow up.

And then you just say, well, it haven't blown up for years on end. And you know what? It may never blow up. Risk does not necessitate outcome. But if you have a fire that starts somewhere else and that fire gets larger and larger and larger, it may touch that barrel of nitroglycerin. And what starts out as a regular fire could explode outwards into something that blows up several city blocks. That's what happened in 87, where we had a routine market correction. Market was down 14 percent. And then that caused the barrel of nitroglycerin known as portfolio insurance to blow up and drop the market 20 percent at one day. We could see something very similar if a fundamental credit crunch, liquidity and leverage crunch,

intercedes with these short volatility strategies the way that they're currently composed in the market. Chris, I just want to point out that your theoretical story about us having nitroglycerin barrels in the office is not as ridiculous as it sounds because I used to sit next to Tracy. And she literally had a mini barrel of oil sitting on her desk for a long time. So our sort of like internal risk management practices with dangerous substances in the office is not quite as. outlandish as maybe you thought. I want to ask one last question I think is really key, and it touches on something you said in the very beginning. You know, it's very easy to come up with sort of naive, long volatility strategies. You could, you know, buy puts that pay off in the event of a massive drawdown, or you could just go long the VIX. But we know that these are really

costly strategies and keeping it very simple like that doesn't really pay off. You could really lose a lot of money fast. So you talked about how the goal at Artemis is not just to provide a classical hedge, but do actually make money over the whole cycle. So can you talk a little bit about how you go about sort of identifying long volatility strategies that don't kill you during the weight during the low volatility periods? It's really hard to do. And I think that's why actually, you know, what we spend, we spend all day and all night thinking about this. So I think it takes a specialist to be a little crazy and a little kooky to be 100% focused on this day in and day out.

Because, you know, it's one of those strategies where you don't see the payoff every day. But there's a couple different routes that you can use to execute this. and some of the tricks that we use. We look for opportunities when we're paid to own convexity. So we're analyzing markets every single day using computer algorithms. And if I sit back and say, Joe, would you like to buy some car insurance? And you'd be like, and I don't really need car insurance. And I'd be like, well, what if I pay you $10 to own car insurance?

But you only get it for three days. would you then want to own car insurance if I pay you to own it? You're like, yeah, yeah, sure. Well, sometimes in markets you're able to buy portfolio insurance very inexpensively or get paid to carry it. But you have to be very quick and nimble and agile to find those opportunities. The other opportunities is, you know, we, if I look at it and you're trying to figure out when a forest fire might break out, you know, you don't look at the spark that lights the

forest fire, you look at a myriad of underlying conditions. So we're looking at when numerous, we use a tremendous amount of data and we crunch a lot of that data to understand when is it opportune to buy that portfolio insurance and when can we get into positions where the probabilities are higher, even when we're carrying a negative bleed, but it's worth it to based on the probability set. And it requires crunching a tremendous amount of data. So these are some of the techniques that we'll use in order to find ways to carry that exposure efficiently. And it's not an easy thing to do. It takes a lot of time and expertise and focus and a lot of data and a lot of quantitative

networks to be able to manage that process. All right. Chris, I'm afraid we're going to have to leave it there. But thank you so much for coming on. That was really great. Yeah, thank you. It's been a pleasure. I really appreciate it.

So, Joe, I love that conversation. And I'm going to start thinking of myself as a call. option, hopefully an in-the-money call option. I really like it, too. I think that the, you know, we've seen a lot of in the post-crisis period the emergence of a lot of popular like perma barotypes who say, oh, everything is going to blow up eventually because of the Fed and run for the hills. And I feel like Chris had a slightly more interesting perspective.

And in particular, his idea of, well, we're sort of, you know, implicitly short volatility all over the plays. And so the idea of seeing investing as a reason to at least sort of get flat volatility or more long volatility, the way he framed it, I think made a lot of sense. Yeah. And I think his point is that those volatility strategies, the low vol strategies, tend to feed on themselves. And they tend to sort of naturally cause the market to double down on those positions. Yeah. And so basically, maybe before the era of low interest rates and central banks and lots and lots of passive funds, you used to have markets and investors that were sort of self-limiting. Once things got out of whack, eventually there'd be a correction and things would get evened out for a little bit.

And I feel like what Chris is implying is that that doesn't happen that much anymore. Stuff just stays sort of imbalanced for much longer than it used to. And that means that when it does finally correct, the correction is more painful than it used to be. Yeah, it does feel like maybe as investors overall are sort of sleepwalking into some big risks that they're not thinking of because they think they have them all taken care of. So they buy an index fund so that they're thinking, okay, I'm going to diversify away idiosyncratic risk of investing in individual stocks. And I'm going to buy a bunch of bonds. So I'm going to diversify away macro risk because I have some bonds. it's like, all right, I bought this, set it, forget it, buy a little bit every month,

and then look at my portfolio when I retire. Like, maybe it's not quite so simple. And maybe it's impossible to just sort of, people just sort of naively think that they've taken care of what they need to do to be good risk managers. Right. Okay. Well, 2019 should be interesting then, shouldn't it? Yeah. No, absolutely.

And, you know, the one thing I'll say, though, in the meantime is that we have had these blowups in 2018, but they, So far, it's worth noting that the market gets by them. Like we had the exchange traded products blow up earlier this year, and we talked about it. But we didn't, you know, and then it sort of flushed out of the system and it was okay. So I think the jury is still out on whether the system is still, you know, sort of so filled with nitroglycerin that the big one will come and there'll be this massive unwind. But maybe we'll find out more in the next year or two. Okay. Hopefully not, then.

And we'll have Chris... He can come back and do a victory lap. The nitrochlycerin metaphor is a little bit unnerving there. All right. Yeah. It had a bit too close to home. This has been another episode of the Odd Lots podcast. I'm Tracy Allowway.

You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. And you should follow our producer on Twitter. He's Tofer Forehaz and he's at Forges T. as well as the Bloomberg head of podcast, Francesca Levy, at Francesca today. Thank you for listening. The news doesn't stop on the weekends.

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