Odd Lots - Vineer Bhansali on Losing Fed Independence as the Biggest Tail Risk Right Now

Episode Date: September 13, 2025

Everyone wants to buy the hedge that will save their portfolio in a time of collapse. But this is easier said than done. You need to understand the specific risks facing your portfolio. You also need to get the disaster state right. Plus, insurance of any sort is costly. This means tail risk hedging is far from a trivial exercise. On this episode, we talk to someone who's been working on the problem for a long time. Vineer Bhansali is the CIO and founder of LongTail Alpha, which works to develop hedging implementations to prevent against left tail outcomes. Bhansali, who started off as an academic physicist before going to Wall Street, talks to us about options theory, the role of quantitative techniques, the time he won big in Liar's Poker, and why he perceives the loss of Fed independence as the biggest risk right now. Read more:Wall Street Rallies as Fed Gets All-Clear to Cut: Markets WrapGold Surpasses Inflation-Adjusted Record High Set in 1980 Only Bloomberg - Business News, Stock Markets, Finance, Breaking & World News subscribers can get the Odd Lots newsletter in their inbox each week, plus unlimited access to the site and app. Subscribe at  bloomberg.com/subscriptions/oddlotsSee omnystudio.com/listener for privacy information.

Bloomberg Audio Studios, Podcasts Radio News. Hello and welcome to another episode of the Oddlots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. Joe, I've been reflecting on this year. It's been a busy year. Yeah, go on. In fact, we're recording this. We're on yet another trip. I know. We're in Huntington Beach for this year's Future Proof Conference, which is an event I always enjoy.

But we have been on the road a lot. We have. And I feel like the entire year is. starting to feel very surreal for me. It feels just very different to prior years for many different reasons. But I was also thinking one of those reasons is because it seems harder and harder to do portfolio construction nowadays. And I know that sounds really weird, given that markets are still at record highs and everything seems to be going reasonably well, even though we had that terrible jobs number. But if I think back to the big leg down that we saw this year, it seemed really scary because basically everything sold off at once, right?

You know what I really like? I like how you started this with this philosophical thing. It's like, we're out on the road and all this. And then I was like, how do I protect my portfolio? And I've been reflecting and the surreality of the times. And now we bring it around to portfolio construction. But no, there's true. And there's two, a couple of things going on.

So one is the sort of like cross acid class moves. The other thing is, and it's very related to that. I mean, it's the flip side of this, which is correlation breakdown. And then there is still this other. element that I think is at play where at least, like, I would say there's two more things, which is that one within U.S. assets, the winners are still the winners, right? Especially a lot of these big tech names. So you haven't gotten the sort of secular. And people have been talking about overvaluations for ages. Forever. And then the fact that, you know, you're not getting paid

much to take on volatility risk or volatility measures are still very low. So there's a lot of difficult, unintuitive things going on. And I don't even know what a tail risk hedge actually looks like at this point because I would have thought, like, well, obviously, maybe you diversify into long duration bonds or something like that. But then in April, when we had the big sell-off, long duration, did not do that well either. So it kind of has me scratching my head about if you were worried about stuff, both literally and figuratively perhaps blowing up at this point in time, what would you be doing? Like, what does a tail risk hedge actually look like now? Right. You're like, buy gold. That's already a record high. Yeah. It's confusing. Yes. Okay. So on that note,

I'm very happy to say we actually have the perfect guest to talk about tail risk insurance and just tail risks in general. Someone who's been working on Wall Street for a really, really long time and has a very storied career, lots of stories involving big names that you and I would definitely recognize. We're going to be speaking with Veneer Bonsali. He is, of course, the founder of a long tail alpha. And again, has worked at many, many firms previously. We'll get into all of that. Veneer, thank you so much for coming on all thoughts. Thank you for having me.

So I should just go ahead and ask you to give a sort of five-minute summary of your career because it is kind of amazing. But the important thing is you didn't start out as a trader. You started out as a mathematician. Yep. I started out as a theoretical physicist. I was finishing my PhD at Harvard. And this is 1991. The recession had just hit.

I didn't know what a recession was. I wanted to be a professor. But my job evaporated because I was going to go work at the supercollider, the superconducting supercalider that got canceled by Congress. 1990s. I had a postdoc lined up in France and one, I think it was in Texas and Austin, and I got a call out of Wall Street, out of Goldman. They were looking for quants like me to work on options trading, or options model building, rather, I should say. So I went and interviewed mostly because it was a free trip to New York, so I went there, got interviewed by an elderly gentleman who was taking note saying, doesn't know any finance. Full disclosure, I knew no

finance, I had no interest in it. It was Fisher Black, who was me young week. Oh, wow. I decided, you know, Black Shoals' fame, little did I know. When I turned that job down from Goldman, I took another job at Citibank, trading derivatives, because in my mind was a sabbatical. I was going to do this for about six months to a year and then go back to physics. Well, little did I know that my whole life would become basically very deeply connected to option trading. So that's what I've been doing. And we'll talk a lot more about tail risk catching in a second. Wait, I got to ask, why did you decide to turn down Goldman, given that, you Fisher Black himself was doing the interview, and you chose to go to City at that time.

Well, one was a research job at Goldman, and the job at City was actually trading derivatives, and since trading was so far away from what I knew, and this was really supposed to be a vacation for me for about a year. It sounded like a good thing to do, a fun thing to do, rather. Did you ever feel like, I'm always so curious about stories from the early days of physicists going to Wall Street? Was there a period where you felt like it was a bit beneath? I mean, you call it kind of a vacation job. Did it feel intellectually beneath you for a while? And then did it eventually become sort of genuinely intellectually satisfying in the way that maybe you had anticipated an academic career to become?

So interesting, though, the modeling certainly at those days seemed a little too naive. So for instance, I'll give you an example. Very first trade that we did, large trade, I was a Citibank at the time. And it was an interest rate cap on yen interest rates linked to a dollar yen. So it was basically a two-factor option called a hybrid option. And it turned out that as a physicist, I was very easy. It was very easy for me, and I was very able to write a Monte Carlo to write this knockout cap.

But for the finance people, it was kind of tough. So the math was very easy. But I also learned that trading is not just math. Trading is a lot of behavioral stuff and so on. And that I just obviously had to learn. And I have some great stories of stuff that I did really badly back in 1994. Tell us the story about you did badly. Well, it's in 1994, if you remember, in 1993, the Fed had eased and rates were quite low,

and everybody was long the front end of the yield curve and buying Eurodollar futures contracts. Wait, didn't it tell on here go bankrupt? Yes, yes, yes, we'll get to that. Exactly. So February of 1994, the Fed raised rates by 25, and then, very surprisingly, April 18th of that year, they did an intermediate increase. And at that time, bond market had always sold off quite a bit, and I just did what, human beings do, which is better on mean reversions. I tried to buy the bond market and try to

buy the bond market again and again and again until I realized that there's something called trend following and exit. And I think the bond market sold off a good 15, 20 points. And finally, I recouped it all that it was a brutal few months of literally getting my face ripped off. So one other thing I'm curious about the sort of early days of quants, but what exactly was the pitch to scientists, whether they're, you know, mathematicians or physics guys, when these big banks or big trading firms are trying to recruit back then. Because, you know, like, Quant was in the, I know we had 1987 by then, but it was still relatively in the early days. So I'm really curious, like, what they told you about what you would be doing. So on the modeling side is pretty

straightforward, right? The Blackshould equation and stochastic calculus, stochastic finance is basically what's called the heat equation or the diffusion equation in physics. And that's something that every physicist learns when they're in early graduate school. It's like solving a partial differential equation. So the math is exactly identical, the math of finance. And maybe that's a problem, actually, in retrospect now that having done this for 30 years and 30 plus years and survived, maybe that's the problem because the beauty can somehow hide the frictions that are underneath it. From the trading side, when I first started trading, I think it was very simply being mathematically sharp and quick.

and being able to answer quizzes just made interviewers feel like they were getting smart people on the desk that they could train, right, the blank canvas, so to speak. So once people on these desks got armed with PhD physicists and understanding of like Brownian motion and stuff like that, did that change how the actual markets traded? From your perspective, like sort of pre-imposed that. Did assets conform more to as models anticipated because of the, model effect on them? Like, what was your observation of actual existing market behavior pre-imposed the physics revolution? Oh, absolutely. And this is a very important question, because if you fast

forward to 2018, the big XIV debacle and the Balmageddon and a lot of things that happen now, and actually fundamentally what we do now, what I do now, is related to this fact that there's a very tight feedback loop between models and markets and models. So give you a very simple example, right? If you have an option that you've sold to somebody and you have to manage the risk, of course, when you sell the option, you're getting a volatility premium. That's why you sell it. You're getting an insurance premium, so to speak. But then to manage the position, you have to delta hedge. But delta hedging means that you have to buy and sell the underlying asset. And some higher order Greeks as well, gamma, vega, theta that you've all read about. But delta hedging requires people to be able

to buy and sell so that they are, the seller, the market maker, is locally flat, of course. So as a marketmaker, that's what you do, and that's how you earn your fees, so to speak. The problem is that there's an idealization in mathematics or mathematical finance that you can do this at an unlimited size. And size doesn't matter. But it matters. Liquidity is actually not there. The basic assumption of Black Shoals is that you can continuously trade with almost zero transactions costs. Well, that's just not true in real markets.

As a matter of fact, in the last maybe two years even, you've seen liquidity in the E-Mini Futures contracts, which are possibly the, I would say, got the zero-th-order hedging instrument for the equity markets, go down relative to the high levels, frequently go down to maybe 120th or 150th office level. So people just can't get out. So what happens is that people sell options, then they start delta hedging. Delta hedging results in the options market reacting to the delta, then it results in new hedges coming in. So this feedback loop gets tighter and tighter and tighter until something breaks. And when something breaks and the bot shut down, which is today's environment, you actually have no liquidity.

And that's when you get these crashes like Liberation Day on April 2nd. Valmageddon was definitely one of the more weirder events in markets because everyone could see what was going to happen when the VIX curve actually inverted. Like you could see that all these products were going to go absolutely belly up. and no one seemed to react to it until it was like much, much too late. That reminds me. So one of the reasons that we are interviewing you here in Huntington Beach is because you used to work at Pimpco with Bill Gross. And the last time we spoke to Bill Gross, I think was actually at Huntington Beach two years ago.

And one of the things we spoke to him about was volatility selling. And Bill kind of became the poster child for a little bit of volatility selling, at least in the bond market, in the sort of like, I guess it would have been 2015 around then, mid sort of 2010's area. I'm really curious who's selling VAL now and how has it changed over the course of your career? Yeah, so a great little side point there. So Bill and I've been great friends. As a matter of fact, I went to Pimco because I heard Bill speak at a talk when he was advertising in book back in 2000.

And Bill's an amazing genius, great investor. And one of the best compliments I got recently, I was communicating with him and he said, I have your paper at the top of my reading list. And I said, which paper bill? And he said, this paper that I wrote with Larry Harris on the volatility selling ecosystem that basically grew up before 2018. So, yeah, so Bill actually, in a sense, invented this whole idea of selling volatility in fixed income, especially through buying mortgages or explicit selling of straddles and strangles.

And what we realized, and again, I was head of analytics at PIMCO. So over the last, or over 15 years or so I was there, I got to see. and help him manage the quantitative risks of those portfolios, we ended up educating a lot of our clients at that time about volatility selling, harvesting volporems and so on, which did end up adding quite a bit of, as Bill calls it, structural alpha to the PIMCO portfolios and, you know, 20, 30, 40 basis points every year. What happened is that everybody got educated and it became part of the academic lore and everybody realized it, there was a lot of crowding. And it's a little bit like selling insurance, right? So when you find that one insurance

policy selling works, then you say, why don't become multi-line insurance provider? So you start selling insurance policy on everything. And so what has happened now over my career, it have gone from institutional selling where, first it was hedge funds, then it was large, sophisticated mutual funds like PIMCO, who could actually still fit it inside of the mutual fund complex because selling naked options is not really allowed unless you cash back it. Right. And then over time, it has now gone to all the do-it-yourselfers. So all the wealth offices and family offices and large endowments. And this whole area, which is now called alternative risk premiums, is based on this idea that you can go and sell volatility in various forms, explicit forms or implicit forms,

to generate income. So everybody's doing it. Yeah, that's the answer. Everyone, even more people are doing it. So when we see alternative risk premium, it's basically of all selling overlay. is that it? Yeah, I mean, you can make it more or less sophisticated. I mean, it's a little bit naive to say it's only wall selling, but wall selling is a very important component of it. And there were some great papers by people from AQR who took every asset class, so equities, bonds, credit, foreign exchange, and then also sliced it down in various types of strategy, style, and quality, and momentum, and so on. They made like a 16 by 16 matrix. And then they recreated this, what I consider to be more sophisticated sounding,

wall selling, but it really is false selling. And what people do, just to be very clear, is it's not just wall selling. They also layer on other things like trend following on top of it to create a counterbalance to the wall selling, because trend following is naturally a wall liking or long ball type of strategy. Going back to, I hadn't realized that

about the declining or the collapsing liquidity within the IMNI futures, but is there some sort of, I don't know, law of thermodynamics or something, I don't know if that's the term or that's the analogy in markets, where such that when some instrument becomes the hedging instrument of choice, the more popular that gets, the less capacity there is for liquidity in that instrument. Does that sort of what's going on here? Yeah, so in this case, the Emini Futures contract are basically a speculation vehicle. They're a cash equitization vehicle. So they serve a lot of different purposes. But I think the biggest thing that's going on here,

here is that starting maybe about 10 years ago and somewhat surreptitiously, the market morphed from human market makers. So when I started trading, it was human market makers. I still remember when I was, you know, in the 1990s, Tommy Baldwin on the pit of the CBOT floor, Chicago Border Trade Floor, you know, you would do a trade and Tommy Baldwin, and he was legendary, obviously, he would lift his hand up and the market would stop and turn and go the other way. Humans could do that. What had happened surreptitiously or, you know, very strangely over the last 15 or 10 years maybe, is that the human beings have sort of left this market-making area, and 90-plus percent is being made by bots.

And what bots know very well, self-survival is extremely important to them, is as soon as they see a liquidity tidal wave coming, tsunami coming at them, they just get out of the way. The liquidity just becomes very episodic. And Muhammad Ilerian is to call it latent illiquidity, which is just a fixture of the markets today. It looks liquid, and when you don't need it, it's there. But if you need it, it's not there.

So how do you actually deal with that as a trader? Yeah, as a trader, so this comes back to the role of options fundamentally, right? So what do options in the world of quantitative finance, you can take an option, you can replicate it by doing delta hedging and so on, basically looking at the partial derivatives of an option pricing equation. Or you can say, I'll just buy the option. So an option is a contractual agreement between you and the option provider. So if there's illiquidity, and you believe this is a fixture of the environment that we're going to live in, then there is no other way than to actually have a contractual agreement for somebody where you're delegating the illiquidity risk to them.

And so you are buying it when the premium is cheaper. But trying to delta hedge it yourself is like literally trying to, you know, put an elephant through the eye of a needle. It's just, people just cannot work out. I mean, I just can't imagine the market collectively trying to get through that needle these days. There is just nothing there. Let's talk about April for a second and maybe that period, like between April 2nd and April 9th, because that was a market event for sure.

And it was also a real economic event with many things going on that weren't just lines on a chart, et cetera. And we know what sort of happened there with the tariffs and then the reversal of some of the tariffs and what so forth. Since then, we've seen some of these correlation breakdowns. that some of our previous guests have talked about. From your perspective, you know, whether it's April 2nd through April 9th or April 2nd through now, what happened then such that maybe some, maybe is it a new regime? What changed in that month? Yeah, so I think one of the things that is going on is we are slowly undergoing a regime shift.

And I like to always paint this picture. And I'll come to your question right after I give you this big macro picture. From the 60s to the 80s, 60 to the mid-80s, you had this period of rising inflation, rising volatility, non-credible central banks, and stuff was kind of breaking, and people were behind the curve. Then you had the Volcker increase of interest rates starting in the 1980s, and until the maybe late 20s, 2020, call it, 2021, COVID was an accelerant. You got negative yields and falling volatility, credible central banks and so on. And I think we've actually turned the corner again. So starting in 2020, 21, I think we are probably going to look more like the 60s to 80,

then 1987 to 2020. Now, having put that backdrop in front of us, I think the issue really comes back to, yes, there is a regime shift both in terms of people's response function and how quickly things happen. So one data point that I can relay is since I started trading is in the past when crises would happen, even including the GFC, which I lived through and did fairly well, it used to take months, maybe weeks for things to correct and you had time to plan and time to execute. Then Walmageddon maybe took a few days. 2020 COVID, it maybe happened in a few days to a few hours. And then starting this year, it feels like things are actually happening on an hourly to maybe minute basis. For instance, in April, when the big crash happened and the correction

happened, all the action, including some of our trading, happened in the pre-premarket. So the markets had not even opened up. And if you needed to do something, you had to do it during the night session. because that's where all the action was. So I think that's one fixture of what's going on right now is that stuff is happening much faster, and it does feel like the balance that's tilted in the favor of more automated trading rather than human-driven trading. Let me ask a philosophical question about tail risk projection,

which is whenever there's a blow-up, we suddenly get all these stories about tail-risk funds that have done phenomenally well out of last month's chaos or whatever it might be. And then no one talks about them for like the next three years. You don't know how they're bleeding you dry during those other months, right. That's right. Until we got another blow up and then the cycle repeats itself.

In your mind, what is the purpose of tail risk protection? Yeah, this is very simple. And I've been trying to do this. This is actually one of my missions since I started our firm is not just managing the risk, but also trying to educate people and what the purpose is. The purpose is very similar to insurance. And not everybody needs it. if you don't live in California, earthquake prone zone or in Florida, hurricane prone zone,

you don't need the insurance. But if you're going to run a large equity-heavy portfolio, and by the way, equities have demonstrated over the last 100 years and maybe going forward are the one way to create long-term wealth because people go to work. The first thing I learned when I was a Citibank from my boss told me was just look at log GDP versus log S&B. The charts are aligned. Basically, if people work, the market goes up.

So what that means is that you need to be invested in the stock market. And the more you invest in the stock market, the more likely it is that you're going to make higher compounded returns over time, but also you will suffer big drawdowns. And one of the biggest problems with people's behavioral function is that when the markets collapse, they forget their plans and they liquidate. So what tail risk fundamentally does, it's not a fund that you should look in isolation and say, is this fund a good performer or not? just like you would not go back home and say, well, what was a total return on my home insurance policy?

Right? It's just a cost of a negative 100%, right, every single year. So would you quit buying insurance? You won't because home insurance or car insurance is not an investment. It is the cost of doing business. So that's the context in which one should think about tail risk hedging is it allows you to first protect yourself from yourself in the bad events. And then secondly, when the markets are down, the value of, those hedges going up allows you to buy assets on the cheap, which results in compounded growth.

Why hasn't Wall Street created an instrument where you could sell away your liquidity to protect you from yourself automatically? I'm going to invest in this fund and I cannot sell until the year 2016. Isn't that called lockups? But do those funds actually exist? Could I buy that? And then there's two things that intuitively seem that, A, you protect yourself from yourself. B, you diversify automatically by the fact that you're across time, and then C, presumably that would be more stable for securities lending and collect the little instrument. Has Wall Street created a fund that one can't get out of? I think like Tracy just mentioned, hedge funds like to have lockups and this term. I should just be able to buy an ETF that I can't sell.

Yeah, I think if you can get over the regulators, I think we are living in a world where mark-to-market daily, NAV, et cetera, for ETS and full transparency is required. But I do think, I mean, one very sophisticated institutional investor who was a client of ours actually said, I would pay you more if you sold me a product that actually had a longer lock. Because this is a question I have about portfolios and diversification in general. And it goes back to the point that you made about how stocks have done very well. And the expectation is that as long as the economy growth stocks will continue to do well for a while, 6040 was a craze, right? And this is a good portfolio over your treasuries and your stocks. balance out. But why should, like, what is the case for diversification? Let's say sitting aside

the behavioral fact that people sell at the lows. What is the case for diversification when there is this asset class that does so well over time? Yeah, so this is great. So if you could guarantee that this asset class would keep growing always, then you would 100% be on stock only. Now, what bonds traditionally used to do was they provided you with income, that when the stock market wasn't doing well, at least you wouldn't go completely broke. Because you would have some. yield. But I think it got taken to an extreme, right? I mean, the greatest example, and I wrote a whole book on this topic is, is the European Central Bank followed the Japanese central bank, and then they start buying it negative yields. And they convinced all the indexers to keep buying bonds with them,

right? I mean, think about this. You were buying bonds, meaning you were lending somebody money, and you were paying them interest. And at that point, diversification is an insult. I mean, you don't want to buy negatively yielding bond along with stocks, because it does nothing for you. And we're living the consequences of it today because the bond market over the last five or seven or ten years even has had absolutely dismal zero returns. Joe, do you think people who want positive yielding bonds are entitled still? That was your position for like a whole year. I still think that. I still don't think anyone is entitled to yield.

No, I don't. If you want to take the risk, go get it. But the sort of moral demands that the government must provide you yield for what? For not spending and doing anything? Give me a break. Joe spent a good year making fun of yield. The yield bugs, as you call them. It's great.

Go out, collect your yield. I'm happy for you. But don't pretend that it's some sort of moral insult that the government isn't providing you risk for yield. That is my only, that is my only stance. That's, I would argue, the U.S. government's most important role. Anyway, let's go back for a second. So it's not just the insurance idea.

You touched on this, but it's also the idea that, like, you can get a massive windfall when there's a market crash, and then you can use that money to actually go on a buying spree at a time when markets are cheap and everyone else is short on cash and they can't do the same. How do you actually deploy that into practice and how do you scale, for instance, an expected windfall against that type of assets that you could potentially buy? Yeah, so I think this is where the first principles thinking becomes really important. So you have to look at every portfolio is different, right? So one of the other mistakes I think people make is they think you can just pick up a finance

one-on-one book and say every portfolio is identical. It's all risk neutral and everybody is exactly the same. is just not the case. Public fund that has a 40% or 50% funded ratio is very different than a 90% or a bank that's 120% fully funded, right? So everybody has different needs. The first thing that you do is you look at the underlying portfolio's posture, how much loss can you take, look at the systemic risk shocks that they can actually withstand. So you run a shock, you run a full distribution analysis, and figure out what is the outcome under which they will be under so much distress or so much duress that they might end up having to liquidate assets. And there are

actually quite a few like that right now where if the stock market went down 20%, and privates went down about 20% in order to raise liquidity for distribution, they would have to actually sell seed corn, right? So it's really, really bad. So that's an existential risk that you want to quantify. So the first thing that you do is, you figure out what that risk is, a full distribution of outcomes. And then you look at the instrument set that's out there in the marketplace, starting from the most reliable and, surprisingly enough, like Joe mentioned already, the cheapest one, which is equity option volatility. You can buy those put options. But people who are not willing to pay a lot of continuous premium, you can do more sophisticated tricks where you can buy indirect hedges.

For instance, credit default swaps today. The CDX index, if you don't see the charts, it's actually tighter than it was pre the GFCs. The tightest has ever been because people are buying it for cosmetic yield reasons. So there are a lot of derivative instruments out there. Cosmetic yield simply means that the total yield. If you look at the yield of a corporate bond today, it is basically treasury yield plus some spread. So the treasury yields are at, call it four and a half, four percent. But the spreads are actually very tight, only 50 basis points on the CDX. So you're getting a 5%, 6% yield, which in the context of where we were three years ago, it looks like an enormous yield. It's cosmetic. I see, it looks good. It looks good. It looks good. But it's actually, you are a

are taking too much risk. Okay, keep going. Yeah, it's a cosmetic yield. Your decorated yield. Yeah. So to me, the yield is not justified by the risk that are underlied. But there's various instruments that you can use and create a portfolio of these types of hedges. Is tail risk hedging like insurance from a business, from a structure of how people buy it?

Is it like insurance where people sort of reload every year in a sort of, okay, start of the new year, what is the tail risk I want to put on, et cetera, or something that renews and they have to keep paying a fee? Or is it just sort of something that can be set it and forget it, a permanent allocation that's sort of the tail risk hedge? Like, talk to us about the business of selling a tail risk hedge. Yeah, definitely. So it goes up to the highest level where this becomes part of where you guys started portfolio construction. It's an asset allocation decision. Yeah. It's not a trade. So the context has to be that if the agents are lined up, meaning boards and trustees and so on, they think of this decision as protecting the portfolio or making a more robust portfolio as part of the DNA.

And the Taylorist becomes part of how you rebalance your portfolio over the long term. Okay, so that's how you set up the strategic portfolio. But then, to your point, every year, yes, you have to renew this policy. You have to recommit premiums. Now, you can pre-fund for the next five years if you want to do. But because options decay, in order to... to have this reliable hedge, you sort of have to buy new options. What would be the worst kind of tail risk hedging in your view? Is it, you know, too expensive or does

it not actually work when there is a big market crash? Like, what is the ultimate sin of a tail risk strategy? Ultimate sin absolutely is the one which promises to work but doesn't work, right? So a lot of people try to reduce your cost by creating synthetic strategies. I already mentioned futures markets aren't very deep when you need them, but there's a lot of strategies, which actually use a futures replication strategy like the 1987 crash also purported to do. And those strategies typically don't work. And so there's many that promise and they look like they are cheaper and they don't cost any bleed, but they also do not deliver, which again, going back to April 2nd, the only thing that worked during that April 2nd to April 8th period was reliable

hedging using index options. Nothing. Duration didn't work. Trend following didn't work. A lot of other altruous premium strategies didn't work. So that is the cardinal saying you just do not, do not have the luxury to go to the constituent, your clients, whoever's bought it, and said, you know, we were trying to be too smart and oops, it didn't work. As you mentioned that to even talk about buying a tail risk hedge, you have to sort of understand as what is the existential risk for the fund. And different funds have different flavors of existential risk, depending on how funded they are. And so obviously an entity that's 120% funded is going to have very different risks scenarios than one that's 40% funded. But you said something interesting, which is that,

and I've been thinking about this a lot in a different context, which is how levered is the financial system or the real economy to an ongoing rise in the stock market? How important is that? And at what point does even though a sideways stock market, let alone a decline, become risky for something that could break? And, you know, we used to think credit is. the thing that breaks. But I wonder if it's in the stock area thing now where you really get the problem with the equity values don't go up. Tell us more about what you said about what happens to various types of economically important players if the stock market one day stops going up for a sustained period of time. I think you have a big problem, right? So not only is the stock,

the whole system 401Ks and public pensions, they're all levered up to the stock market because that's the only way you can get to your seven and a half or eight percent actual yield. So if the stock market doesn't keep going up and keep delivering those kind of returns, it's very hard to get to that point. Maybe if inflation rises, at least, again, cosmetically, maybe the long bond gets up to 7% or 8% and everybody can just lock it in and immunize and you're there. But in real terms, you're not going to have the income that you need 30 years from now to retire. I'm fine.

I have a Zerpira mortgage. So I have a mortgage that's locked in from that one sweet period of time. Yeah. Exactly. So the system is very levered. And then corporate credit, clearly, it's very, very concentrated. We all read about fangs and so on. But corporate credit, based on the Merton model, again, that connects equities to corporate credit spreads,

is also leveraged the stock market. So the stock market suddenly had a big sell-off. Corporate credits widen out, which is the real problem, right? Because if corporate credit widens out and the cost of borrowing goes up for all the corporations, maybe not the fang stocks, but the 493 other stocks, then how does the system produce? because our whole system is based on borrowing. And I don't think very many companies in the U.S. can function if your cost of operating your business was 10% a year. Okay, well, on that note, we would be remiss to have a tail risk person here and not ask,

what's the big risk that you see on the horizon in, let's just say, the short to medium term? I think for me, the biggest risk right now is what people have been talking about is, you know, the so-called, and I call it so-called Fed independence paradigm shift, because I don't believe the Fed was ever really fully independent, but now it's coming to the fore that the fiscal and monetary authorities are actually one. So what happens in the aftermath if the Fed actually becomes part of the central government, the fiscal authorities, I think at that point all bets are off, because that's the one anchor that everybody, whether realistically or not, has held onto, but if interest rates can change just based on the need to finance something, that totally

upside downs the financial system. So to me, that's the single biggest risk right now. So would that materialize into an inflationary risk, for instance? And then would you be focused on what you can do to offset that? Yeah, inflationary risk. And I think one of the best option trades, again, this is not a direct option. So going back to what you were asking before, you don't always just have to pay premium, the yield curve steepener, where, you're a lot of you buy the short end of the yield curve and you sell the long end of the yield curve. Today, you can do it through using swaps and all that for essentially zero net carry. So here's an option, very similar to shorting the negatively-ealing bond market in Europe a few years ago, where if you put a

yield curve steepener on, either in a hyper-inflationary, maybe not hyper, but a lot, high-inflationary scenario, or in an aggressive Fed cut, the yield curve steepens. So, yes, so that environment is an environment in which the curve steepener could work. And yes, my zeroth order prior forecast would be that if we lose explicit independence of the Fed, the yield curve actually steepens a lot more. Something I'm interested in, so, you know, you're talking about the recent eras and the 60s and 80s and things may have gotten a little unglued, and then the Volcker era and then the post-COVID era, and now this question about whether what's left of Fed independence is at risk, you know, you're a physicist and a lot of people in your space are mathematicians.

Is there a limit to how much you can sort of math it out, so to speak, because a lot of these questions are external to mathematics. And so how do you think about the limits of quantitative analysis when we're dealing with things like, will the political system allow the Federal Reserve to remain independent? Yeah, I think a lot of it is actually non-quantitative. And what I've learned, even though I come from a quantitative background, is not the math itself, but it's the sequence of logical arguments that you can make to get to a conclusion, right? So, for instance, we knew even before fancy mathematics was discovered, you know,

Lagrangians and so on, that gravity exists. Gravity's existence has been known before maybe math was invented, but gravity has been there. And so I think there's some central laws of finance, which will still continue to exist, regardless of the mathematical modeling of them. And, you know, the Bill Gross, when I used to work with him, he used to say some things we can take for granted, I'm paraphrasing it, but the steepness of the yield curve, the fact that the yield curve needs to be upward sloped for the financial system to function because people lend money in order to get something in return. Those are not mathematical devices. Those are really just the way the capitalist system works. So I think you can take the quantitative modeling

to its own limit, but there are certain things that have happened in our system where we're a point now where gravity, so to speak, of the financial markets are going to have to take over. But presumably also, if you can't predict the politics, because it's very difficult, especially nowadays, if you can't predict the politics, then maybe right-sizing your positions becomes more important. And so the maths actually becomes one way of dealing with the very uncertainty, non-mathematical element of what's going on. Yeah, exactly. And I think to take that point one step further, so correlation has been the greatest gift since the 19, mid-80s to 2020, right? So you've got stocks and bonds to say it's 64. stocks went up, bonds went up, and they were diversifying, which is what a beautiful place to be in, right?

That sounds nice, yeah. So that was a freebie, and again, this goes back to financial gravity, so to speak. That state of affairs, that free lunch should not exist. So I think we might be entering a phase where stocks and bonds maybe are actually not diversifying and you have to look at other things. Gold, of course, as you mentioned, maybe Bitcoin. Who knows? But I think the fact that reliable insurance or portfolio protection is so available today

using the options market, to me, would be the place where I would look. When you look at the long end of the yield curve today in the U.S., is there an element in which these concerns about the loss of Fed independents are being priced in right now? If suddenly you could snap your finger and know for a fact that the Fed will operate at it as has been for the last 20 years, for the next 20 years, would there be a change? Is there some margin that's concerned there? You know what? I don't know if the Fed is going to be a committed inflation fighter as well as it has been in the past.

Therefore, I'm demanding extra yield today. No, not yet. I don't think so. Maybe a slight amount of premium has gone up, but one of the most striking features of the system is that if you look at the treasury yields, look at the 30-year bond today is 470, but you look at the 30-year interest rate swap, it's trading at, believe it or not, 389, right? So it's almost 85 basis points under the U.S. Treasury. Now, you ask, why would somebody take the swap market at a lower yield?

And I've been trading swaps since its inception back in the 1990s. Swap spreads are negative 85. And that goes back to the receiving of interest rate swaps to hedge liabilities by a lot of large institutions. So they have certainly not priced in inflationary effects into the swap market. But at some point, this has to also equilibrate. So in my view, it has not been priced in. maybe it's too early to price in because maybe the Fed does not lose its independence and, you know,

rises as Phoenix from the ashes. But I'm a little bit pessimistic about it. Just going back to your storied career on Wall Street for a second, how good were you at playing Liars Poker? I was actually pretty good. I think, I mean, I learned it after I joined Solomon Brothers. It was a good group of people. And I think the first year, maybe I lost a bit. But I think in the third year that I was there, I won it. And I was actually, I think the one who took the biggest pot. Also, my boss gave me his 18-foot fishing boat. He was buying a new one as part of the settlement. Oh, in lieu of cash. He was like, here, take my own. Well, cash plus the boat. Wow. That's a really big pot.

That was a big pot, yeah, at that point. We used to spend after the trading day was over every day. We would print out randomized liar's poker sheets, usually about 24 or 30 of them. And we'd play about 30 rounds every day. Wait, Lyers Poker She's, I thought you played with actual cash. Yeah, so actual cash, you play with dollar bills. Yeah. But, you know, if you're playing 24 rounds, they're not enough dollar bills flying around. I never thought of that. Yeah, so you randomize based on how the dollar bill numbers are generated. Is there going to be a future in finance for a young physics student or a math nerd in high school today?

You know, people worry about this with AI and so forth. But a young person who's quantitatively minded, do you feel confident that there will be role for them in finance in the future? Absolutely. I think finance has existed from the very, very beginning because it's based on the two fundamental emotions, right? Greer and fear. Right? So as long as there's greed and fear and there's smart people around, and again, going back to math and physics, it's not so much that the toolkit itself is teaching you anything special. It's just that teaches you think in a discipline, logical fashion. And I think with tools like what we're seeing with AI and so on and coding becoming completely democratized,

I think the ability to ask important questions rigorously becomes even more important. I think it's going to be even better than it's been. Veneer, that was absolutely fantastic. Thank you so much for spending time with us at Huntington Beach at the Future Proof Conference. And that was great. Yeah, thank you so much. That was fantastic. Thanks for having me.

Joe, that was really fun. We should have Veneer back and just do stories from Wall Street in the 1990s episode. Let's just do that. I love the stories. We could do a lot more on the stories. And I'm also interested in basically, you know, the philosophy of portfolio construction. I mean, obviously there's the math of portfolio construction, but I do have a certain dissatisfaction with many conversations about portfolio construction, including this.

In what sense? Well, diversify stocks have almost always gone up. Has every insurance, I mean, I guess another question that I could have asked is, has every insurance contract on the stock market essentially so far been a waste in human history because the stock market is at all time highs. I have questions about that. But the counterpoint to that is, and I've come to realize this as I get older in my life and in my portfolio is there is something nice about like waking up during a sell-off

and going like, oh, shoot, my 401K has been absolutely decimated today. But if I look at some other position or some other tail risk hedge that I have, like, that's actually up a little bit and it's offset some of the pain. And if I actually had to cash out of my portfolio on that day because of whatever, I had to make a mortgage payment or whatever, then I would have some extra cash to spare. And you could get an extra return by having that extra cash available to you to then go into the market and buy stuff on the cheap. I think that we really should have an odd lot's ETF that is advertised its illiquidity,

that you can't sell this. If you need cash now, this is not the instrument for you. If you are putting your money in this, don't expect to see it again for 30 years. But the plus side is it will keep you from making bad irrational decisions on a day when everything is red. I mean, there's, there's a value in that. There's a value in that, and there's also a value in being able to, you know, sleep at night a little easier because you have different positions. But anyway, shall we leave it there? Let's leave it there. All right. This has been another episode of the All Thoughts podcast. I'm Tracy Allaway. You can follow me at Tracy Allo.

And I'm Jill Weissenthal. You can follow me at The stalwart. Follow our guest, Veneer Bonzali. He's at Longtail Alpha. Follow our producers, Carmen Rodriguez, at Carmen Armin. Dashel Bennett at Dashbot and Kale Brooks at Kail Brooks. For more Oddlots content to go to Bloomberg.com slash oddlots. We have a daily newsletter and all of our episodes. You can chat about these topics 24-7 in our Discord. Discord.g.g. slash oddlots. And if you enjoy Oddlots, if you like it when we talk about portfolio construction,

then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.