The Derivative - 2020’s Best Strategies, Styles, and Stories with Adam Butler and Jason Buck

Episode Date: December 23, 2020

2020 has been a year for the books – be it the fastest every market sell-off or a just as amazing tech rally from the lows. Whether you’re looking at it from a social/emotional/fiscal lens, it probably didn’t pan out the way you imagined based on your New Years Resolution. And in today’s podcast, we’re focusing out with the long lens to take a look back at the year that was 2020 to investigate what strategy types got it right, which got it very wrong, and more. We’ve brought on two of our favorite people in the space to add some vol/macro viewpoints to the conversation, Jason Buck, CIO at Mutiny Fund and Adam Butler, CIO at ReSolve Asset Management. To get rolling on part 1 of this 2-part series, we’re covering the early part of 2020 including: Early convexity through Jan/Feb, Cheap protection in the beginning of the year, How Corona blew up the markets in March, The craziest stats during the third week of March, Risk parity, Trend following & volatility strategy performances, The unbelievable rally that followed the crash, and The societal question of big corporations dictating the market. **Don’t miss out on Part II coming out on Thursday, December 31. Subscribe to us on Apple, Spotify, Stitcher, and/or YouTube to be the first to listen next week!** Chapters: 00:00-02:07 = Intro 02:08-21:27 = 2020: Pre-Pandemic 21:28-47:19 = The Third Week of March 47:20-53:40 = Let’s Talk Trend, Risk Parity, and Volatility 53:41-01:21:06 = The Rally Follow along with Adam on Twitter and LinkedIn, and with ReSolve on their website and their ReSolve’s Riffs series and the Gestalt University podcast. Follow along with Jason on Twitter and LinkedIn and with Mutiny Fund on their website and the Mutiny Fund podcast. And last but not least, don't forget to subscribe to The Derivative, and follow us on Twitter, or LinkedIn, and Facebook, and sign-up for our blog digest. Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit www.rcmalternatives.com/disclaimer

Thanks for listening to The Derivative. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations nor reference past or potential profits, and listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk

of substantial losses. As such, they are not suitable for all investors. Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. March was a endogenous liquidity event, if anything, right? Everybody points to the COVID crash and everything, but COVID was the camel that broke the straws back. It was like anything could have happened at this point.

Any sort of movement in liquidity was going to create this cascade effect of degrossing or deleveraging the books. And that's what we really saw in March. And that's what exacerbated a lot of those moves. And that's what Adams was referencing with the bond ETFs having such a divergence is due to illiquidity. And when illiquidity hits those markets, we start seeing all of those correlation breaks or those correlations go to one. And it's very fascinating to people find out what their diversification really is in an event like March. Hi all, quick note before we get started here.

We had a great conversation with Adam and Jason going more than two hours with the back half going deep into some philosophy on what the reality of money is, AI, Bitcoin, and more. So it sort of became two separate pods and as such we separated them. So here's the first half. Enjoy. Hello everyone and happy holidays. 2020 is nearly done. We made it somehow and to celebrate I've got two of my favorite minds on the pod today to discuss all the ins and outs, ups and downs, circles and squares, risks and rallies. Anything else? That's all I could come up with, with contrarian things of this crazy, crazy year.

We've got Adam Butler, Chief Investment Officer of Resolve Asset Management, who also hosts the excellent Gestalt U podcast and the Happy Hour series, Resolve Riffs, with many of our favorite alternatives minds on there. And Jason Buck, CIO of the Mutiny Fund, the first of its kind volatility trader, Fund of Funds, who also does some podcasting on the Mutiny Podcast, as well as conduct some great interviews on Real Vision. So welcome, guys. Thanks for being here. It's a great pleasure to be on your podcast again, as always. I know. The last time you were on was live in Miami before when things were somewhat normal. That's right. It's almost inconceivable to think back to those times, all of us

marauding through Miami as though there wasn't a pandemic on the way. And I was thinking about that earlier today, too. We were talking about the year of reveals. all of us marauding through Miami as though there wasn't a pandemic on the way. And I think about, I was thinking about that earlier today too. We were talking about the year of review. I was like, wait, when's the last time? Oh yeah. We were all in Miami at the end of June physically there for all the conferences. And then I believe, I believe Jeff Malik had quite the quite the retort about the pandemic, Jeff, if you want to bring that one back up.

Yeah. I think we were all there and there wasn't, correct me if I'm wrong, but there wasn't like a huge feeling of like, get in your bunker. This is going to get nasty, right? There was just kind of like, yeah, the virus is out there. I was telling people, yeah, I think that China would nuke like 20 million of its citizens before it let the virus get out into the greater world, which might not be the most PC thing I've ever said. On a public podcast, no less.

Yeah, it was right. Sorry, China, if you're monitoring this, don't nuke me. Yeah, so it seemed like it would just be under control. We were all a little bit like scratching our heads, if I recall, right? It was certainly a topic of conversation and we were watching the market rocket higher, right? Day after day, it just kept, and there was this insane vol compression right so like the sharp if i look back the sharp ratio through through january and and through like even late february was

some silly astronomical number like six or seven on the sop and and uh then boy did we get some meaner version? Yeah. And I think we were met with some guys in Hong Kong back there in February and they were like a little more worried about the the riots in Hong Kong. Like, doesn't that seem like 30 years ago? But there was like, well, it's a little more for us worried about those riots than the virus. I think that'll be contained. Yeah. Remember when democracy mattered? Yeah. So let's talk about that. We never talked about Jan and even into Feb, there was still, even though it was on people's radars, people were starting to sell, there was still some super cheap convexity out there. And you could, if you had your timing right, kind of buy that protection before everything hit the fan.

Jason, you must've been lining up the stool and the rope by mid-February, man, with that crazy 2019 vol compression, and then it just sort of accelerated into Jan-Feb. Exactly. And I think that this is what we talk about a lot lately is the market swings, yeah, from vol compressed to vol expansion or explosion is faster than we've ever seen in markets. And that may be a harbinger of the markets to come. And I think, you know, if we, if to start talking about the beginning of 2020, we may have to look at 2019 is like, if you looked at, you know, people trying to trade that volatility risk premium, you know, between implied and realized, and you look at the last, you know, three-year trailing returns or rolling returns, you would have seen since 2012, it has

just asymptotically gone down to zero. So as the real money, pensions, superannuation funds came in and started selling vol, it started to compress. They were reducing their own volatility risk premium, so that victim of their own success. And you saw it start to touch on zero Q3 of 2019. So you're starting to see that compression of all, like we saw in 2017 and 2019. I mean, we had realized balls in the single digits. That's insane, right? And I remember even talking to Hari Krishnan in January and February when we were talking about being able to buy your more classical deep out of the money protection at maybe

a negative 15 or negative 20% attachment point. Historically, those have cost you 3% to 5% a year. But when Hari and I were talking about January, it was like one and a half to 2% a year to buy protection. So either if you're, you're spending it and you know, a percentage of notional, you know, you're getting it cheapest ever. Or if you were just set a set it and forget it percentage every year, you are loading up on inventory in, at the beginning of, you know, in January of 2020, it's just, it's amazing. How do you view that of, of the classic that everyone says complacency. So people just weren't buying up protection. They weren't bidding up prices or the supply, like all these pensions,

everyone's saying, Hey, I need yield and I'm, I'm selling it. So I'm pushing on the, uh, sell side demand that kept the price low. I think there's two things on that. Um, one is I think when people, things on that. One is, I think when people, the first one, when you're saying about supply demand, we think about that when we have like zero sum markets and participants are set off against each other. But as we know with options markets, you're going to have the dealers in between. And so you can have this crazy supply coming from like the pension funds of selling volatility. And that doesn't pass directly

through to the other side. It's got to go through the dealers first. And so that's what you're saying. Like you're pushing on that string is like they're the victims of their own success is as more and more pensions start doing the same things. You just have this amazing amount of supply of selling volatility, which is going to suppress that, you know, on a go forward basis. And so, I mean, Adam might look at the same or slightly differently, but. Yeah. I mean, that's not the lens through which we typically view things, but I have to say that we have increasingly been trying to use those lenses to try and get a hold on the dynamics that are driving market moves, especially in the sort of intermediate term.

And obviously the open interest in individual equities and in index options over the last 18 months or so has just skyrocketed. I mean, I don't think we've ever seen open interest, especially on call option and on individual names in the S&P. I mean, we've exceeded all records by quite a substantial margin if what I'm seeing is representative. It's been shocking. So certainly the options market, you know, there's been talk over the last several months about how the options market is the tail that wags the market dog. And, you know, I was skeptical of that as, you know, as recently as a few months ago, and I've become increasingly persuaded of

the important role of options, especially in terms of how it impacts moves in the market over horizons and on measured in days and weeks. But I think Jeff, I know that you you're going to find that Adam does a great segue to what you're going to talk about later before you get the best at it. But it made me think about two things. I want to go back a little bit is I remember what I want to say is like, it's, it's, it's easy to think about it as,

if we take a poetic license with Hyman Minsky, right. Is stability creates volatility. Like the longer that volatility gets suppressed the more you're building up that air pocket for for volatility to explode and there's no way of uh maybe as accurately timing that but it's it's a weird uh perversion to think about that in a counterfactual that the more stability reigns supreme the more you're building up that cash of volatility to come you know rapidly into the marketplace and what why do these pens volatility to come rapidly into the marketplace. And why do these pensions just keep falling into the same trap? They know, right? They've read the papers. They've seen the things. And they're not just selling naked puts, right? So

are they getting duped into new complex structures that are actually short gamma way out of the money and they don't realize it? Or are they just accepting that risk and knowing like, hey, I know that there's that risk, but I just want to grab that yield in the meantime. Maybe the risk doesn't hit for two or three more years. Is your cue to go into how vol is the only risk premium? Yeah. So just go for that, man. No, I'm not going to go for that. And Adam talks more maybe pensions than I do, at least

on a certain side of it. But the way we learn about it, the way we talk to the pensions is that they have consultants and that's what people don't realize. There's a whole CYA industry of consultants that sell the pensions. And part of it is they sell, they go back and look at a back test and go, look, from 2009 to 2012, you should have been selling volatility. That was the right thing to do. And they go show them this back test, but they start telling them this in 2012, right? It takes till about 2015 before it goes through all the machination of the pensions before they approve it, right? But meanwhile, this consultant's been selling this to every pension and he's been telling them, look, you don't need to do much,

maybe a few percentage points, maybe five, 10% max of your book, but they're not thinking about the aggregate amount of pensions they're talking to. So they all start moving these, they're, you know, there's these ocean liners that can only move so quickly or turn so quickly. So it takes them years to get approvals to put this on their books. And then they don't realize the aggregate exposures that they're creating, but also in their defense, let's be honest, you know, everybody wanted to rip Alberta, whoever they lost $2 billion, but it was on it. Yeah. I was going to bring that to the Canadian of like, they, they didn't blow up. Maybe it's not a bad thing for them to have that in the portfolio. On the $200 billion book, $2 billion is nothing.

I mean, granted, you're losing people's real pension assets, so they should never do that, right? But it's not a big of a deal as people go, oh my God, the headline number is $2 billion. Let's put that in a little bit of context. And I think that Adam may spend more time talking to pensions so he can give you some more insight on how they work, but that's the way we look at it at a high level. when we don't target people who have this problem typically. But if you're swinging a $50, $100, $200 billion asset base around, then your options of how you're going to cobble together premia in order to meet your liabilities and just your cash flow streams in the intermediate term are just extraordinarily few. I mean, really,

when you're 50, you're a hundred billion dollars, you are the market. Any active risk you might try to put on is going to have the most vanishingly small impact on your total P&L. And so what they need to do is go out across all conceivable risk premia, spread their bets in every corner of the market that might deliver them a few basis points of excess returns. Volatility risk premium is, and we can get into the philosophy and the theory of to what extent the VRP permeates all of the other risk premia or many others. But they view this as one premia in an arsenal of different premia, and they're just trying to spread their bets. Like you say, it was a $2 billion loss on a $200 billion book. It's really awful optics. It's terrible line item risk. But from their point of view, they're spreading their bets and they sort of expect a few of them to go pear-shaped in any

given three to five-year period. And obviously this was some egg on the face for Alberta and a couple of people got the ax because of that. But really, they can't really be faulted. Sure, they can be faulted in execution. they can be faulted in execution, they can be faulted in not understanding the reflexive nature of if everybody piles into the same premia, then what should we expect from the premia, both in terms of the expected return, but also in terms of the expected risk that we're taking by all piling into the same sources of risk and return. And like you say, when you sort of consolidate the advice industry

with three or four primary consulting firms, everybody ends up on the same side of the trade. And this is how things go very wrong. Real quick, I'll give you a chance plug. What was that with Wayne Himmelsine or another one you had where you guys were going into the hole? They're too big.

They can't even access this tail risk stuff. They can't even access. So do you remember which episode that was? Yeah, that was two or three episodes ago on Resolve Rifts. We had Wayne on and just going through their strategy, which is primarily tail hedge oriented. And just talking about the size of institutions that might be able to benefit

from this type of strategy and how you would layer on a tail hedge for an institution with a 50 or a hundred billion dollar equity book. And I think we all agreed that, uh, these institutions are just, are, are too big to hedge. And, um, I, you know, we went on to discuss why, you know, smaller investors. And when I say smaller, I mean, very large family offices on the order of, you know, a billionaire or a few billion in assets have a lot of options in this regard, right? You've got a lot of options of different types of premia that you can chase and different types of risk management strategies that you can put on that these huge pensions and huge endowments just can't, and you should be

making use of all these tools. And yet they model themselves often after the huge endowment. So that's the mismatch, right? Of like, no, you have much more nimbleness, use it. And two more things before Jason, you're going to jump in. Like to me, the issue is not necessarily that you lost 2 billion, but you caused, right? Like what did they lose on the whole portfolio? So because that was there and because it started to cascade, you lost, who knows what it was, 15, 20% on the 200 billion. So that's a little bit of game theory, right? If only I had it, it's not going to cause it, but if everyone has it. And then the flip side of that, not to pick on the Canadians was CalPERS, right? Who got rid of their tail hedge rate in January or whatever that was, which was another terrible headline.

Which again, you know, obviously an awful decision in retrospect, an awful decision if you're being more thoughtful about the nature of your liabilities and what the assets are there for and the types of things that can go wrong. But at the same time, you've got an investment committee that needs to answer to a board of directors. They are seeing a line item that needs to be re-upped every month or every quarter. It's a consistent loser on the balance sheet. And you've got a CEO or an investment committee that's got to come back and explain the nature of this expense every quarter. And you can just imagine that they keep getting

heat. This is the stool and rope that I was talking about with Jason earlier, right? I mean, everybody who was in the business of risk management coming into January, February of this year was ready to commit Harry Carey because all of the risks that they have been discussing as things that people need to think about hedging hadn't materialized in years. Except for one day in February of 2018. Exactly. Exactly. And as usual, all the chickens come home to roost at once. And so everybody has a chance for a day in the sun. And what Adam and I've talked about privately a lot, and I think this is very interesting, is we've both been very charitable towards these $200

billion books. You literally cannot hedge the notional value of that. So everybody that wants to point fingers at them and say they should have hedged their books and everything, it's like, you have to understand what level of the game you're playing and what the constraints are. I mean, it's ridiculous. But on the flip side of that, what I think Adam and the team at Resolve have been really pounding the drum for in the last few months especially is that these can be benefits if you're capacity constrained,

if you're a lower size fund, you have time arbitrage, you have liquidity arbitrage that these big funds can get into a lot of the strategies you can get into. So you have a lot more opportunity set than they would. And so you can out-compete them if you're a smaller fund.

And that's kind of the way people should look at it. And part of that leading to what happened in 2020 is maybe it was just in our corner of the FinTwitverse, but you had AQR and Nassim Taleb. You had Cliff and Nassim going at it on Twitter. But part of it is like they were both right. Nassim's right. You should hedge your book. And if you don't have portfolio insurance, you don't have a portfolio. Was that after the crash? I remember

that slightly, but I can't remember it exactly. But Cliff was right too. It was like, if you're a $200 billion fund, you can't do that. So you're going to probably use more of a trend following approach. So it's like, they're both right, but it was an enjoyable part of the Fin2it sphere for while it was going on. And we would love to think that a $200 billion fund might be able to make effective use at scale of even a long-term trend following strategy. But I'm even skeptical that they can make material effective use of even that type of risk management technique. You know, the two things that we always harp on as being the primary advantages of smaller investors. And again, when I say smaller, I mean, measured in single digit billions and not double digit or triple digit billions. Right. But what these smaller investors

have. Rich dentists, we're talking. Well, yeah, but rich dentists can benefit too. Right. But, but up, up to sort of the, the two to five to, to, five to whatever, single digit billion range, is you've got mandate flexibility. In other words, you have the ability to change your investment policy or change your portfolio to suit different objectives, to suit changes in views. You can shift your mandate. These big pensions in order to change their policy portfolio is a multi-quarter, probably multi-year process involving a very large number of stakeholders, all of which have a great deal of risk involved in providing any latitude whatsoever. Like it's just an, an almost a possible task. And the other thing you've got is portfolio agility, right? You

can move substantial portions of your portfolios around relatively quickly with just with fairly minor market impact. And so, you know, you can chase a much wider variety of active strategies, place a much wider variety of higher frequency active bets to take advantage. And look, the information ratio that you can extract from the market is a function of the number of active bets that you can take. It's the diversity of the bets and the frequency of them. So obviously you can make more bets on a wider array of instruments more frequently with a smaller portfolio and investors with smaller portfolios should be making as much use of those advantages as they have the expertise to target. Hear, here.

So let's shift gears a little and talk. We'll we'll let the institutions off the hook for a minute and talk like, like so March full on capitulation. What were some of the craziest stats or environments, things that you were seeing in real time as we were in the throes of that going into the third week of March? One of the major memories for me was a break in the nav of some of the treasury funds, the treasury ETFs.

I mean, I remember the iShares 20 plus year treasury ETF trading at a 7% discount to NAV. So you could buy the ETF and short the underlying treasuries and earn a risk-free 7%, assuming that markets normalized to any extent. But I mean- And treasuries, we're talking not high yield or which in theory you should have been able to access and sell. Definitely. Yeah. I mean, when you've got broker dealers and firms like Citadel and some of the higher frequency players that cannot access the margin to arbitrage, what is essentially a risk-free bet at a 7% discount, that is really stressed liquidity conditions. Where was Warren Buffett? You think he would

have said, cool, I want half that 7%. What were you going to say, Jason? No, I think it's a good point to stress the liquidity conditions. I was actually going to take a step back for a second, just talk about that March was a endogenous liquidity event, if anything, right? Everybody points to the COVID crash and everything, but COVID was the camel that broke the straws back. It was like anything could have happened at this point. Any sort of movement in liquidity was going to create this cascade effect of degrossing or deleveraging the books. And that's what we really saw in March. And that's what exacerbated a lot of those moves. And that's what Adams was referencing with the bond ETFs having such a divergence is due to illiquidity. And when illiquidity hits those markets, we start seeing all of those correlation breaks or those correlations go to one. And it's,

it's very fascinating to people find out what their, what their diversification really is in an event like March. And I'm more curious about how Adam saw it when they have like a, some of their funds that are like, you know, targeting, you know, portfolio volatility or anything, and you have to kind of de-gross those books rapidly. You know, it's been another speaks to the nimbleness of being smaller. You can get out that fire exit faster, but that's got to be quite nerve wracking when you're sitting in that seat in March. Well, it's a funny thing because yeah, we're smaller, but you know that we're not the only player that's using this type of strategy, right? So we're swinging a few hundred million around, which if it was just us, we could descale really simply with very little impact in almost any market condition. But there are other funds that are much, much larger than

us that are also trying to manage their risk book and using approximately the same type of metrics and specifications and mechanics in order to do so. And so- Can you give us 30 seconds on what that looks like? We're talking more of a risk parity kind of rebalancing. Well, any type of fund that... So the basic fundamental building block here is it goes all the way back to the 50s. The idea is you build the optimal portfolio. The optimal portfolio, when you're dealing with five or six dozen different global markets, often is so diversified that it has a very low volatility and commensurately

without any leverage, a very low expected return. But it's still the optimal portfolio according to your estimates. And so you simply need to scale it along the capital market line. So you borrow to just invest more in this risky portfolio in order to generate your target return, right? So you're running with a little bit of leverage, you're relying on diversification. You're measuring the diversification opportunity regularly in the market, right? You measure it every day. How are correlations changing? How are volatilities changing? Some other guiding factors. What is the shape and curvature and level of some of the volatility indices?

These types of inputs, right? But you've got some kind of model that tells you how much risk you've got in the book. And as risk increases, correlations in many markets come in and volatility escalates, then you lower your exposure in order to maintain your target risk over time. And so a good way to say that if I put the portfolio together, I come up with a 10 vol, I lever it up. I'm at a 10 vol, everything's normal. If correlations move and vol moves, now the portfolio is at a 50 vol, probably not that

extreme, but say 20 vol, hey, that's two times more risk than I want. I need to cut the leverage in half to get back in line. Yeah. And there's this really strange non-linearity. The move, if you're at 10, if you're estimating, let's just use the S&P for example. So let's say the S&P had currently over the last, whatever, 60 days or however we're measuring volatility, has a volatility of 10%, just keep the math easy, right? And it goes to 12%. Well, that's a 20% increase in volatility. We've got to descale the portfolio by a conventional amount.

If the vol is 30% and it goes to 32%, well, that's a much, much smaller percentage reduction, right? So things get extra tricky when vol is really low because the movement in volatility has a much larger impact per point on the amount of scaling that you need to exert on the portfolio in one direction or the other. And so the liquidity that's required for you to change your exposure when volatility is very low is different than the liquidity that's required when volatility is high. So there's some other sort of non-linearities. And would it be fair to say that's somewhat of a knock on risk parity type models and fault targeting type models that they have to sell into the sell-off and they kind of crystallize some losses. Yeah. Well, in a lot of ways, it's like only put options or portfolio insurance. They're all the same type of exposure. Do you want your cost up front or your cost on the back end?

Yeah. Or stop losses. They're all sort of similar. The idea is you're just, you're trying to manage risk. Um, but really what you're trying to do is, is target risk. And when you're targeting risk, that, that is very useful and beneficial most of the time. And I mean, what was so interesting about the March episode was that vol escalated and markets collapsed at over twice the rate that those events had ever happened before. I mean, even if you go back to the 1987 portfolio insurance event on October 19th, 1987, that was previous to this, the fastest sell-off in market history. And before that, it was the 1929 Black Monday crash. Well, those crashes had absolutely nothing on the March crash, right? So you needed

to be able to model or anticipate a vol event that was twice as extreme as anything that you'd ever observed in history. And I think that speaks to the value of the types of strategies that Jason's firm offers. And then part of it, every strategy has its downside. So that's just part of life is that almost insult to injury is when that liquidity event happens and people are just throwing out the baby at the bathwater. Everybody's just going to cash. So they get rid of things they really want. So normally in a risk parity or permanent portfolio or something, a good holistic portfolio, you have all these offsetting return drivers. But when liquidity dries up like that, all of a sudden your stocks, bonds, gold, and even if your commodity trend look back, it's not fast enough.

Everything's going out at once. And so the things that were providing a ballast previously are not like, it's just got to be just hair raising in that environment. Yeah. I mean, the period between March 19th and March 23rd was very, very interesting, right? Because you had prior to that, liquidity conditions were sufficient that treasuries, gold, equities, rates, everything in the portfolio, the prosperity portfolio was doing what you expect it to do. Treasuries were rising sufficiently to offset a significant proportion of the losses in some of the more cyclically sensitive commodities and equity markets. Gold was still relatively buoyant,

acting as a ballast as you'd expect. What happened on the 19th was that liquidity conditions dried up so much and the margin clerks took over and instructed everybody to have to sell whatever they could sell. And so that's when you saw firms selling treasuries, selling gold, selling everything they could because that was the only thing that they were able to sell. You weren't able to sell any of your individual equities. There was no bid, right? So you went in and sold whatever you could sell for the time when the margin clerks took over and ran the show. And then of course, you had the stabilizing force of the Fed coming in and saying

that they were going to buy more bonds. They were going to step in and set up structures to buy corporate credit. And all of a sudden there was this reversal. And I mean, the reversal was, if anything, maybe even more surprising in its extremity than the sell-off due to this major reversal by the Fed and the preceding vol and liquidity so quickly. So just, I'll put a bow on risk parity and then we move on. But so not you guys in particular, but overall risk parity space, it was a tough March and a tough 2020. Well, actually, I would say it was a rough four days in March. And I think if you look across most of the risk parity funds, except for those four days in March, they behaved pretty well like you'd expect. Some of them that

were a little bit more equity heavy did a little worse. Some of them that were a little bit more bond heavy did a little better. Most of them have recovered to new highs on the year and have participated in a good chunk of the rally. And now that we've started to see a shift where markets are beginning to take notice of foreign equity indices and commodities, which typically happens as- What are those? There's foreign equity indices? I know. Yeah. Who knew, right? Is that new? Poor, neglected emerging markets, European markets, Japan. These tend to outperform during periods where investors are anticipating an upward shock in inflation. And I think we're seeing that type of scenario play

out right now. Obviously, you're seeing a widening out of the rally. Some of these big value funds have started to be resuscitated and commodities have started to come to life, right? The energy sector has just had a massive rebound, even though we had a pretty substantial surprise build in crude inventories last week, the energy sector has proved resilient. And I mean, it's pretty remarkable to see that the strength in not just the underlying commodities, but also some of these commodity sectors that have just been wrecked over the last three to five years come back to life. Jason, you got something to say, or can I ask you on the vault? I want to know which flavors of vault did best in March.

It was a complex question. I was just thinking about Adam being the segue master and leading you to your oil trade next, but I actually want to jump forward before we jump back. Adam, because we can talk about on the vol targeting at the portfolio level. Have you seen now as we get into late 2020 that the people are re-leveraging their books depending on their look back? Because March has kind of rolled off a lot of people's look backs on risk parity. Are you seeing risk parity kind of re-leveraging their books across the border? Obviously, it depends on individual funds, but is that what you're starting to see? Well, pairwise correlations

haven't really diverged the way that we were seeing in late 2019 and early 2020. And the vol complex is still not giving trend funds and risk parity funds, some of the other of all targeting funds, the same room to breathe as we had in 2019. So we just aren't seeing a recovery in equity positioning, typically a risk on type positioning in a lot of these funds. I know where our exposure is lower than it had been. And we've changed our approach relatively pretty significantly over the last six or eight months as well. So I'm not sure it's apples to apples. But just in general, I think we are seeing trend funds and some of the other vol targeting

and diversified risk parity type funds hanging back in terms of their overall aggregate exposure at the moment. There may come a time, I expect there will, before whatever this is, let's call it a mini cycle, comes to a turn. But at the moment, I don't see that we're in sort of danger territory for general exposure in the vol targeting space. And then, so Jeff, to answer your question on the long volatility terrorist side, it was actually like a story of weeks, right, at the sell-off. You had that last week of February, you know, or maybe some of the, you know, some of the options started, uh, started to look a little bit, you know, they're going to pop, they started to look

a little rich, but you mainly had like people like the trend followers in short futures started to really, um, you know, short the market going into the last week of February. So they start doing well, you know, as, as the weeks pass, then, you know, maybe you had a, um, you know, first week or second week into March, the vol of all picks up and the market starts whipping back around. And like Adam referenced, you had the market popping back up 10% in a day. You just had markets whipping around. So then the ARB managers have a really target rich environment. They're doing well. And then you get in the second, third week of March when the market really starts tanking off. Then you have

those deep out of the money put options. you're going through those strikes, those are really starting to pay off. So it was more of like a tale of weeks, as you saw, like the markets moving around, then the different strategies kind of, they're overlapping a little bit, but some are picking off the different trades here and there. And, you know, how you can, you know, manage that risk throughout the month of, you know, when the market rips back in your face, 10% in a day, that's, that's pretty tough for everybody. And it seemed the, there was some high variance between managers in the tail space, right? Because it was all about monetization. So if you're holding 12 months puts, you know, December puts in March, what do you do? Do you get out of them? Do you hold them? What did that look like in terms of the different managers and how they monetize?

Yeah, to your point is like you have, you know, Adam referenced earlier is if you have a one-year option and then you have drift for like February, March, and the market drifts higher and then takes off, you might not hit your strike. So you might have worked your way right out of a strike. You know, the shorter term, you know, it's all about your monetization heuristics. And so volatility can cluster or it can mean revert. And it can mean revert so quickly, you didn't monetize any of those profits. And so you had certain funds that were on the tail risk side. When the market got down to 35% down, they could have been up 40% to 60%.

But the market finished the month only 12.4 percent down so like they they that mean reverted all the way back in and some funds were only up 12.8 so it's it's just like it's if you can cross margin and others others monetize way early right the first or second week of march and then they were sitting there in week three like oh no what did i do i missed out on you don't know right like is is this the big one or is it not? So do I monetize early or is it going to mean revert? So maybe if the monetize, so it would mean reverts. If this is the big one, I have to hold for that monetization. And then, okay, it passes through 35% down. Is this the big one? Do I monetize? Okay. What if there's a second leg down after? I need still something on the books because otherwise I'm going to pay up for

that inventory now. It's just a nightmare of monetization. And that's why we look at it as across the board of different heuristics for monetization because you don't really know what that path dependency is going to look like. And so it's really easy to put on these options trade. It's the monetization, the managing, and the role that are exceedingly difficult.

Well, I think also just to make sure we get out of that everything there is to get, I think it shouldn't be undersold just how remarkable the contrast was between that first, what was it, maybe 30 or 35 trading days of the year with such a huge run higher in the S&P, right? So options hedgers need to continue to roll their strikes higher or they get further out of the money before they see a payout. So having to, and it's exactly the same problem as the trend followers have, where, you know, your, your, um, the risk in your trade is a function of how far out of the money your reversal is. Yeah. Your distance to your stop essentially. Correct. Correct. And so, so that huge run-up was such a massive confounding variable for any type of hedging

strategy. And both that and the speed of the sell-off and the speed of the snapback, I think, were the primary variables responsible for such a high dispersion in not just tail hedge funds, but also trend following funds, which I think is worth also discussing their performance. Yeah, that was going to be my next. And I'll just bring in that, but if you had tested your vol strategy, your tail strategy since 09 to 19, you're going to monetize super quick, right? Because it snaps back in days, not weeks, not months, days. So then you'd be getting out in

week two or you know week one or two and here we are then it goes right through that and to your point jason like oh no this is the real one this is the big one and then nope not really we're gonna snap back so yeah so sorry go ahead then i'm gonna ask adam about trend well yeah because i'll leave that but also tell three stories about those trades I think are really fascinating. And part of the one with like with trend, right, is they got sold after 2008 on crisis alpha. But because it was a long drawn out recession, they were crisis alpha and you didn't see that in this really quick one in March. So that's Adam can speak to that. But I think about three trades that may tell the story that are quite interesting. And going back to what Adam was saying is like the first month and a half, the first 35 trading days, the market was grinding higher. And so one of the trades we were watching that was fascinating to us was the structured products coming out of Asia and Europe, right? And so a lot of these had a knock-in or knock-out option at a negative 30% drawdown to the S&P. And you go, well, in March, the S&P sold off 35%, so they should have kicked in. Well, it depends on the vintage that they were created.

So if it was January 1st they were created and the market drifted higher before it sold off, you never touched those strikes. So we were waiting to see if you got this cascade of structured products knocking in, would it have just been unbelievable? But very few of them got touched. And meanwhile, also exacerbating the sell-off was the banks actually hedging out some of that risk, you know, as their Delta hedging that made it a little more, you know, Explain real quick what those look like from a client perspective. So I buy these knockout options, I get some yield. And then if it goes down 30%, I lose 30%. So it's like, give me 8% a year, but if it goes 30, I lose 30. Yeah. Say I'm just a retail investor in Japan. I go to my local bank, typically a French bank for some reason. And they say, you're used to getting yield on bonds. We'll

provide you a yield of 6% a year. And they say, great, I'll take it. But they don't read the fine print that says they give them those because they have a knock-in option at negative 30% of a worst of usually scenario between the KOSPI, the Hang Seng, and the S&P, or whatever it is. So if the market does not drop below 30%, they keep getting their 6% annual yield. But if it drops below that, they get knocked in at that level. And so that's the difficulty of these structured products. They own the market at that level or they lose 30%? They lose 30%. Got it. You basically- Sorry, I derailed you. So that's the backdrop. Tons of these things

are sold for some reason, mostly in Asia, some in Europe. Yeah. And so we were waiting to see some of those in the cascade that could have happened when those got knocked out, but very few of them did. So that was interesting. A lot of those are still sitting out there. The second trade that was interesting is what people call Bill Ackman's greatest trade ever. And it's interesting. We always say you can't really time portfolio insurance, but I think Bill kind of proved you can. But it's interesting the actual mechanics behind it. And that might explain it better to people. He's sitting there in February worrying about this huge equity book he's got. And like most people, they're just primarily equity traders or long equity. He's thinking, okay, maybe I need to start selling

off some of this book and that's how I can reduce my risk in case anything bad happens from this COVID pandemic. And instead of doing that, he thought, maybe I can actually hedge this with CDS. So he bought CDS on a basket of corporate bonds in mid-February. Now that CDS was going to cost him, he bought, I think it was close to $70 billion worth of notional protection, right? And he bought it for his monthly carry was 27 million a month. So he starts off the first month, you know, mid February, he's got to pay 27 million that month for that protection. It just so happens that he can roll out of that in the second to third week of March, right? So he didn't even hold it for 30 days. So he had $27 million outlay and he brought in $2.7 billion of that $70 billion notional.

And he put that trade on though that people don't realize he didn't put that trade on because it's the greatest trade ever. And he wanted to put on a CDS trade. He did it to hedge his equity book. I think he was sitting on about $7 billion roughly in equity. So he just thought of it as the cheapest way to hedge. Like, hey, these puts have gotten expensive. The CDS looks like a good spot. Exactly. Those spreads haven't widened out yet.

Exactly. Well, it goes back to Adam's thing earlier, too. It was also a function of ability to get a trade on. And you can get it on in CDS in that size. He took a $70 billion notional position. And at least he had the humility to tell people too, if it had rolled on for another few months, he would have had his pony up 27 million a month every month. So the exponential return wouldn't have looked as good. It would have been more fun if he came in and bought 70 billion worth of VIX

futures. That would have made things a lot more fun. So this one I think is interesting because the reason I'm also telling the story, so that's somebody that had timing luck and he admits to that, which is fantastic. But more importantly, we have to think about how it hedged his equity book. Cause this is one thing that Adam and I are both big fans of is a rebalancing premium and having negatively correlated assets or uncorrelated assets. And how do you hedge out your risks? And so that one was interesting because then it allowed him on March 23rd, he started buying back up all those names in his equity book and now at a lower NAB position. So he's going to compound his wealth so much greater because he added this hedge on that

gave him a convex cash position. And he rolled those profits into his equity positions at a lower NAB point. So it was a brilliant trade on more on the equity hedge than anything else. The other trade to think about that made a lot of headlines in March is Universa and Martz-Wixnagel. You know, you got all these headlines that they had a 4,000% return. So I was getting all these DMs, like, how does somebody make a 4,000% return? I know.

They lose 100% a year for the last eight years. Yeah, exactly. And so if you think about what Universa does, they hedge out the notional exposure of institutional clients. So say I come to Universa and I've got a $100 million equity position. They say, if you can pay us 3% premium a year, we'll hedge out that risk beyond a negative 15 or negative 20% attachment point move in the S&P. Great. You put that on. So for the last 12 years, you've been paying this like 3% bleed every year and

nothing has happened for you to get a trigger. Then the March sell-off happens, right? They start to see a payout on those options. And then they cover the risk you had on that $100 million notion actually exposure. So if you just think about it, and I'm just using rough numbers and it's a lot more nuanced than that. But if you think about if it was 3.6% on an annualized basis, you're paying 30 bps a month if you're putting on monthly put options, and that was your premium. You're paying 30 bps a month, right? So if you think about if I put on 30 bps a month in March, and then it's up 4,000% on that one month's premium, that's going to give me a 12% return. So in March, Universa was up 12.8% while the market was down 12.4%. So they were up 40 bps net net. Congratulations. They did their job.

They hedged your book, but that's not a 4,000% return the way any rational person would look at it. What a party pooper you are. The 4,000 sounded way more fun. Yeah. My favorite headline was goat herder makes 4,000% return because he has a goat farm in Northern Michigan, but it was, but they did their job. Like they did an amazing job, but like, it's not that, but also, you know, like we said before, there was probably a point, you know, mid month where their book was probably up 35, 36%, 40% because of the expansion and then contraction. 1,000%.

Yeah, exactly. I love it. So they're saying they actually were underachievers. Yeah. They were- Let's see who else we can offend on this. I'm just kidding. We've got the French, the Canadians, the-

Chinese. The consultants. We've offended everybody. That's right. the consultants. We've offended everybody. So I'm going to bring it back to trend, Adam. So how did trend perform? As Jason alluded to, it was kind of too fast of a move for classic 08 style trend performance. What did you see in your trend roots? So, I mean, obviously I'm going to, I'm going to ping this back to you because I'm sure you've got lots of good comments on this too, but I think what struck me was just the amazing dispersion in performance across all the different trend funds, you know, and there've been, I was watching

a panel from several prominent trend fund managers from Nordia last week or the week before. And there's been all these kinds of reports and panels and whatever podcasts with trend managers. And it came down to what type of trend, breakout trend or time series momentum type stuff. Do you have stops or not? Do you trade full positions daily or do you sort of smooth it out as more of a risk premium style strategy, right? To accommodate more assets. So what you had was smaller funds that are more nimble and are able to trade full positions in a single trade and that had either shorter-term breakout or shorter-term based look-back type strategies fared much better. Some of them fared quite well. And then other managers that had longer-term lookbacks or used trenched-type trading in order to accommodate larger AUM and weren't able to move fast enough for the fastest crash in history didn't do nearly so well.

But you can map this to an option profile where shorter-term is analogous to shorter term puts, right? And therefore you've got- More at the money. More at the money, higher gamma, higher exposure to major explosions in vol. And so as a function of that, if you look at the profile of rolling long put strategies over the long term, obviously the return profile of that is very negative, right? That's a negative carry strategy. And typically extra short term trend strategies, certainly over the last 10 or 15 years, have had either negative or very, very small positive carry, right?

They've been very unattractive to hold as a long-term strategic allocation. Whereas the longer term strategies have done okay, right? If you're thinking about sort of one year or longer trend lookbacks, these types of strategies have done better because they more approximate a typical long beta exposure. So they're more capturing drift than they are capturing any sort of gamma. And so, you know, they just don't have that negative carry. In fact, they may have some sort of small, small positive carry over the longterm. So if you happened to be a firm that could suffer through this negative carry on extra short, look back, high gamma type trend strategies for the last five

or six years, you're probably in a 20, 30, 40% drawdown position on this strategy. And you were able to benefit from the exposure to that at the exact right time. So kudos to you. That was what the strategy was for. You ate the drawdown and you reaped the benefits. And as Jason alluded to, then we're able to announce into your core positions at the right time. And that worked out very well. I suspect very, very few institutions or investors were able to stick with that.

On the other hand, you've got the longer term strategies, which have a higher long-term sharp ratio. They're easier to stick with. They resemble more of a sort of typical risk premia type profile. The sad thing is people were, I think, expecting them to act like crisis alpha and they just weren't designed to act like crisis alpha in this type of drawdown. In a 2008 or 2000 style

bear market drawdown, I think these strategies would have served that purpose. But in this type of crash, they're just not designed to do it. And so I think there's just a mismatch in objectives and expectations. And if you want to earn that crisis alpha premium, when the crisis hits, you got to eat that negative premium over the long term when there is not no crisis period for a while. Yeah. And which we've written a lot about of like negative correlation versus non-correlation. People are buying non-correlation and expecting negative correlation. Yeah. I mean, risk premium typically is a, they're uncorrelated typically, right? If you do it right,

they sort of have on average zero correlation, but at times they can be very positively correlated. They can have very positive beta. And at times, they'll have negative beta, right? But they're not guaranteed to have negative beta at the right time. And then I think the other thing that's going on over the last since 2009, right? Everyone made all that huge bleed. The shorter term, your strategy is everyone kind of morphed into more equities, long bias, longer timeframe. Those were the things that lessened the bleed or even had a slight positive bleed. That was a survival strategy. Nobody stuck with the shorter term trend strategies because of that long-term negative carry. You go through seven years of negative carry, you're in a 40%

drawdown. You're going to answer to either investors or the board of directors, good luck. Yeah. You want to be out of business or change your strategy. But to trend followers' defense, they didn't get whips out as much as I would have thought they did. You would have think you'd seen tons of them come in and go short at those lows in size or whatnot, but they seem to manage that pretty well. So you don't see huge losses. You don't see huge gains, which investors might've expected. But from what we're seeing- Well happens right is the position sizes are smaller, right? Because the vol is so high that your position sizes are, are very, very small, even on the short side near the lows in March.

So they were, most of them were caught off side. Some of them were cut off side for a while, but the positions exposure was, was low and vol came in so quickly that, uh, I think that the losses were, were reasonable. And then energies helped a bit too. We've mentioned it, the huge, unbelievable rally, which is still going on. Um, some of your favorite stories slash stats from that rally. And now I think we can also, which we touched on before, like get into the whole Gamma story.

I think, Adam, I've been mostly in your boat that that's kind of a good bedtime story, but not necessarily the whole picture. And it seems to be becoming actually more and more of the actual picture. So, Jason, I'll throw it back to you. Just thoughts on the rally and, and gamma. Yeah. I wanted to, you know, obviously we all, we all focus on markets, but one of my favorite stats or, or least favorite stats for March and the real economy is close to home

because my family owns a single screen theater is that box office in the week of March 20th to March 20th to March 26th was $5,000. And the year prior was $205 million domestically. To give you an idea of the full stop that we went through, just to remind ourselves how crazy both the markets and the real economy and dealing with COVID was at the time. That was like some theater in South Dakota or something. I have no idea where that

5 000 came from right i want to know those people so then you're talking about the recovery one of my and i i think all of us on this call have a penchant for schildenfreude is that unfortunately and i guess i just mixed my french and german that uh is the uh when people started buying zoom z-o-o-m thinking it was zoom zm the the teleconferencing like just to give you an idea of like i always worry about people's lack of due diligence and people just hitting the buy button on and not doing any diligence on what they're actually buying during the rally for sure that gives you gives you an idea of that but going to answer your question about gamma so it's come back into vogue, I think,

this idea of focusing on dealer hedging, right? Whether it's Gamma, Vanna, or Charm flows, and it's become part of the zeitgeist, at least in our corners of Fintwit these days. But I think, honestly, people like Charlie McGilligut at Nomura have been banging that drum for a long time. A lot of people have been talking about that. And the thing is, you can get an idea if you get exacerbated moves or you get

vol being pinned on whether the dealers are short gamma or long gamma. But it's a static snapshot, right? And that can flip so quickly. And it's just one explaining factor, right? If it predicted the future, those traders would be crushing it right now, right? But it doesn't necessarily predict the future. And so it's become in vogue again, and it is partially, you do have to pay attention to those flows. But to Adam and Jeff's point that now I think the derivatives market is 20 trillion real value. I'm not talking about notional value, 20 trillion real value of derivative contracts. And so it is becoming the tail of the wagging dog. I like to think about it in much more simplistic terms that for the last 20 years, I've been thinking about this as

we become more financialized and derivatives become more and more part of the market and people are searching and searching for more yield. You used to be able to almost hedge your equities with cash, right? If you think about Harry Brown's permanent portfolio, but now the derivative exposure has become so large that you need a comp, a convex derivative to hedge it. So almost like you don't have cash anymore because derivatives are tail that wags the dog. So when they crash, they crash so quickly. If you need to hedge, you need another derivative that has a similar level of convexity to hedge that because this, this notionalional exposure and then the real exposure of those derivatives may potentially be the tail that's wagging the dog. And I'm sure

we're going to get to it. But part of it is, you know, call buying by retail traders or whales coming in for equity replacement. And so you do, unfortunately, even if you are just, say, a value equities manager, you kind of have to give a little bit of an eye to the macro outlook of how these derivatives are moving markets. And I think, yeah, I wanted to get that, like part of it's got to be the stimulus around the world, right? Not just US of like, hey, citizens, here's this money to help save your lives. We're not all rational beings who stock up the pantry. We're going to be like, cool, here's this free money from the government. I'm going to go buy ZOM calls. I'm going to even buy the wrong

calls, right? But they're going to put that money to work. So I think that's a big piece of it. I've said with some of these option guys on the podcast, we're like, are we in the golden age of access to options? Probably, right? Like every platform in the world, anyone can open an account, a few clicks and buy an option. Like in the old days, not even five years ago, you had to probably go through a few extra hoops, sign some extra forms. I would hopefully think you had to do a little bit more education. So I think all those factors are coming into, yeah, have driven that from those lows up to where we've gotten. I think we're all old enough to remember the heydays of the late 1990s. I remember being able to call in option trades from, I remember I was a camp counselor one summer and I was calling in options trades from a pay phone while the kids were in the field.

Are these on Toronto Stock Exchange? No, these were on like MindSpring and some of these big tech names in 98, 99. And these were crazy days. But for sure, you were in the top 1%. I don't think everyone was doing that and had the ability to call in options, right? I was doing the same thing. And I'm sure Jeff was doing the same thing. So that's what's great about now everybody wants to bash the Robinhood traders. I'm not saying it's a pejorative because we were all there, right?

In the late 90s, we were young guys buying these calls, getting rich, thinking we were geniuses. But then you learn about markets, right? So it's your entree. So it's great. Yeah, no, I agree. We definitely saw option enthusiasm in the late 90s that is in the ballpark of what we're seeing today on the single name stock call option metrics. It's not a different order of magnitude anyways.

So we have seen some portions of this movie before. I like this idea that dealer gamma and signals from the option market are more informative today maybe than they were in some years past, but that they're not the only thing that's informing potential market direction. that we've made in the last six months or so is we have directly incorporated some features from the different vol markets as explanatory variables in our machine learning models, right? depth and curvature of the VIX futures market and the move index and a variety of other, like the crude oil options curve, a variety of different markets end up explaining moves in a variety of other markets. The curvature of the vol surface in crude explains the moves in treasury futures over the next five or 10 days. There's information to be gleaned from these markets that are not obvious if you don't have the right tools to be able to, you know, ferret out how the relationships play out. And we probably, or no, I'm telling you straight out that just wasn't on our radar to the same degree prior to this recent episode, right? It's just that because of the size of the derivatives market, that ends up, and because the other thing that derivatives have that cash markets don't is that

they're all forward-looking. So you're directly observing how traders are placing their bets and the probabilities of different scenarios according to the way that the bookmakers are seeing the world. And you're able to use an aggregation, an ensemble of those views to inform your own positioning if you have good tools to determine how those trader positions, what they imply about how you should be positioned. And I think if you're not using that information, that's a major missing link that I think many investors should consider adding to their arsenal. So two things. One, I know they're technically forward-looking, but how many speculators, hedge funds, everything I'm right there trading that just to make money

over the next hour or something. So I don't know if I'm buying an e-mini or this call option or that, and I'm actually forward looking and providing information to the market. I could argue that either way, we don't need to go down that path. Well, I think again, at the aggregation level for every buyer, there's a seller, for every buyer, there's a seller. For every seller, there's a hedge book. And that hedge needs to be offset in the cash market, right? So you've got stuff like the Dick's Index, right? What type of activity is playing out on some of these exchanges? D-I-X, those teenagers listening. That's right. I remember tweeting as we observed this Dix index move down into tenuous territory a few weeks ago, limp Dix sink ships. more peripheral indices that have come into sharper focus recently and that in our research do provide a dimension of information that is at an acute angle from some of the more

traditional features that investors look at and I think can be really helpful in a portfolio context. It's in essence the same thing as crude builds and the USDA report, right? It's kind of a supply view. It is, but at a higher frequency. And I think- And it's not as accurate, although I would be hesitant to say the USDA reports are accurate, but it's an estimate based on where different options were bought and sold, right? They don't really know what the banks, what the deal, I guess.

No, you're right. You don't know exactly who is on which side of the trade. You can sort of infer and make some generalizations. And you're right. There's an error term there. And then what do you think about, right? 15 years ago, we had all the banks were doing this and they've gone out of the game. They've gotten regulated out of the game.

This is kind of unintended consequences, right? Now there's just basically Citadel, Susquehanna, a few different players that are being these market makers everyone talks about and doing this gamma hedging. So that to me is a kind of a societal issue or like a little bit of a red flag of like, do we really want all this power?

And they're just trying to protect their capital, but they're going to act in their best interest, not necessarily the market's best interest. That's a whole nother societal question, whether the market's best interest is in the society's best interest. But you know what I'm saying? Have we over-concentrated to these few names and now they're just pushing the market wherever they need to, to hedge their profits? Well, I think, you know, in large in large part, because the dealers aren't able to carry any material risk budget on their own books, that they are now forced to offset that risk into the market. So that risk gets diffused into the market itself. And there may be some reflexive

dimensions to this decision to not allow banks to take some of that risk on their books at times because they ended up being some ballast, I think, at times when they were able to capitalize on dislocations those opportunities. And if the market is left to its own devices, most of the time that works well, but there are times like March where the markets in themselves are just not functioning and they're not able to play that role. And we were talking with Ben Ifrit actually was bringing this up, like back in the old days, you could kind of, the banks would do stupider trades, right? Like, I feel like we've progressed as a financial community where the risk people are much smarter. And now it's like, no, you can't go home now. You have to hedge that risk out.

Whereas they used to kind of, as you're saying, warehouse that risk either accidentally or on purpose because the regulations allowed, you know, maybe the regulations allowed it. So the banks didn't care to monitor the risk as clearly. But either way, I think- I remember back when I started trading, we had, everyone had an omnibus account, right? You could hold inventory and you could earn P and L on trading the inventory. And,

and, you know, those, those days are gone. And, and because of that, you don't have those traders with, with bank sized wallets on the other side who are seeking to arbitrage and have the capital to do so. And it's also, I've brought up before, like if you write, like who's the guy that's going to sell, um, Akman those CDS next time. So like, you can only hang these people to dry so many times with like, Oh, I got that for super cheap. They sold to me. They're idiots. They sold that vol to me. Like eventually the price.

Sold those CDS to somebody who is desperate for carry, right? Like they were looking to earn 27 They're idiots. They sold that vol to me. Eventually the price is- Well, I don't know who sold those CDS to somebody who was desperate for carry. They were looking to earn 27 million a month. And where can you earn 27 million a month in the current market environment in order to generate the 7% annualized that you need in order to meet your pension obligations? The fact is it's an impossible scenario and we try to shotgun blame, but really the blame needs to be evenly distributed among all market participants. We all got here together. Yeah. And part of that's like the unintended consequences of Dodd-Frank, right? If you take that risk off of the prop desks at the banks is you had an enormous liquidity back then, but also the bid-ask spreads were pretty

wide. And now bid-ask spreads have come down, but the liquidity is only maybe at one and two sigma events. And then they're going to take away that risk if things go haywire. So it's like there's trade-offs on both sides. It used to be that you'd say that about the banks, right? What's a bank? Someone who will give you an umbrella when it's sunny and take it back when it's raining, right? And now it's the same with the high frequency traders, the market makers. It also sees me, there's not a never ending supply of retail call buyers, right? Or even institutional call buyers. And those market makers are pushing the prices up, pushing the prices up, which is driving everything out.

And they're going to, you know, those traders, those people buying the call options have overpaid. Although I can go both ways on this because the markets come up into their strikes, but perhaps the market, they have the direction,

right. But the volatility wrongs, they're losing money on those. So like how many. You're right. Both ways though. Right. The,

the first time, you know, these, this, this rise of wall street bets and Robin hooders and YOLO trading is they actually beat the market makers. The first time they moved in mass into single name calls, right. The market makers kind of got their face ripped off and their gamma hedging, you know, exacerbated the move, but it's not going to happen a second time, right. They're going to get ahead of those gamma hedges. They're going to overcharge for those options. And now those Robinhood traders and Wall Street bets are going to figure out what fixed strike ball means and that you're overpaying on the volatility side of those options. You may

be directionally right, but you lost money. So those things come back into line. But at the same time, we're seeing, you know, whales buying, you know, call spreads and call options as equity replacement. And that's a totally different, you know different vega trade over the longer term. And now they got to hedge those Vanna flows. And they're buying the call replacements, just a risk strategy, right? Of like, hey, I'm worried about owning the stocks outright because it could drop another 30%. The vaccine starts killing people, whatever happens. I'm worried I'm just going to spend premium instead of spending the whole cash out. And so like you said about looking at like these flows as maybe looking at the wrong metric, or maybe it's part of your metric ensemble that you look at

is a lot of people look at like put call ratio, right? And right now it's exceedingly low. So people are like, oh, it's a risk on environment. Well, you have to think about what put call ratio is and the calls are the denominator. So it's more of a function of call buying, right? And so if you have whales out there buying calls and call spreads as an equity replacement, you're going to go, that's saying risk on and put call ratio, but it's actually saying risk off. They're taking off the downside risk of an equity replacement trade. So you have to think about second and third order effects to these things. understand the value of buying calls instead of only cash and buying puts. There's a parity there that is it legitimately cheaper to do that? Maybe it is because I haven't looked at the relative cost of hedging with puts at the moment relative to just selling the cash and buying the calls. Well, traditionally it wasn't, right? The puts were overpriced because people would buy them for protection. Yeah.

Quote, unquote, overpriced. But yeah. Now we're seeing a call skew in the single name. So now the call skew is getting overpriced. But also, Jeff, going back to like, what's your story of this rally? And I think we'd be remiss or I would be if I didn't mention part of what came into the Overton window of the Zeitgeist. And you guys actually both, I'm not going to create any animosity here. You both had two of

the best podcasts with Mike Green I've ever heard. We got to talking about variable things, but what's come into the into vogue this year is Mike Green's passive thesis. And that may be what's driving the rally in this market of 401k flows of target date funds, just hitting that buy button. And those flows never stopping because even during a COVID slowdown, it was more of the managerial class this market of 401k flows of target date funds, just hitting that buy button. And those flows never stopping because even during a COVID slowdown, it was more of the managerial class still had to inflows those 401ks and vanguards and the BlackRock's and their target date funds are still hitting that buy button. And we're seeing that on those monthly or quarterly rolls and that a lot of times the third week of the month and at the end of the quarter. Yeah. The seasonality in markets right now,

it is kind of uncanny how many reversals over the last three years have come on quarter end roll dates. It really is pretty amazing. So it's hard to argue against the assertion that there is something meaningful going on at quarter end. And the sheer size of some of these target date funds certainly would argue that they're having an outsized impact on moves at the end of quarters. And I mean, there's been some really, really cool new papers out just in the last six months or so that are really trying to get at the impact of flows in markets. And they've all concluded, I think, to a paper that the impact of it, I've seen a range from sort of like the impact of $1 of flows is equivalent of a $3 move in the underlying. So it's like the sourcing of liquidity drives a much larger move than you would expect

given the size of the flow. And different market participants have an outsized impact. So buybacks- That's Mike Green's thing. Like you're trying to take all this money and stick it through this little pipe. You got to make the pipe bigger, which is the price. But what Adam's saying too is like the papers like by Vincent Delaward, that's combining

flows, QE and stock options is like, they're kind of fascinating reciprocity. Like he's saying, create a perpetual motion machine of higher stock. But I'm wondering, Adam, how do you, like we think about it often, obviously, for the fragility that creates in markets that melts up and melt down when you're trading option straddles or strangles. But how do you factor those into the models that you're building? Well, there's a first order impact, which is it obviously creates these very large, significantly significant seasonality effects, which you can identify. And then I think you've just got to be more aware of your active bets coming into the end of quarters, right? This is where some of the cross-market stuff plays out, right? So if you've

got cross-market seasonality, maybe that the S&P seasonality doesn't just give you information about what to expect from the spools, but also what to expect from treasury markets. Because a lot of this comes about from a rebalancing effect. You've had a major move down in equities relative to bonds in the quarter. Well, you've got these huge funds that now need to sell bonds and buy equities. Or in the reverse dynamic, if you've had a huge sell down in bonds and a massive rally in equities, you're going to sell equities and buy bonds. So you get these cross-market effects that you can also take advantage of that relate to seasonality. And I think you can also account for some of these seasonality effects in your estimation of risk, right? So your estimate of vol, are you expecting vol to come in or expand towards the end of these periods?

And there's information- When you say seasonality, you mean the target dates, the flows are coming in at a certain time? Yeah, they're coming in. Maybe it's around OPEX. Maybe it's around the end of the quarter, even in a quarter we're balancing. Not like the Santa Claus rally or selling May and go away. That's one. But I mean, if you look at the, when did the market turn in March? It turned at the expiration of March OPEX, right? And March was also quarter end.

And so you had these two major events that were positive feedback impacts on one another. And so I think that needs to be pointed to, or at least identified as, as a potential major catalyst for that reversal and why it happened when it did. And do you think that starts to self-correct or like, if I'm one of these target day funds, I might do some analysis and be like, Hey, we're kind of getting slippage at the end of each quarter. Cause we're all're all rushing in like let's start layering in over the quarter and like you'll get some of those effects over time you'd think so you know and we've actually analyzed i went and and or we can all start front running yeah yeah but but i mean

vanguard rebalances every day so it's it's not like the vanguard funds the margin are responsible here. And so, you know, again, this also may be structured products. Like there's, you just, you don't really know at any given moment what, what the actual end agent is that is causing these dynamics. But the seasonality is just an unbelievably powerful economically statistically significant phenomenon in markets and it's timeless i mean it's if we go back and look at the features that are explanatory seasonality is one of the most persistent sustainable and powerful explanatory features in markets that no one ever talks about it's like voodoo or astrology or something well because oftentimes it gets tied in with like moon cycles or something and then people are, I don't know about that.

That's right. It doesn't need to be counter effects, it can be. Right. If it's like people get paid these dates and they get their 401k and then it goes into the market, like that's a trackable thing. Absolutely. People don't get paid on the second Tuesday of every month or something. And then also on this target date concept, eventually they go to zero stocks,

right? Well, yeah. Right. But they're not zero, but some lower, right? They ramp down as the people get older. So as our whole society gets older, doesn't this whole narrative flip? And we start- You've also got the inheritance, right? So somebody passes away and now you've got a fund that was previously 80% bonds, 20% stocks, getting inherited by somebody in their 30s or 40s who are then reinvesting those funds into a target date fund that's now 70% stocks and 30% bonds because of their age category. So I think there's some redistribution dynamics that may offset some of that. And Adam, do you know too, I think over time too, they've changed the rules. It used to be 60, 40, then it went 70, 30, then it's like 80, 20. So the amount of equities they're

holding to hit their target date returns, it's changed over time. It hasn't been set in stone for the last 30 years. No, for sure. And some of the research in retirement funding has argued for a higher equity allocation. And I think a lot of this, I was just having a conversation on Twitter last night with some guys that I deeply respect, but I consistently believe that people, and when I say people, I mean advisors, but I also mean Vanguard and iShares and DFA and a lot of these firms that create these target date structures place far too much faith in the empirical distribution that we've observed in equities and bonds, and that the risk in equities may be considerably larger than they think. And the, um,

equity allocation that they're advocating for because the historical return to equities has been so much larger than bonds, um, is probably substantially overdone. So, well, and the bond offset might not be there too, right? Yeah, well, absolutely. Yeah. I mean, we can get into just the complete farce that is the 60-40 portfolio in terms of its ability to manage the right tail of inflation risk. I was just quick thought of like how long until we get some of those target dates are like, no, we need 120% stocks, right? Like that's for sure going to be in the card someday. If someone like, cool, I can't compete with Vanguard. I'm going to amp it up and give a little extra stock low. Well, I mean, it's already a bit of a big question mark. If you have a withdrawal expectation of 4%

and Vanguard is expecting equity returns over the next 10 to 15 years of between three and 5% nominal. I mean, can you even achieve your distribution objectives with a hundred percent equities? Right. I don't do math for a living, but it doesn't seem like that works. Right. And that's one of the pensions are saying too, right there, they're saying I'm going to apply leverage. leverage no that was their move instead of like yeah and you know this leverage

gets a really bad bad rap right you know if i mean the irony is of course if you own the s&p you own two to one leverage because the s&p is is levered about two to one in terms of debt to equity so it's not like you're avoiding leverage by owning stocks, right? You can either own leverage by levering or by concentrating in your equity portfolio, or you can gain leverage by diversifying your portfolio and getting the leverage explicitly.

But you've got leverage either way. I've heard you or Rodrigo have said like, or you could buy a volatile stock or you could buy a volatile stock or you could buy a less volatile stock. And that's the one way of applying leverage as well. Yeah. Hi, everyone. As mentioned at the start,

we split this conversation into two pods. So we're going to break here and come back next week with the second half. We'll see you next week. Happy holidays. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel. week. Happy holidays.