The Derivative - A Professor, Prop Trader, & Risk Manager walk into a bar, with Victor Canto

Episode Date: September 17, 2020

The “bar” we walk into in this episode is one that specializes in blending the unique flavors of beta and alpha, and our mixologists are Victor Canto, Chief Economist of Cadhina & Co, and Donn Stobierski & Jim Kleinops, the Founders and Managing Members at Black Bear Capital Advisors joining us to talk about convexity and rebounds, and adding equity to global macro. Today’s podcast delves into the Dominican Republic, the secret sauce behind how the tail works, the ability to stick with your beta, convexity risk profiles, Paso Fino horses, diversifiable risk, nimble strats taking advantage of regulations, US bonds going negative, modeling based on the election, a world defined by liquid assets, commodity trend inflation hedge, the poor man’s tail risk, the Boilermakers, volatility-based weighting, and the cost of risk mitigation. Chapters: 00:00-01:39 = Intro 01:40-14:39 = Background 14:40-34:00 = A Unique Investment Strategy 34:01-49:01 = What's responsible for the movement? 49:02-1:02:47 = The upcoming election & Sizing Volatility 1:02:48-1:10:05 = Favorites Follow along with our guests: Donn      Stobierski on LinkedIn,      Jim      Kleinops on LinkedIn, and Black Bear Capital on their website. Victor      Canto on Linkedin,      check out his book Cocktail      Economics, and connect with Cadhina      & Co. 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. Well, if there is aggregate demand, when the economy is expanding, aggregate demand increases, interest rates go up, you have higher GDP growth rate and higher profitability. That's bullish for the market. So we see that happening. We like to increase exposure to the U.S. large cap stocks. Now, if the dollar declines, well, we might still like large stocks, but we might not want to be in the U.S. So we play those things around and we move our funds around based because there is always somebody doing well and there's always

somebody doing below average and there's always somebody above average so we always want to be in the above average side and fully invested and then we let Don take care of the tail risk Hello, everybody. Welcome back to The Derivative. You ever heard the one about the professor, the prop trader, and the risk manager walking into the bar? Me neither. So we got all three of them on the pod today to hear the story. It's a story about blending beta and alpha. It's a story about convexity and rebalancing. It's a story about global macro. It's the story of Victor Cantau, Jim Kleinhops, and Don Stabriskie. Did I say that right, Don? Stabriskie. That's close. Stabriskie, sorry. Who've all been involved in trading markets nearly 100 years combined. So welcome, guys. Thank you.

So I've known Jim and Don for a while here, although haven't seen your familiar faces since the pandemic began. Nope. You'll notice I'm rocking the second version of the COVID cut, which has become a new family activity of shaving dad's head. And Victor, great to meet you finally. We've conversed over email. I've seen all your research and whatnot over the years. So good to meet you. Nice to meet you.

Yeah, we usually start out with some personal backgrounds, getting to know you, but we have a lot to cover today in all three of you, so let's just do some quick intros to start us out. Okay. Jim and Don, you're both founders and managing members at Black Bear Capital Advisors, which manages your personal assets. So, Jim, why don't we start with you? You worked at companies across the board, UPS, Deutsche Bank. Give us a quick rundown. All of us go back 40 years from starting with Victor and Clay Strube, our other partner, hanging out with Fisher Black at MIT. Tong Wei and I crossed paths at O'Connor and Associates.

We spent many years. We went from O'Connor to Swiss Bank to SBC Warburg to UBS Warburg to UBS Payne Weber. And then I left. I then met, first met up with Victor in about 2002. We were working on a, what was called the Explorer Fund, which is kind of a precursor to what we're doing now. And we've all built similar, worked on similar systems. Look at risk as Don will go into the, the kind of the whole SIBO,

the option business is all, we all trace back to the early days. And tell us, give us a quick little rundown of the O'Connor tree, right? Cause I feel like there's, you know's kind of like the tiger cubs, like the number of great traders who've come out of that tree. It's unbelievable. Yeah. I mean, at one point, we're ahead of O'Connor alumni.

We're heading derivatives at Deutsche, Morgan Stanley, UBS, Bankers Trust, and Morgan Stanley all at the same time. And what was their, when they were back in the pits, they were just one of the first to have basically sheets with their own Greeks? We had theoretically a theoretical, but I call Clay Struve the inventor of risk control. And we were built about trading options as a portfolio. And managing the risk as a firm. Managing the overall exposure of the firm in as near as real time as you could. So these are like the early days of Delta hedging and things of that nature.

Yeah, we had mainframe computers and dumb terminals and clerks tallying, but we knew kind of what our positions were, which worked great until 1987 when all of a sudden 12% up and down slide wasn't enough. Yeah. But we all kind of started with that we've always been trained um to look at the you know both the down and the upside but uh i think our focus was what was interesting is no matter what model you're using it or what are the conditions that will make it break and protecting against it.

So we've been... I'm going to write that book one day when I have some spare time. I think that'd be an interesting book of tracing the lineage and the background of that whole thing. The trees, yeah. And Don was right with us because I will let him go into his background but we all crossed paths and uh uh uh tongway or other partner we you know we've built three different systems including um uh our core systems for uh trading machines which we ran for a few years so we've been doing the same thing

and the kind of the genesis of this is. Let me cut you off and go back to Don. We'll come back in a minute. So, Don, you have two of the bigger trading firm names in Chicago on your resume, Hull and Citadel. Give us a quick background. Sure. I started just a few years after Jim on the floor of the CBO with Hull Trading, traded in various equity option pits, ran the DPM, but then they were also sort of pioneers in electronic trading. But at the time, this is in the late 90s, all of that was overseas, primarily Germany and Switzerland and a few other places. So I had the opportunity to move there to Frankfurt, Germany and help get that business going. Then about a year or so after I was there, Goldman Sachs purchased Hull Trading and I

was able to move to London for about a year and a half and help integrate that business. And Hull famously, I think we did a blog post, wasn't he one of the only buyers in 87? Like he has the trade card where he bought all the... He does. He was the only buyers in 87 like he has the the trade card where he bought all the uh he does he was the only buyer there there was no markets open except for the i believe it was the market mmi and someone just said hey i need a bid for 100 or 200 which was a enormous size i don't even know if they were solvent to be honest but no one did uh so he basically bought the bottom in 1987 and about sold the top in 1999 when he sold the firm to. All right, well, hook us up with him on a podcast down the road here.

So then you're in London? Yeah, no, then. So we were there integrating the business. And then, you know, after my time was up, I was able to move back to the US and I was promoted to the desk head for the index trading. But then a couple of years after that,, I was able to move back to the U.S. and I was promoted to the desk head for the index trading. But then a couple of years after that, I had the opportunity to move to Citadel and help get their option market making business going. And as you know, after a few years, we are the largest option market maker in the country. And I'd say a couple of years after that, I became the managing director and desk head in charge of portfolio and risk management. Do you wish that Robinhood was around back then where you could be buying that order flow? Well, I think they are. I don't know for sure, but that's very profitable order flow.

And that was part of the name of the game. But yeah, and then just a couple of years ago, I became one of the founding members of Black Bear Capital Advisors. So here we are. Love it. And now Victor, you're the chief economist at Kadena & Co. Did I say that correctly? Kadena & Company. Yes. Kadena & Company. You're also an author, economist, PhD, bunch of stuff,

contributing research and whatnot to institutions around the world. So give us, we'll let you go a little longer if you'd like to, but give us the background. Well, it all began in the sugar cane fields of Dominican Republic. How's that? Okay. I'm just kidding. Is that your accent? You're from Dominican Republic right now? I am, I'm from the town where all the baseball players come from I'm not going to mention one of them No, he's

persona non grata in Chicago now Sammy Sammy Sosa? I guess we're back to liking him a little bit. I went to prep school on this coast, went to MIT, got a degree in civil engineering, went to the University of Chicago, got my PhD in economics,

and I moved on. In Chicago, I met Fisher Black. That's how I ended up meeting Clay later on, a few years later. And Fisher Black's of the famous or infamous, depending on your stand, Black Shoals model? Yes, he was. And Myron was ahead of me a couple of years ahead of me. But then I went to USC. I taught for 10 years at USC. I was a tenured professor there. And I had a little company. I had a partner. We had a company for about 30 years or so called Lafricanto and Associates.

And we parted company about 20 years ago. I've been doing investment advice and money management since then with ArtFu. So I'm very interested in politics, economics and investments. So I tried to combine all of them into one shop and that's what I try to do nowadays. And so you do that mostly through this company, but you're also involved with La Jolla Economics?

No, I do different things. I sell investment research to institutional investors. I try to, and I help a lot of people with their strategies and their investment, you know, try to make them more efficient investors and how to incorporate some of the macroeconomic effects into their portfolio strategy. I do that as a consultant, but I also get involved in money management with other people. I have a couple of interest in different money management, small money management companies. And my biggest one, I was very involved with Lazard.

As in management, they use a lot of my strategy in the Lazardar capital allocators series and so what do you think of yourself first as an economist a professor oh no a good husband a good husband all right that's a great answer yes write that down i want yeah i'm gonna have to if my wife ever listens to one of these podcasts I'll make sure

I say that no but I'll tell you like I'm very fortunate now seriously seriously I was very fortunate at the time I went to the

University of Chicago you know there could have never been a better place in the world and Chicago gave me a great opportunity because I had never

taken a class in economics and I went and they accepted me when I couldn't get into anyone else and at that time Chicago was the number one place in the world and that was at the time that Jim Fama was doing the efficient market of hypothesis and all that and you have been the economics department the rational expectation then you have in the political scene, the Chicago Boys in Chile. So you have the connection of politics, finance, applied economics. So I was very fortunate to experience all that. At that time, they were still intuitive.

They have become very mathematical. But I did learn how to try to integrate finance, economics in a practical way and apply it to the real world. That's the best because that's the knock on economists generally, right? They can't apply it to the real world. So you've done a good job of that. And your research, quote unquote, is also doing practical allocation percentages to different assets. How does that work? That's across the globe or domestically?

Across the globe. You know, across the globe, you know, like, you know, like I hate to sound like a Chicago person. No, we're all Chicago people here.

Go ahead. You think they know everything, right? We do. So, so then you'll do anything. No, no,

I'm just joking. I'm very, I'm a citizen of the world and I believe in global investing. And when you chase me, you look for return. You look for the best risk-reward anywhere in the world. But I have two very important words that guide my investment principles. Liquidity and transparency.

They're really important to me. Okay. I love that. I want to be able to get out and I want to know what I'm buying and selling. Right, so you're shying away from frontier markets and whatnot? No, they're okay because they're relatively liquid market in an ETF world. so let's jump back to uh jim or don and talk about how you guys hooked up with victor and uh how you started managing your own money with a kind of a unique investment strategy who wants to jump on that grenade uh don what you have a you have a crack at it. I mean, this is sort of, you know, when Jim and I, you know, met through TW, again, isn't on right now. We talked about, you know, tail risk strategies, you know, and that's a hot topic now, obviously. So, you know, a few years ago, well, TW and I were in the same firm and we both left and sort of looking for the next thing to do, but TW for a long time had been working on tail risk strategies.

And I was saying that's kind of a hot topic right now. We could dig into more later, but there is, you know, certainly a lot of interest in it. And what's really the best way to mitigate downside risk? You know, is it, you know, the simple answer is just to sell what you have or buy puts. But the trick with these is to find a very cost efficient way to protect your downside. Because, you know, us, like a lot of other people, we're not looking to hit home runs really at this point in our career. We want to preserve our assets and make some return as the market goes up. But we don't want to get destroyed if the market drops 20%, 30%, 40%, as we've seen a few times in the past couple of days. Well, we just saw in March.

So that we were working on and thinking, well, this really fits what we want to do. Um, but what about other people? There may be interest in this. So, you know, we started experimenting and working on that strategy, but really the best thing to do is to combine that with a beta strategy. So if you have your beta and your tail risk strategy integrated into one strategy, you know, where you can work them together, that's the best of both worlds. So let me pause you for a minute. So let's just talk about TW for a second of who that is and fit in? Oh, uh, uh, uh, Tongway, um,

as I said, he worked with us at, uh, uh, it was, uh, SBC O'Connor back in the nineties. Uh, and, uh, and he ended up, uh, running electronic trading for, uh, all electronic vol trading, uh, for UBS globally, out of London and then Stanford. When the decimalization of options came about, they realized they had to rewrite all the risk systems at UBS.

And so him and a couple other, uh, colleagues left UBS and we started this company called trading machines, which was, um, just to do high frequency market making. Um, I was brought, I was like the, uh, the two founders and myself was brought on as risk manager and we built a automated, uh, trading system and then uh we had uh uh the uh whole issue with the uh after the flash crash it became very uh very difficult uh times for not only stock market making but options and so I returned back to

Chicago and Tongwei moved to Chicago and worked with our other partner Clay Struve at CSS and for several years before going to Volant but we have always we always remained in in contact and having run through 2000 97 together and 2008 um you know we've seen a lot of uh yeah a lot of crash events and uh so you two were both looking personally with your own money for some downside protection tw had had a strategy so we the first thing was we kind of know what the what the strategy is uh the hardest part was how do you get what what is your true beta um and uh the more we looked at it we said hey we're gonna um you know i got back in touch with victor because he's been running this model and i said this is about the purest uh at least with uh victor's model we'll know exactly you

know what we're betting on and why and and what are the drivers and let me come back to the beta part because i want to focus on the tail part first. So can we dig into how the tail works? The tail works, we looked at this. Without putting away the secret sauce? No, not the secret sauce, but if you're running a global equity macro as we are, and you say, okay, I know how much S&P or mid or small cap I have, what do I do? If I go full out and try and hedge with puts or synthetic puts on any one of those, I am impacting my delta, my asset allocation. And pretty soon we would be running an index option book, not an asset allocation. So we look at the proper sizing. We know what our beta is. And the closest I'll get to secret sauce is we do have a proprietary model for VIX and VIX options and S&P. It's all integrated. And that helps us size the appropriate amount of protection. And I think Don touched on it.

One of the critical issues is what are your pain points? And we focus protecting against 10% or greater drawdowns, not every 2%, 5%. So you can give up some of the belly to be out on the wings, and then that's less costly. Well, yeah. And it's one thing to trade options and another thing to use them. And we think we have an efficient way. We certainly know exactly what our, what our beta is. And we know the, our tolerance level, as I say,

we were targeting 10% out of the money, but we're, or 10% or greater drawdowns. That does not mean, you know, oh, we buy a 10% one year out of the money, put and hold it. That does not work. Your goal is to beat that cost. We want to be as efficient as possible. And we think our combination of index options and VIX options and futures,

it gives us a very cost-effective hedge and that's all we're worried about is protecting the balance. You need to be careful with the derivative instruments that you use they need to be appropriate it's important to understand the characteristics of these and the different dynamics so you're not overpaying something you don't need. And that's what our quantitative model is for. And in terms of integrating the tail risk into your portfolio, one of the most important aspects is to capture your gains when there are gains with that tail risk strategy. So, you know, the market's really dropping again, if it's a, you know, not two or three, but 10, 15, 20%, you're going to get gains there. What do you do with those? How do you reinvest them? Because these reinvested gains

can compound your returns over time, which is obviously what you want. That's critical for long-term performance. So how do you view that, though, against the possibility of it goes down 60% and you got out down 20%? We don't get out. We always maintain a certain convexity risk profile. So we're able to do this, you know, and again, there's a little of the secret sauce there, but we're able to do this you know again there's a little of the secret sauce there but we're able to do this as the market drops um you know there'll be a point where you start getting outsized gains in your convexity so you know you not only get some mitigation against your beta you get a lot well at that point maybe you can take some of those gains yeah so but it needs to be a part of your portfolio in order to be able to do that. And then the flip side of that is what do you do in a end of March,

early April scenario where the protection is super expensive, either in the options or the VIX is at 80, right? And even the far out VIX was at 30, 40, 50. It was crazy. You know, there's different things you can do. It's not smart to wait and buy 60 calls in end of March. Say it again. It was not a good, it's kind of like trying to buy insurance after the house is on fire. As Don says, we always maintain the convexity.

And I don't want to get technical, but if you think of a very large backspread, as the thing moves, you have to take some off. The futures, we just hedge what we call our volatility exposure and realize profits on the way up and maintain, always keep our hedge on. Just the sizing will differ and the term that we- Right. But in theory, mathematically, you either have to go smaller size or further out, right? You have to give up some, kind of have to accept some basis risk there too. Sure. There's going to be some, I mean,

you're not going to have it both ways without paying some sort of cost, but you know, the idea is, you know, for us to capture a decent percentage of the upside and we'll get a little help from that with, with Victor's model, even be better than just, you know, the spools or just some other flat beta product. But, you know, our biggest concern is protecting on that downside and mitigating that risk. Can I say something here?

Yes. I'm a simple man. So let's use some trivial stuff like capital asset pricing model. You know, where we learn, you know, the capital asset pricing model taught us about risk. You know, for example learn, you know, the capital asset pricing model taught us about risk. You know, for example, there is some diversifiable risk and there is not worth paying for any risk that you can diversify. And the argument is, if you have two assets, let's say two assets, they move in opposite direction. And when one goes up, the other goes down, all you need to do is do what? Size them correctly, and if you're able to size them correctly,

you can eliminate all the volatility, and you have a positive rate of return guaranteed with no risk. That would be the ideal. Now, let me tell you a bit. This is how I look at the world where we have the two assets. One is beta, and the other one is convexity, but you have to look at them jointly in order to be able to size them correctly and to manage it. Because if you hire two independent managers and try to combine them, what happens?

If you don't size them correctly, then you're introducing what? A risk that you could have avoided and diversified that you didn't. And you are adding exposure to your, so the moral of the story here is, yes, you can hire, you know, like a convexity manager to manage your beta separate and it will protect you and it will do a reasonable job. But if you combine both of them at the same time, you can always size your convexity properly and

in some cases in the case you're talking about you might not need to buy as much insurance because of your beta is protecting you on some of the other issues I'm saying and that's very important inside that a lot of people don't think and I think this is what what we try to do. We combine both of them and look at it, you know, like holistically, however you want to call it, at one point in time. So you're always, you don't look at convexity alone. You don't look at beta alone. You have to look at both of them at the same time because otherwise you're

missing some diversifiable risk and you'll be paying for insurance that you don't need to pay for. Right, so that let's dig into the beta side of that a little bit now. So how are you, you said you're a global citizen, you're looking at the global markets, let's talk about which markets that entails and how you approach the beta side. Basically as I told you, remember my two famous words were liquidity and transparency. So the argument is, to us, the world is defined by our liquid assets. So if you look at the market capitalization of all liquid assets, that tells you what the benchmark should be. And then the question is, do you think an asset class will outperform or underperform?

And then if you think the asset class will outperform, you increase your exposure to that asset class. If you think it's going to underperform, you reduce your exposure. And that's what we try to do in a very systematic way that we have an econometric model that tries to measure that. We also make a very important assumption here is that we think that it's costly to adjust. You know, for example, we have the coronavirus now. You know, people say close down. It will take a while to get, you know, you don't get back to normal overnight. It will take six, seven, eight months, a year. So if you know that it's going to take a while, why rush it? We know where

we're going. We'll take advantage of that. And, of that and we'll ride that wave. We don't have to capture everything. We're not saying that we're gonna be the best. We just want to be above average. And let's talk which asset. So equities obviously. Anything that is in the MSCI. How's that? In the American Stanley Capital Index. Anything in the MSCI is fair game. So just for the listeners, roll off 10 or so assets that are in there. Okay. Well, in the U.S., you have large cap, mid cap, small cap. Then you can have Europe. You have Asia. You have the emerging market, frontier market. You have the Pacific market. And then you can break it down by region if you want to. Okay, but we're talking all equities. Yes, all equities.

So the model doesn't consider, okay, bonds are yielding 12%, as if that will ever happen again in our lives. But if that was a thing, would the model say, hey, we should be in bonds instead of equity? Well, yeah, but you see, if you look at that, and then I have to answer my question a little bit differently, is if you're doing a global balance, so to speak, the allocation, the bonds would be like the hedge of your portfolio. Yeah, they'd be the convexity piece. And they did do that. If you look at the TLT, just to pick a number,

the TLT has done like 20% for the years. But imagine if your money – all you had to do was buy TLT at the beginning of the year, and you'd be okay. But almost as good as Jim. Almost. But the point is that we think that the fixed income equity will be like a poor man's tail risk. Okay.

So the beta component is just equity beta? Yes. Got it. And then so digging into that, Europe has underperformed massively for years and years now, right? Not since the recovery. digging into that like europe has underperformed massively for years and years now right uh not since not since their recovery if you look at the you know it's sort of interesting that you mentioned that you know if you look at this stuff i'll tell you like it's sort of a correlation but it really i'll bring it back to why it makes sense if you look at the coronavirus

whenever you know early on the europeans were doing much more poorly than the US and the dollar went through the roof. Then they sort of got under control with the lockdown and the flare up here. And then we got worse than that. And since then the dollar has been weakening. And guess what happened since the dollar started weakening? The European market and the foreign market have been doing a little bit better than the US market.

And that identifies one of the variables that we pay attention to, the foreign exchange value of the dollar. When the dollar is appreciated, we tend to increase our exposure to U.S. equities. When the dollar depreciates, we like to be away from the U.S. And is it purely a systematic model? Are there discretionary overlays? No, it's systematic. You know, it's strictly quantitative. You know, we have an econometric model that uses historical relationship and try to estimate the expected rate of return and standard deviation. And once we get those estimates, we use the traditional finance, capital asset price and model optimization technique, but with our expected return on our standard deviations. And we estimate the

probability that one asset class will outperform. Instead, you see, when you do an asset allocation, like everybody talks about, it gets very complicated because people don't understand that. What we've done is we simplified pairwise. We said is the large cap gonna outperform the benchmark? Yes or no? Yes. And we based on the expected return what is the probability? We said well it's 60%. Just to pick an example. So if you flip a coin you know it's 50-50 head. So if it's 60, say oh it's better than 50-50. 70 is much better than 50-50. 80 is even better. So then essentially what we're saying, the probability tells us how many chips we put on the table. The bigger the probability, the more chips you put on. And then the other,

the initial bet is also depends on the size of the market and the market cap. Obviously, you know, you don't put, you'll put much more money in the U S than you'll put in Dominican Republic. Yeah. Because one doesn't move the needle and the other does. So, you know, so we take our model, incorporate the size of the economy of the market and the likelihood of outperforming. So you're typically always overweight US just based on that mere factor alone. We have been over the last few years, but in general,

you know, like I think if the dollar started, the cycle is starting to turn, I think over the next few years, you're going to be much more international then. of them. Let's just get all your thoughts on the, this isn't necessarily apropos to your model and everything, but just on the dollar and the U.S. economy and Apple and, you know, five stocks are really responsible for all of the move. Well, there is a misnomer. Let me, I hate to. Please, no, correct me. I'm about stuff out that, I hate to. Please, no, correct me. I don't mean that. I'm about to spout stuff out that may or may not be true. What you said is exactly true.

Oh, good. In the following sense, you are true, actually, but that's not necessarily true in the following sense. Do you realize that there are 245 stocks that have positive returns year to date? 245? In the S&P 500. Wow, okay. Okay, so there are plenty of seeing the fish. Yeah, yeah, yeah. You don't have to fish those five stocks alone. So remember, we don't have to be the best. We just have to be good. And we're better off looking for the

other 240 because nobody's paying attention to them. Everybody's paying attention to the fangs. Nobody's paying attention to the other 240. And there is a high rate of return in those 240 stocks. But your model doesn't buy individual names, right? We could. No, we haven't done that. But the model, since we have the probability and it's cap weighted, one of the good things our model has is that it works either bottoms up or

top down. If you forecast each individual stock in the S&P 500 and you add them up cap weighted, it adds up to the S&P 500 forecast. So we can slice and dice going downstream or upstream, whatever the client desires, we'll do. And just for you personally, does this current environment drive you crazy with like Tesla and all these things disconnecting from reality? No, it's wonderful. Good.

Yes, because there is volatility. You can make money on volatility. And then, you know, if you identify the underlying trend, the people who are high frequency traders tend to ignore the systematic underlying trend that we're paying attention to. And that's what the model tries to capture. I saw the average hold time of Tesla is 11 days. Yeah. That sounds high.

Yeah. Yeah. But, you know, we remember, you know, like what Don said, we, in general, we try to be fully invested in almost everything. What we change is the weighting, the allocation changes over time. So we're always fully invested because you're fully invested. You watch it all the time. What you do is you buy more or you buy less.

You adjust your weightings of each one because what we're trying to do is beat the global benchmark by a little bit. We're not trying to hit a home run. Which the global benchmark here is the MSCI All World? Yeah, MSCI All World. So, you know, all you want to do is, you know, I joke around, you know, like I tell people,

you know, my dream performance is I just want to beat the market by one basis point every single day. Yeah, that'd be great. Yes. That's all I want. Especially when the market's ripping off 30% years. With no volatility either. Yeah, yeah, yeah.

So let me bring you back. So you're saying you want to be fully invested but then you also downsize so in my brain that means i'm not actually fully invested so if i no no no no i am fully invested what i'm saying is for example how do you adjust our risk and all that for let's say right now let's say the large cap yeah let, let's say I have $100 invested. All hundreds always invested? Yeah, all $100 invested. I'll have, let's say, like 60% of the U.S. large cap on the S&P 500 and 40% all over the world. What I might change is if I see the world changing, I may reduce my exposure to the

U.S. and increase my exposure. For example, you know, like we're looking at November, we have an election coming up. And what are the scenarios and what are the variables? Let me tell you, we pay attention to four variables. Interest rate, for the sake of argument. Like we say, okay, inflation. So what do you do?

If you think the inflation rate is going to go up, you shorten duration. Why? Because, you know, although we don't invest in it, because long-term bonds are going to get hammered and short-term bonds do not. So you choose to reduce duration. Okay, fine. Then the other one, if you see interest rate going up and there is no inflation, what do you say? Say, well, if there is aggregate demand, when the economy is expanding is aggregate demand, when the economy is expanding, aggregate demand increases, interest rate go up, you have higher GDP growth rate and higher profitability. That's bullish for the market. So we see that happening. We like to increase exposure to the US, large cap stocks. Now, if the dollar declines, say, well, we might

still like large stocks, but we might not want to be in the U.S. So we play those things around and we move our funds around because there is always somebody doing well and there's always somebody doing below average and there's always somebody above average. So we always want to be in the above average side and fully invested and then we let Don take care of the tail risk. Yeah. And so, but from the tail risk perspective, you guys were saying, depending on how much exposure there is, you can see the tail risk, but it seems like there's always 100% exposure. Yeah, no, no, no. Yes. But the question is, we look at the relative to the benchmark. Let's say, let's say for the sake of argument, we, the benchmark allocation to the U.S. is 50% and we are at 60. So what is our risk? Say, okay, what happens to the U.S. situation?

There are four possibilities. The U.S. volatility can go up. The expected return can go up. If you look at the risk return, there's different, there are four different core quadrants that you could be, that you're protected. But there's one quadrant where you don't really care. What do I care if the market surprises me and the volatility and rate of

return go up? Am I going to be unhappy? So for that possibility, I don't buy insurance as much. The one where I want to buy a lot of insurance is if I think the market is going down, the volatility is going to increase. But Don, are you trying to, for your money, protect one-to-one sell-off or something less than that? Not necessarily. I mean, again again we look at our quantitative model and that really helps us sort of combine all the

instruments that we're trading uh and helps us get the most efficient uh hedge on when you know for for the portfolio and then if it's at 50 50 u.s foreign are you only hedging the 50 i mean we're going to target it appropriately so yeah if it's going to be you know somewhat less than that then we will adjust our hedge accordingly so again yeah we want to keep that cost as low as possible right but you're not only hedging the US percent, like it's the total portfolio. Correct. And then why go with this model over just holding S&Ps or having a simple SPY ETF? Well, I mean, this model is far superior than just SPDRs.

I mean, there's going to be times like Victor probably answered it best those times when it's the best to be in the US, but there's going to be other times where you want to be a lot more international. You know, like one thing I like about this one problem I always had was, how do I invest my, you know, my beta assets? Do I go all S&P? Do I go IWM? Do I look at the world market? I talked to my financial planner and say it's 50% this and 30% and 10% this with no reason. You know, now I actually have a reason that I, you know, I understand where my equity assets are going. So, you know, you... And that model is totally momentum based? No, no, no, no.

No. Let me back up. It's fundamentally based is what i told you yes if you think uh the dollar is going up less more internet more domestic if you think inflation tax and regulation are going up you use smaller size go to small cap so it's all based on fundamental but it's also on price variable and this is the difference between other models see you can look at the environment because everything we see is being traded we don't use gdp because gdp you don't know what's going to be until six months from now yeah i know what interest rates

are i know where the dollar is today and i know and based on what i just told you i tell you what my allocation is and what don was saying that is very important to make pointed. If you look at our allocation and what Don is invested on, you can tell what he believes and what he likes. Because we are right now, we're exposed to what the large cap and they said okay they like large cap, they think the dollar is gonna be you know like you look at there's a one-to-one mapping between our allocation and the variables that we use to describe the environment. So, I mean, if that doesn't match what you believe, you see who's wrong.

Is the model wrong? Am I wrong? Or what's going on? And you can always check. And that's a very simple way to check your model and the consistency of your. And then what if, what if it doesn't jive with your belief? Do you change it? Do you override it? No. Okay.

And then... Then you figure out what is it that you're missing. And then maybe add to the model. You know, like, I'll give you one example. The last election. Yeah, I was just going to bring up the election. To bring that. I really believe that Mrs. was just going to bring up the election. To bring that, I really

believed that Mrs. Clinton was going to win. And I had a somewhat negative view of the market. And the model, in fact, we're saying that. If you go back to the numbers, the market was sort of tanking before going into the election. Yeah.

The yields were going up and all that. The market's telling me she's going to win. So we were in a position to, for Mrs. Clinton victory. Then the election came out and said, hey, this is a different world. We ran around the mall and, you know, we flipped from, I'm overstretching it, but it is from 75, I mean, in my long only, the money I manage long only, I have 75% fixed income. I went from 75% fixed income to 75% equities. Wow. And so you mentioned regulation or possibility of more regulations.

How do you get that input? Like, how does the market tell you that? Well, it's very easy. You know, like what you see Well it's very easy you know like what you see is for example you know like we I'll give you an example right now with the coronavirus. You know little guys are nimble. Well-timed cough after coronavirus. Yes little guys are nimble they can take advantage of regulation and all that.

In fact, what did the administration do when they tried to help the businesses? They say usually the regulation exempt all the little guys. For example, we've got the small people, less than 50 employees don't have to do this. Blah, blah, blah, don't have to do this, don't have to do that. With the coronavirus, they gave all the financing and all that what all the franchises did do or you know like whether you know like what did they do they didn't use a single corporation that would be too big each franchisee apply for all the small loans you see what i'm trying to say small guys guys can always take, are more nimble. They can take advantage of the taxes and regulation, number one.

Number two, you know, like the tax collectors are elephant hunters. They don't go rabbit hunting. If you need the revenue, who are you going to go after? Me. Yes. Not me. Guys like you. So that's exactly my point.

So I meant I'm a rabbit not an elf oh i thought no but you know what i'm saying like they go big taxes regulation and inflation they usually tend to harm they go after taxes go after the big guy the regulation go after the big guys because the enforcement causes to like the little guys canvent. So whenever you see taxes and regulation going up, guess what happens? Small caps tend to do better. Right, but I'm just trying to get to what's that, how do you measure that, that taxes and regulation are going up? Like count the number of laws or relative performance? I used to do a lot of research on that area. I'll tell you, it's a very simple measure. The number of pages in the Federal Register. Okay, so if that's increasing small caps, if it's decreasing large caps.

The only time the small pages of the Federal Register really went down was guess when? Reagan. You got it. That's the name to my heart. really would have been my guess that it never goes down. It just goes up less, right? Yes. And you see it happening now with the coronavirus. What have we had? We have had an increase in regulations.

Remember, because we have all the executive orders. You cannot get thrown out of your house. You cannot do this. You cannot do that, et cetera, et., etc., etc. Guess what's happened? Who's outperforming? The small cap or the large cap? I thought large caps were based on the big trillion dollar companies, but... Well, you'd be surprised that the small caps have outperformed the large cap by about 200 basis points. For a year to date? No, no, since the recovery, since March. Okay. Just the last couple

of months. Yeah. The big swing, upswing. Yeah, and then you don't have any sort of value, right? Like Cliff Asness is all crying all over Twitter lately, values never coming back and dead. What do you think about that? Everybody talks about that, but the question is that value is no longer value. Yeah. Remember, in the old days when I was, you know, like, value was a very clear, precise definition. Now, anything can be value. And the other problem we have now with value and growth is you look at the sectors. I used to joke around.

If you tell me what's happened to finance and and energy i can tell you what's happened to value all right so values a lot of those energy players and the financials and they got hammered by yeah yeah and they're doing all that well. That all sounds good. So we mentioned Mrs. Clinton. I've never heard her mentioned so respectfully before, but well done. And then, so this election, it

seems the odds are in Biden's favor right now. Where, what are the models telling you? Will you do anything different this election than the one you mentioned? Oh, yeah. We're paying attention to a lot of stuff. You know, like the model, you have to be very careful with what people are saying and what the market is saying.

Remember, the market has been doing fairly well. Yeah, new all-time high. Well, let's go back to our four variables. We have interest rate. The Fed has said that interest rate is going to be as low as far as they can see, and we don't see any inflation in sight. So, you know, like for the pedestrian, little guys like me, you know, TLT might still be a good hedge

because I don't see any danger on the big sharp rise in interest rate, a big spike in inflation. Fine. And that is the same for both candidates. It doesn't matter who wins. The Fed is going to keep interest rate low. What do you use as your inflation gauge? Just CPI?

Yes. PCE. Personal consumption expenditures. Yeah. And then... So that was two. Interest rates? Yeah, more or less that.

But we have what is very clear, very different than the candidates is their views on taxes and their views on regulations. And, you know, so if you think you're going to have tax rates that are going to go up, regulations are going to go up,

I think that will favor small cap as a versatility number one. But also the higher tax rate means what? I think that will be that the stock market is not gonna do as well. And I think not only that the stock market is not gonna do well, the dollar is not gonna do as well. So under that scenario, if you have to invest in the US, you increase exposure to small cap. But if you're gonna invest in equity,S., you increase exposure to small cap. But if you're going to invest in equity, you're going to increase exposure to internationals. And you're going to reduce your overall exposure to equity because you think the market is not going to do as well as bonds. I'm not going to mention the candidate, but you can figure out which one I'm talking about. Yeah.

Let's talk bonds for a second. Where do you think we will go negative in the U.S.? We already have sort of, but what are your thoughts on bonds overall? Well, I think, you know, like there's no problem with the inflation rate. I don't see bond yields spiking up a lot. And I may see, you may see negative interest rate for the following reason. Everybody is missing one point. There is a look at the expansion of the balance sheet, and there is no inflation. Why? Because if we have financial repression. So you have to have lived in Latin America to understand, or in the emerging market to understand what financial

repression is like. Look at all the banks here. They're holding excess reserves. So, you know, like 60% of the expansion of the balance sheet is being held by banks as excess reserves. And excess reserves are idle. They don't do anything. Yeah, and then I've read that they also aren't wanting to lend to the smaller names too. They're just going to lend to the biggest of the big.

Of course, because nobody wants to make a mistake. You get fired if you make a mistake. You don't get fired if you don't do anything. Right. So, you know, like... Which makes me think we're Japan all over again, right? Well, you know, in that situation. But remember, what they're doing is they're opening up

for a window of opportunity for people like, how should I say, all those huge funds are lending money, like Apollo. Yeah. You know, all those people who are, you know, are becoming non-bank banks, basically. Yeah, yeah. And what are your thoughts on,

so say you did a huge hyperinflation here. In theory, you'd see it in your asset prices, but you don't need or want like a gold or some sort of commodity trend inflation hedge? No, I don't. I'll tell you why. Gold has done well, and don't get me wrong, and I would have lost money. I would have not spent that much money. But I don't see the

inflation rate going up, number one. I don't see the economy booming in the sense like around the turn of the century, when we had the commodity know, the super cycle and all that, because I don't see the world economy growing that fast. So if you don't see that, what is the case for gold? The only case for gold has to be uncertainty and volatility. But, you know, I joke around with people say, you can't take it with you. You know, can you imagine you can resolve, you know, like what you have to do is if you're going to do that, you might get into the cyber currency. You know, like, and then hope

that you don't have an Alzheimer's and forget your key number. Yeah, I'm in the Warren Buffett, although Buffett's been buying gold miners, right? But yes, but remember, both of us had a bad decade. Yes.

Yeah. But you write his line of they alien saws, dig it out of the ground, put it back in the ground, put some guards around it. They'd be like, what are we doing? Yeah. Remember, when you're 90, you're not as good as when you were in the 80s. Maybe 90 is the new 80s. Yes, maybe.

And then I have one more point on when you're sizing and based on the volatility, right? There's been research on the flaws in volatility-based weighting how do you counter that right like in theory you could have a big sizing on something that has a you know japan for instance they might have super low volatility but they don't produce any return um how do you view all that but that's where the beta comes in yeah and remember the way we look at the world and then i let don answer And remember, the way we look at the world, and then I let Don answer some of this. The way we look at the world is a very simple issue. Think in an economic term,

you have to think in terms of reaction coefficient, you know, like the beta changes by economic policy. Let me give you one simple example of that. You've seen, I don't know, like, I don't know if you're, how old you are, you look young enough, but I don't know, like, I don't know if you're how old you are. You look young enough. But I don't know if you remember that airline used to be regulated. Yes, yeah.

And when the airlines were regulated, they were high beta. Why? So it's a very simple answer. Because they had the landing rights and the gates were the limiting factor. Since the gates were fixed, during the good times, the man through the roof and you can't increase the supply. So what do you do? How do you ration the increase in demand? You charge a higher price and you make a lot of money. And during the bad times, you get hammered. So the airlines were high beta. And if you remember back in the 1980s, you say, Jesus, Reagan gets elected. Airlines are regulated.

You know, the airlines are high beta. Oil prices are going down. Interest rates are going down. That's the steal of the year because, you know, the market is going to boom. And with the high beta, you were going to make a lot of money. Guess what happened? You would have gone bankrupt. Because towards Alfred Kahn. I don't know Because two words, Alfred Kahn.

I don't know if you remember who Alfred Kahn was. No, I like the story already though. He deregulated the airline industry. Okay. And then they became elastic. And then they were competing. If you made money on the airline, I started a new airline and charged 30 bucks per seat.

You know, and guess what? They competed away and the beta went from 1.8 to 1. Yeah, I think I've read the history of airline stocks. Nobody's ever made mine. Yes. The combined stock prices are negative. So, you know, the airline, so the elasticity can change dramatically based on taxes and regulation because the regulation can inhibit competition, prevent entry, and all those things.

And that's why we have to pay attention to the same thing with oil. When Reagan got elected, he did control oil, and he basically bankrupted. Look at what happened to OPEC. Remember, we had two oil crash. It went to $24 in 81, and it went to, later on in the late 80s, it went to 10 bucks. I remember I wrote a piece in the Oil and Gas Journal in 1981 saying that the oil prices were going to go down to $20 a barrel and gasoline $1 a gallon. And a guy from Rowan and Company wrote me a letter you know wrote a letter to the oil and gas journal that how could they publish that kind of junk that was worthless that I didn't know I was talking about

and guess what happened two years later Rowan and Company was not went under yeah I was gonna ask how you remembered an an article from 1981 but it's because that guy gave you a note he wrote the letter but that's what happened, you remember those things no plus it was a very good forecast you get lucky twice twice, what was the other one?

later on, five years later I predicted the $10 a barrel gas I gave a lecture at the, I made a presentation in Denver Petroleum Club and they went after me because I don't know anything about oil. I'm an economist.

I just know about economics. And they started going after me. All I can tell you is that I got lucky twice. There you go. Yes. And Don and Jim, let me bring it back to you quickly. How do you view the rebalancing premium in all of this? Is it active? Is it at month end?

If the convexity pops in, is that immediately going into the beta component? It depends. We look at a few different things. It's not necessarily immediately going in. We need to measure that versus the additional cost that it would to, you know, to mitigate that risk as well. So, you know, there's, you know, again, we'll look at our model to help us decide that. But, you know, like you said, you know know at the very bottom and March sure I mean the the cost of added protection is is pretty high and we need to weigh like the rebalancing and reinvesting against that I mean it's a

we were able to do it rather relatively quickly which again which is what you want when when you were talking about compounding over long periods yeah and I from other products I'm involved with and whatnot it's always right the it's not just the rebalancing but the ability to stay in the beta that's probably been... And we stay that we stay in the beta that's that's that's the idea. That's the one thing I will I will say that we are definitely not market timers we always want to be in the market. And when people talk about risk mitigation,

A, it's hard for people to actually bite the bullet and get out of all their positions. And if you miss one or two days, I mean, we've had a couple five, six percent days. The thing that on the risk side, one of the things Victor talks about with interest rates are going to be low to, or someone describes it return freefree risk for the next, you know, 10 years, it kind of means that, you know, a dollar a day is going to be the worth, the same as a dollar in 10 years, it lengthens everyone's horizon, which is going to lead to, I think, increased volatility.

So, yeah, are we nervous? Could there be a disruption or a shock? Obviously, with the election, because there are some very stark fiscal and tax regulatory differences in the two parties. And you're seeing a lot of people, I think everyone's pretty nervous and, and sometimes I think I'm not nervous enough, but I see just increasing volatility because people have gone to a lot of

cash. I think there's a lot of reset on, on you know, where do I want to live? What do I want to invest in? And I think most people have gone to that, all right, I'm going to go to cash. And I think all that movement to what I would call short-termism now is what's kind of driving the volatility that we're seeing here. Except the Robin Hooders that are saving the market. I don't know how much I buy that narrative, but the whole problem with going to cash is when do you go back in, right?

You're never going to feel it. I mean, timing is not a strategy. That's just a recipe for the future. Most likely you're going to miss out on on the return so it's not a way to manage your risk or manage your portfolio all right guys i think that's good we're going to move on to our favorite section close out learn a little bit more about you guys so Victor one of your passions is Paso Fino horses did I say that correctly yes what what's a Paso Fino if there are gated horses they're like

Tennessee walkers they were gonna for beat lateral beat and they come from the berber horse from the during the conquistador the desert you know like traditional horses are diagonal and when they walk and the center of gravity goes up and down so if you look at a lance if you're a lancer, you're going on an English horse or a quarter horse, the lance will move sideways and you may miss your opponent. But the Berbers were lancers and the horses were like pacers. And when you're in a pacer, the lance goes up and down, but never sideways. Okay. Can I bet on them at Saratoga or something or no?

No, no, no. But the advantage of the pacers is that they're very comfy because the center of gravity doesn't switch and you glide laterally and that's why they're called plantation horses. So the plantation owners like to ride in a comfy horse to go around their property when they look at what they're working on, and that's how they develop. And so you own a few of these? I own a few of them. I own a little ranch in Dominican Republic. Perfect.

What's your favorite one? Do they have names? I love them all. Oh, you've got to pick one. We have a big ranch, and we've been in the sugar cane business for over 120 years now, my family. Wow. I always have a big ranch and we've been in the sugar cane business for over 120 years now, my family. Wow. I always have a question.

When I, if you crush up the sugar cane, what do you get? Brown sugar? No, you get, you get the syrup. The syrup. Yeah, you get a syrup. Like, it's like a white washy syrup that's very sweet. And that's what they make the sugar from. You crush the sugar cane, you get the syrup and then they cook it.

You break it down into molasses, it's the residual, the leftover, and the other part, you know, you keep growing until the centrifugal force, you know, to get rid of the separated sugar from the liquid, and it crystallizes. Okay. And you're offering a free stay at your Dominican ranch for anyone listening to the podcast, right? Oh, absolutely. And I will make them, you know, like the antelopean days, I'll make them milk the cows and cut the sugar cane for me. Perfect. I've actually cut sugar cane before I grew up in Florida. And we did, I can't remember why, but we were out there in the Everglades.

Oh, by Oquilanda? The Oquilanda? I can't remember exactly. It's a sugar mill that is owned by the Franjuls. Ah. And they also own Casa de Campo, if you are into high-end places in the Caribbean. Okay. I don't know that one, but I am into it. Well, the Jack Casa de Campo is the most complete resort in the Caribbean.

All right. Well, check it out. You can fly in your own plane if you want. All right. And he has two Pete Dye golf courses. And amazing. I met Pete Dye there at the party. You know, that one.

Wow. And then I'll tell you a story. I'm sorry about that. No, go for it. I'm talking to him, chatting with Pete Dye and all that. And he said to me, and then I started talking about it. And he said, where do you live? He said, well, I live in Rancho Santa Fe.

And I said, oh, me too. At that time, we lived in Rancho Santa Fe. And he did the farms in Rancho Santa Fe. While we're on golf, Jim, favorite Chicago golf course? Well, I'm partial to Exmoor, which is my home course. But I do love Shore Acres is probably one of the prettiest in Chicago golf we're spoiled for choice

here and I'm just happy to see it's great to see at least a live sport even without spectators I don't miss Baba Booey after every tee shot to be honest we have the teeth of the dog, if you ever heard of it.

Oh, yeah. Teeth of the dog. I don't know that. That's a vicious course, Pete Dye. Okay. It's a hole in the ocean. It's really cool. Don, you golf?

I'm probably about eight or ten times a year. We have the Village Links out here where I live. It's a fantastic public course. Glen Ellyn, yeah, I've played there. It's like the value play if you live out here. It's nice. This year. And what – your favorite college football team, Don?

Well, it's got to be Purdue University. All right. You're a Boilermaker? I'm a Boilermaker. I'm a Hoosier, you know. Uh-oh. Uh-oh. Attention there. Yeah, we didn't know that. We're just bitter rivals here, but yeah. And Victor, favorite cocktail to drink

while reading Cocktail Economics? Oh, I like Sangria. Sangria, okay, not some Dominican rum made from the sugar? No, no, no. Because sangria makes you nice and pleasant, you know, like in the afternoon. And that's your book, correct? I haven't read it, but Cocktail Economics? Yes, Cocktail Economics. Why would you?

I have a more recent one that is a little bit more academic. All right. We'll put links to all the books in the show notes. Oh, you don't have to. He goes back. We ask all our guests' favorite Star Wars character. I'll start with you, Jim. Oh, Han Solo. Han Solo.

Okay, no repeats. Oh, that was going to be mine. Well, I guess I got to go with Luke Skywalker then. All right. He's pretty good. Victor? Darth Vader. Darth Vader.

All right. pretty good. Victor? Darth Vader. Darth Vader. Can you do a Darth Vader voice? No. But you know, he was a good guy. That sounded like it. He was a good guy in the end, right?

He redeemed himself. Yes. Like economic. Yes. All right, guys, this has been fun. Thanks for coming on. And we'll talk to y'all soon. Hopefully in person. All right. guys. This has been fun. Thanks for coming on.

And we'll talk to you all soon. Hopefully in person. All right. Thanks, Jeff. Thank you. Thank you. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel follow us on twitter at rcm alt and visit our website to read our blog or subscribe to our newsletter at rcmalt.com if you liked our show introduce a friend and show them how to

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