The Derivative - Nobody is prepared for a 2nd leg down, with Ari Bergmann of Penso Advisors

Episode Date: September 8, 2022

It's not every day you get to sit down with a Volatility veteran with over 30 years of experience…..Well, maybe it’s a bit more common here on the Derivative than elsewhere, but we’ve got a special treat with Ari Bergmann(@AriBergmann) joining Jeff on this week's Derivative episode. Listen in as they dive into where to find convexity, why that’s not the same thing as buying lottery tickets, how there’s a difference between a low price and a value, and the processes needed to maintain portfolios of convex instruments. Ari is the Founder and Managing Principal/CIO at Penso Advisors, where he leads the firm's investment committee and manages various Penso funds and clients' mandates. Ari and Jeff are sorting through all of the Volatility mumbo jumbo and taking a closer look at the practical limits of cheap convexity, where imbalances come from in residuals and structured notes; how the ignorance of the possibility of a second leg down formed and still exists, trading complex options vs. vanilla options, the importance of monetization, and so much more! Plus, Ari is giving his hottest take on gold and why it's crucial to keep your personal life private — SEND IT! Chapters: 00:00-01:53 = Intro 01:54-14:38 = Confusion de Confusiones & the start of Penso 14:39-24:48 = Approaching the limits of cheap convexity, residuals & structured notes 24:49-34:45 = Ignorance and Opportunities for a Second leg down 34:46-42:51 = Dual digital, complex options vs vanilla options & the importance of Monetization 42:52-52:19 = Always rebalance your portfolio 52:20-56:32 = Hottest take: Gold is good & Keep your personal life private From the Episode: Check out and read Confusion de Confusiones Follow along with Ari on Twitter @AriBergmann and for more information on Ari and his team at Penso Advisors visit their website at www.penso.com  Don't forget to subscribe to The Derivative, follow us on Twitter at @rcmAlts and our host Jeff at @AttainCap2, 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

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. We've made it, everyone. It's a World Ampersand Day. 9-8. I guess because when you write an 8, it sort of looks like an ampersand. I'll allow it.

And I'll allow us to bring on a few fun guests over the next few weeks. We've got the guy who taught Fin to it, Phenom, Chris Abdomacia, the derivatives ropes, talking about a market-making game he designed. What? And then one of our favorite trend followers, Eric Crittenden of Standpoint Funds, to talk through what's next in that space. But up next for you is a real treat. We've got the founder and managing principal, CIO at Penso Advisors, Ari Bergman, on this episode. Don't let his folksy voice and style

fool you. Ari is as smart as they come in terms of structuring trades where you can find cheap convexity, which is exactly what you want when and if there's a second leg down. Send it. This episode is brought to you by RCM's VIX and Volatility Specialists and its Managed Futures Group. We've been helping investors access volatility traders for years, like Penso, and can help you make sense of this volatile space. Check out the newly updated VIX and Vol white paper at rcmmults.com. Under the education menu, then white papers link. And now back to the show. All right. Welcome everybody. We are here with Ari Bergman. Welcome Ari. Hi, how are you?

Good. Thanks. We're chatting a bit before we got started. You're there in toasty New York, you said? It's warm today? That's it. Nice, warm, and humid. Where do you escape the city for in the summer, anywhere? I just came back from Panama, actually, with my grandchildren. Yes, it's fantastic. People don't know it's a hidden jewel. Really, really great. Similar to Miami or more culture, I'm assuming? Yes, I think it's much nicer than Miami in many aspects and has lots of nature. I think that you go from the Caribbean

and the islands of the Caribbean to the Pacific in 40 minutes. And that's a familiar drive and that's fantastic. Yeah. And I got to read up what they're doing on the canal there, right? Are they expanding it? Or that's already done? They did.

They expanded the canal. The canal is going full force. And you see those humongous boats going through. And it's human engineering. It's amazing, right? That's the electricity. It's nothing. Just understanding the force of death.

The eighth wonder of the world. Yeah. And has been growing stronger and growing since 1914. Since 1914? Yeah, yep. That's how the canal was inaugurated, 1914. Wow. And if you can, give us a little bit of your background.

So you've been doing this volatility mumbo jumbo for 30 plus years? Yes, I'm doing thebo Jumbo because I joined Bankers Trust in 1989 and doing the real estate since then. I saw many developments, many issues and opportunities

and it's great. And so what were you doing back at Bankers Trust? Bankers Trust, I joined in as an associate, right? At the bottom of the totem pole. I joined the interest rate derivatives trading desk. And then I came to run the desk during 92 and 93. 94, I became a partner at Bankers Trust.

And I was doing them. So I basically started from 89, from the bottom of the total pool in interest rates to actually running the desk in interest rates and then moving, becoming a partner and running in equities, more on the strategic side, doing acquisitions, doing M&A transactions, all using derivatives. And that one, 1997, I left my open-owned business and has been good since then.

And what happened? They are no longer? They got gobbled up in some acquisitions and whatnot? Yeah, yeah. I left when Bankers Trust got acquired by Deutsche Bank. Got it. Bankers Trust, at that time, first, it. Bankers Trust at that time first, and that was they actually acquired Alex Brown, right?

And then Bankers Trust had some troubles and this and that. And then finally they got acquired by Deutsche Bank. So that was the time that I thought, time to leave. Went down and invested. And then started your own firm, went right into Penso?

At that time it was called Sentinel Advisors. But then I realized the Sentinel name had been used by so many people. So we thought of the name Penso. And the name Penso is very interesting because the first person to talk about derivatives, the first book, was written in the 17th century, 1688. And it's actually one of the 10 best books ever written on the financial markets. And it was written in Spanish about the trading of the company of the West Indies in Amsterdam, the stock market in Amsterdam. It's called, by the way, the name is amazing. It's called Confusion de Confusiones, Confusion of all Confusions, right? To expand the market.

He talked about the Revenue, Food Costs, the first crash. And that was actually the first book on the financial markets. And it was on the Revenue. And it was basically 100 and some odd years before the invention of calculus right calculus is like this a new thing in the 18th much later so like 50 years later so this is pretty good at that time yeah so and it was written by a guy called pencil de la vega and so de la vega that was his name. And we took the name Pencil. So the name Pencil

is an allusion to Pencil de la Vega. He was at the forefront of derivatives. His book is 1688. The next book of the financial markets is 1850 by Robert McKay for the markets. But there's nothing. And he's still

the first book on the modern financial markets, first book on derivatives, and one of the 10 best books ever in the financial markets. But there's nothing. And he's still the first book on the modern financial markets, first book on derivatives, and one of the 10 best books ever on the financial markets. All right. I got to add it to my list. And what's he talking about? Were there actual derivatives

on the South Sea Trading Company at that time? Or he was promoting saying there should be? It's the West Indies. No, he said he was describing his descriptive,

not prescriptive, descriptive, right? He's telling you what happened there. There were futures, there were puts, and there were calls, and there were trading. And people priced it, not using black shawls or anything like that. They just priced given their gut.

And it's amazing how close they got to what's called the closed-end formula. See, this is truly something that we know the wisdom of the crowds right that the crowds can price stuff intuitively sometimes better than the most sophisticated models and we see that they had the first crash right when they work at the west indies were losing their colonies to the Portuguese. And they had the first short selling ban and they didn't work.

So I remember that in 2008, we had a short selling ban. Yeah. So I just don't remember this had been tried in 1688. It didn't work. Didn't work then either. It seems like that'd be the perfect stock for an option, right? Because the chip would come in or not come in. So it'd be like a built-in expiration.

Absolutely. And I'll tell you that if you got information, if you got some kind of a rumor that there were pirates taking over the boat or stuff like that. So it doesn't fascinate. It's confusion of confusions. And it tells you the rascals and all the people playing games, the world didn't change much. We had meme stocks today. We had today the short squeezes. We had short squeezes and meme stocks at that time, but it was only coming to the facilities.

Preston Pyshko It reminds me of the, was it Barron von Rothschild who was the world's first high-frequency trader, right? Because he had the carrier pigeon, was faster than the foot messengers. Yes, but that was later, right? So he knew Napoleon lost before everyone else. Yep, yep. So this is way before, but good and same. And Newton and Leibniz were at the time working on calculus

and this stuff was already being used. I love it. Well, listeners, everyone go add that to your reading list. The confusion of all confusions. Right. And it was translated and abridged into English. It was done by Harvard Business School. Harvard was the one, one of the professors did a abridged vision, a version in English because it was written originally in Spanish. It's a much larger book.

And it's fascinating. I love it. And so when you first started, were you saying, hey, I want to be this protective piece of the portfolio? Or was it more of an absolute return and we want to be a hedge fund that makes tons of money for our investors? At that time, when we started, it's doing what we do best. It's finding what's called cheap convexity in the market. Agnostic to risk. And the reason, the way how we started going into this idea

of hedging the tails was actually only in 2006. 2006, we saw the market. Very much like today, we sensed that there was a lot of, it was a bubbly market. At that time,

you had, we even published that it was Warren Buffett's famous line, the times of greed be worried, right? And that was extreme greed. And even Bridgewater at that time has shown how much what spreads came down and how balance sheets looked at we saw at what was going on in the housing markets. So we said, okay, the time is to create for our own portfolios, a hedging system that will take advantage of a tail event. We started 2006 and it was like,

looking back, perfect timing, but who knew at that time? We thought at that time that could take as long as two years for something to happen. Exactly today. So you weren't early, you were a little early, but pretty much right on. Yes. The key is because you see the most important

for a hedging for stuff like that is that you can't be too cute on the timing, right? Because it's very, very easy to lose the opportunity. And hedges are such that it's available until it's not. And once the hedges are not available, that's it. It's too late. So we started too early, but it's okay. And these things reprice right away.

And the main, I think that the most important aspect of any hedging strategy is you cannot depend on timing. That's it. Be very careful about the budget, not to spend too much, to realize that you have to have a horizon. And at that time, we said, okay, we are ready to be in this for two years. We think at least it could be two years for something to happen. We were lucky that it took shorter.

I think for the same timeframe, the big short book, right? Taught everyone that of Michael Burry, like almost ran out of money trying to hold that trade. Yes. And I think that this is a very big lesson, but we were very careful. We never bought CDSs on the housing market. It was too expensive. Yeah. So that doesn't make any sense, right? It looks good, but we always look for convexity, which means to find stuff that doesn't cost much,

that allows you to hold it, and has a great multiple. That is where we come in, and we knew that at that time. So this idea that you almost ran out of money, it is interesting because a lot of people did run out of money, right? I always look at the histories made out of the winners, right?

The conquerors. You don't know how many people like him were also right on the idea, but they were dead by the time it came. We actually, in 2006, we bought a huge CDS portfolio. We did not buy on the housing because it made no sense. We said, you know something, let's look at the next vulnerable link in that chain, which are the providers of liquidity.

Forget about the people who are being borrowing, the people who are being lending. And at that time it was extremely cheap, right? It was 25 basis points, right? But we actually bought it from somebody who had hedged throughout and lost so much money they had to bail out. So we don't know how many people were like Ron Barry, but only they just lost and got out of the game. Yeah. He's usually considered like a genius right but it sounds

like we're saying hey he maybe he is but he chose one of the most expensive ways to get the convexity there and he was almost out of the game and never confused luck with genius right yeah that's it i think it's very good but that genius everybody which basically comes back to this idea, right? You never want to be dead right. Better to be dead wrong. Dead wrong means you're dead for the right reason. But if you're dead right, you're dead for the wrong reason. And dead right means that you're right, but by the time it happens, you're long dead.

And you're dead for the wrong reason, because you're right. You shouldn't be dead. The flip side of that is fail fast, right? Yeah. So if you started out and you're looking for cheap convexity, how do you put the guardrails on that? How do you limit it? Because I would be running all over the world saying, hey, we can get these French electricity prices and this spread in net gas. And there's so many trades out there that you could structure that could provide that cheap convexity.

How did you go about figuring out, okay, how do we want to approach that? Where are we going to put the limits on that idea? Okay. First of all, what's very important is a lot of people confuse cheapness with a low price, which is called the lottery ticket phenomenon. Okay. Look at that lottery ticket, right?

It looks cheap, but it's not cheap. It's a low price, but it's extremely expensive. Probability speaking, you'll buy for a dollar something that's only worth 30 cents. If you're lucky, 30 cents, probably worth 10 cents.

So that's not cheap. It's a low price. So in the world, number one, you've got to look for opportunities, but you have to be smart. Most people assume, oh, I could buy a lottery ticket here, a lottery ticket there. It's just a very big much of a waste of time and waste of money. So you have to be careful to measure. That's number one. Number two, you have to have a budget. And you have to be very, very systematic and very disciplined and very structured to do the hedging, which I mean to say is the following.

Just buying stuff out there, lottery tickets and see what works. I can tell you, it never works. You only see results. You see, we have very much resulting. Look at like the biggest trade ever. And that's BS, right? Because you're taking one guy that was lucky and survived you don't see how many people died and how many people lost all their money yeah right so that's resulting

resulting is never a good process so therefore when you look for trades the number one is to be very very systemic systematic and very disciplined and very structured and that's what we do we say okay we are going to look for, scan the world for two types of trades. One of them are called the proactive. We have risks out there. Let's say we look at the housing. Let's look at the most effective trade to give me returns if that happens.

And you have scanned the world. And what you don't want to be right, you want to make money. To be right, it's great to put a book, but your investors never make money. So therefore, you have to say, okay, where can I find a trade that's long enough, that gives me time, that there is a multiple, that if I'm right, I'm not making money, I'm making multiple of the money. That's what it takes. So you have to be smart. You have to be structured. And that's what's important. Yeah. I think of it like parlays and football

betting, or we could use the craps table, right? Like, oh, there's great odds on those double sixes, but no, those aren't the true odds. So a low price, but not a good value. Right. And that is the key why people lose so much money. Because people don't have structure. You need to have a structure. You need to have a process. You need to have a budget.

You need to give yourself time because timing is the worst. And you want to make sure that you don't blow up your chips in the first game. Because sometimes it takes many innings to get to the final result. And so who are selling you those? So you're basically buying these cheap convexity. And those are usually in options, correct? Usually in options format. Not always.

So that you could do in swaps. But usually they are not people betting against you. Those are residual risks of trades because you look at what the REITs are fascinating is that it's basically taking an asset and carving out the risks, turning an asset, one asset, into a basket of risks. Let's say you buy a bond. When you buy a bond, you have interest rate risk, right? Because if interest rates go higher, your bond loses money. But you have credit risk.

You have currency risk. So one bond has many risks. So you could carve out. So people, banks do structural products with their clients all the time. And they are left to residual risks. We take advantage of that. So if people are selling those protections,

not even realizing they're doing that. And that's called the residual. And that's what we look for. The non-obvious risks that people are selling without even realizing. And that's why there are so many supplies. Yeah. But it seems to me in this day and age,

after so many books, after so many people highlighting those, that they would catch up, right? That these banks would catch up and be like, okay, I understand that there's risk here. So do they still not get it? Or are they just greedy and say, I don't think it's going to happen?

It's not because they don't think. I don't think anybody does that. First of all, the opportunities are still there even more than before. Because I told you, they're not taking that risk. They are passing on, they are creating. The more these products became, the more these books exist, right? They create all this product that they sell. When they sell product, they are left with residual risks. And many times, without people realizing them, you have very

mispriced residuals. And that's what we do. What we thrive is, that's why hedging cannot be done as a hobby. It cannot be done by people who don't understand it. Because then you clearly are going to overpay. Because like you're saying anybody today who sells you there is a reason why he sells you right because it's not worth it but you have to look at the residual risks residual risk is basically when you build something there is always left over my father used to say if a guy works with gold, like in Mexico jewelry, the dust of the gold is gold. Just people don't realize. That's the key.

When people do it, derivatives, derivatives are tools that they create instruments. And because of the books and et cetera, these tools are very, very cold

and people make money and people lose money. In the end, they also make money at the banks. And they are like anything. They create stuff and they sell this called structured products.

Most important, structured products. But the dust that's left over, the risks, those are the most mispriced. And people don't even realize that they are selling out of the money stuff,

not realizing it. And so the buyers of those, you're saying, so if I'm in where this is big in Asia, it's getting bigger in the US, right? I think we've seen record number of structured product issuance. So that's what you're talking about, of it's getting more opportunity. Right. That creates opportunity. And so do you have an example of some of these structured notes and what some of those residuals they throw off? The correlations. The correlations. Some people bet the quantum notes. Some people say, okay, I want to invest in Europe, in the DEX, but I want to invest in dollars. I don't want to make things in euros because I don't like the euro. That, by nature, you're doing a correlation

trade because you make money in dollars and you lose money in the S&P in dollars. So it tells you that you could have a higher dollar, lower DEX trade out there that the guy

by nature is selling because you realize that by doing dollars, in essence, the dollar will appreciate more when the market goes down. Preston Pyshko Larson Yeah, yeah. Gareth Garlison So if you took downside in dollars, you're losing more and more money as it goes down. So debt correlation, the banks take advantage of it and they sell it out.

Preston Pyshko Larson Because they don't want that risk. But they're taking of it and they sell it off. Because they don't want that risk. But they're taking on that risk by selling it to you. By selling to you. No, because they are offsetting the risk that they need on the structure notes. Always that. Okay. So they're long that risk.

They're selling it to you. Now you're long that risk. That's it. That's always the case. Always the case is that out there, the correlation books, these books price these residuals and that's what opportunity shows. And is it the case, it seems some of the conversations I've had in the past, some of these banks didn't quite know what they were doing as they structured these notes or a new team came on. So you could a little bit take advantage of the banks as well. And the incentives. I think the incentives.

So there's the banks. They want to book the profit right away. Yeah. The head, when you talk, the headache, the guy who got the bonus is long gone. You realize that's like, it's like the government, right? You have the guys who are elected. They create a mess. The short-term gains for the long-term pain, the banks are exactly the same.

The short-term gain from the long-term pain. And we take advantage of the long-term pain. The banks are exactly the same. The short-term gain from the long-term pain. And we take advantage of the long-term pain. And where do you stand, just as we're on structured notes? I had this later, but I will touch on it now. Do you think this growing popularity of them is a long-term problem, that it could cause some cascading effects?

Or do you think the other side of that would be, no, now these banks have so much that they have to hedge that it can pin the market at certain levels? What's your overall take on that? I think neither way. I think that it depends on the risks, depends on the market dynamics, but the market does in such a way that is going to hurt the most people the most time. So I don't think, I think that the risks where people are focused on really never happen, the payouts,

because people are so hash. Like you said, it makes a position. But at the same time, well, something that people are not prepared for can have a much more cataclysmic effect.

Look at what happened in COVID. COVID was something that came out of the cold, the cold blue, and it made a lot of money because people were not expecting it. Always the market. I think you have to, you see, a lot of people spend too much time

trying to divinate the market to see, okay, what will happen. And the reality of it is the great risks are the things which are people least expecting. You guys have some great slides in your decks of these second legs down. And I kind of view your product as something that protects against a second leg down. Yes. Probably 80% of the investing world right now has never seen a second leg down.

I'll say more, Jeff. I think 80% of the people don't believe that there is a possibility of a second leg down. Not only they have never seen, they don't believe in it. They think that the central banks are omnipotent. They have unlimited powers to prevent a second leg. Which they've been proven, right?

They've been proven right. But past performance is no past. History is never a guarantee of future performance. But that would create something called complacency. If I can tell you one of the most dangerous, mispriced, misunderstood risks out there is the second leg. And the second leg tells you that after market declines, right? Like it did in Japan, let's say in the 90s, right? POJ was there so the market had a huge rally declined and then

bounced back because this mentality of buy the deep BTD has worked you just go and it's an easy one everybody goes I think they even amped it up to BTFD but we won't use the swear words yes

we're trying to leave a very clean good T, F, D, but we won't use the swear words here. Yes. We're trying to create a very clean, good, G-rated podcast. So you have this thing and people buy it. But then if there is a challenge when the market doesn't rally enough and the rally fizzles. That happened in every market we've seen this. From the South Sea bubbles. People used to divide it until it didn't work. So then the market realizes that their assumption is not right. And the second leg is the most painful.

And the reason is for a couple of reasons. Because not only the people that didn't sell by the first need to sell, but a lot of people actually bought more when this thing dipped and now they need to sell. Hedges are not available because hedges have a long memory. So volatility lingers. So people don't have hedges.

So short hedges. We are very positioned for that because we are by nature multi-asset. So we're always looking for opportunities. And there is always opportunity. But if you focus on, let's say buying puts on equities, they might not be available.

Like now, they're at 30%. And the second leg is the most problematic. More people need to sell. People are not expecting. And that happens. And that I think we are going to see. And I think we're very close to a second leg event. And the reason is because the central banks have basically pushed themselves to the limit, which we are seeing in inflation, inflation numbers. You saw

that after COVID, their balance sheet doubled from 10 trillion to 20 trillion? It's a hockey stick. And there's so many imbalances. And Honig, right? One of the Fed governors was against QE, right? He always said there is a great book called Lords of Easy Money. Lords of Easy Money. And that's Honig saying this. QE, it's easy to get in. It's impossible to get out.

It's like, basically, you're half pregnant. There's no way. It's impossible to get out. It's like, basically, you're half pregnant. There's no way. It's too late for abortion, which means, right, which doesn't go. So therefore, the balance sheet grows and is in such a way that you just don't have a way to get out. And therefore, okay, the second leg is very, very possible. We are as close as we have ever been to a second leg. And the market not only hasn't seen that, the market has this secured feeling that this will never happen because the central banks won't allow. And their mistake is threefold. Number one, maybe the central banks have a different view of how far that put out. The famous central bank put, maybe it's a lot more out of the money.

Number two, they might not be able to do it. Either because there is political pressure, because there is inflationary pressures or just because there is a currency war, I guess, and they won't be allowed to do it. So in other words, maybe they won't do it, either because they don't want or because of political pressure

or because they can't. And the third one, which is even the most problematic, is at some point in time, even if they do it, it won't help because they will lose credibility. In a world that there is such balance sheets,

there is so much inflation building, the bond vigilantes, which you are seeing them coming out, they'll be the first ones to not allow. So in other words, you could have them buy bonds and rates going higher. Preston Pyshko Larson 1.0 Yeah, it seems so. And even in this environment, we got this quickly, the narrative changed to, oh, the

Fed's going to pivot. So it's just, we created a Fed put out of nothing of like, they're going to pivot. Andrei Bordachuk 1.0 Yes. And I think that we are up for, I told you, this is why investors need to hedge, because I'm telling you, one day you might look back at it and say, my God, oh my, this is so obvious, but people keep drinking their Kool-Aid until they can't. And how do you define the second leg down? Not in terms of like it's from 20% to 40% or just that environment where people, there's no more hedging available, there's no more liquidity, it's a cascading effect? It's a cascading effect and it goes very quickly down and it goes on and it stays.

It usually takes the recovery from there to the all-time high seven years. So 08 was the second leg down? The 08 was a type of second leg down, but there were other times. Japan, I thought Japan is the classic. Yeah. 01, the 2000, the 01, 2003, you remember, right?

The market had big rallies, then just came down, and it was triggered by WorldCom. You always have something that triggers right you always need a trigger i had uh i think i told this story on the pod before but i had a friend who used to work at worldcom in new york there and their biggest client was uh jordan belfort doing from the boiler room right their phone bill I said, was two feet thick because they were just calling every house in America. So no wonder that it was not a solid market. Yes. It's a very interesting aspect and you have to be very careful because as you know, these things can be very problematic

and very big issues. And so what types of trades when you're thinking about, okay, I want to prepare my investors for a second leg down that nobody of trades, when you're thinking about, okay, I want to prepare my investors for a second leg down that nobody's worrying about, nobody's thinking about, but conversely, there's still a bid for far out of the money puts, right?

Out of money puts don't work. They're very problematic, right? Out of money puts are very problematic, but you have to scan all assets, all asset classes. And when you scan all asset classes you've got to see what they are and it has to be something which is not obvious and clearly we cannot go over trades to tell you because then the trees are available but that's why people pay us

but we have to scan and you have to find something which is not obvious and many times okay just look at it bad movies are not fire hazards only good movies are fire hazards in other words you go to a bad movie and there's a fire who cares there's five guys there you just look at the door yeah if you go to a good movie and there's a fire hazard you're dead which means that the bad trades, right, which shorting bad stuff, never helps you because nobody's in there anyway. So you have to be very contrarian. So the idea is you've got to scan the assets. You have to be very, very, very, very disciplined,

methodic, go through a lot of stuff. And you have to divide. We divide the hedging into two buckets. One of them is called proactive. Proactive means we are hedging a specific risk. Most of our portfolio is reactive. It's stuff that we believe that will perform if and when the market tanks. It's reactive.

I don't care what it does. It could be a ball of lightning. It could be Martians coming. Or it could be that they found the, who knows what, they found the new COVID variant, God forbid. Who knows? It doesn't matter. Because for us to be just proactive, to look at risks, a pot, if you watch a pot boil, it will never boil. All those quote unquote, obvious risks never work. And so sort of by definition, that introduces basis risk against your S&P holdings or whatnot,

right? So the non-obvious hedges are going to have basis risk of, right? And we've seen that this year of if you thought gold was going to protect you against inflation, if you thought bonds were going to protect you against a down market, you took on some basis risk, neither of those work. Absolutely. So how do you view that? How do you control that basis risk?

Is it just a price of doing business? No, you diversify. You know that if you diversify well, if you have enough, if the convexity is mispriced, you assume that we all sometimes assume that 60% of the trees won't work. But the winners carry everything. You can never assume

that all of them work because it won't. If you put all your eggs in one basket, Murphy tells you that that basket will crush and we have nothing. Let's talk a little bit about these dual digitals

and complex options versus vanilla options. So that's another way to do it, right? You'll get more convexity there because two legs of the, what I call the parlay, have to come in instead of just one. Right. Right. This year that was, hey, if bonds are down,

stocks are down. In a dual digital, that paid out way more than if you'd done each separately. Yes, that is true. So how do you, that's just part of the math there of, okay, these things to have better payoff structures than vanilla options. No, but many times they're bad trades because it's hard enough to be right on one thing, which is to be hard on two things. So it depends on the correlation. It's all a mathematical game.

I told you, this is not anything that's too obvious ain't going to work. And then what about the counterparty risk? So some of those are offered by these banks and whatnot that you're doing. So you do a lot of exchange trade stuff, but some OTC as well. Right, so the OTC, the only way to do it

is number one, you've got to have two-way margining. Two-way margining, every night we post to each other. If they owe me money, they pay me overnight. Because you can never take more risk than overnight. You cannot hedge. If you remember the movie Fargo? Yeah. Do you remember the guy goes to ask about a loan and he says, who guarantees?

He says, okay, I guarantee it. So the Fargo guarantees if you buy stuff from the bank, because the bank might not be there. So the only way to do it is, number one, have a very efficient cross-margining daily mark-to-market, number one. Number two, you need to diversify your counterparties. You can never have a lot of concentration risk. And number three, you need to constantly monitor the changes in your counterparty. Changes, negative ratings, risks, stuff like that. So three things.

Number one, daily mark to markets. You can never take more than what's called overnight risk, which is still a lot overnight risk, right? You have to maintain very carefully. You got to maintain very carefully your counterparty exposure. Number three, you need to monitor them on a constant basis. And then speaking of, so right,

that if their hedge doesn't pay out, you're not hedged is the obvious part there, but kind of built into the same thing. And let's talk a little bit about monetization. So, right, a big problem with hedging with these is when do you monetize them? If you don't, right, in March of 2020, if you didn't monetize, you might not have gotten the opportunity to buy back into your stocks.

So talk a little bit about how you guys view monetization, when and where you do it. We think the monetization is the most important part of the business. You have to have a very, very clear and a very well defined strategy. We do have that. And that's defined in various aspects. But it cannot be left to total discretion. We have a system. We have a method. And we have models to tell us. I think to put on hedges, it's actually easy. The tough part is how to monetize and not to be exposed.

Because if you monetize too early, you are exposed. You're left naked. Because this thing can go to a second lockdown. You have nothing left. If you don't monetize, hedges go away. So what sets apart the men from the boys is the monetization. So it has to be

a very clear, defined, methodic way of doing it. And we have very much of a defined method. Plus, you need a lot of modeling to signal when the monetization. And then you have to know how to replace what you monetize.

Which of those is hardest? The last seems the hardest, right? No. No. I think there is no hard, there is no easy. There is no easy. Everything is hard, but life is hard. You don't want an easy life.

If your life will be easy, you're not available. We are only here because life is hard. So hardship is good. I think I always told you, I always tell my kids, don't ever expect an easy life. You don't want an easy life. You want a meaningful life. It's a hard life. It's fine.

Challenges are always good. So it's not harder or easier. Everything is hard, but everything is, if you do it right, there is a process. The process is laborious. That's very important. And the three of them are as hard as laborious. But if you have a system, you have a process that's well-defined ahead

of the game, it works. You cannot be by chance. Don't ever do it resulting just because you got it right once. You realize the market lulls you to feel resulting, right? You feel you got right once, so you think that you have it.

And then when it comes, you just miss it completely. So you have to have a process, a very structured process, very clear process. And besides that, you need to have modeling to allow you on a very much systematic way to flag what's called the monetization windows. Preston Pyshko And I'm sure it helps that you guys are in all these different markets and dual digitals and cross, so you have a much larger data set than someone who's just trying to model it based on S&P and VIX, say. There's not enough observations to really build a model of when to monetize. Absolutely.

And not only that, if you do only one asset class, you don't have what to replace with. If you monetize that, so what? That's it. Life is good. Then life is good. Then you might be lucky

or you might be very unlucky. Right? You cannot build a strategy on luck. It's great to have luck, but you can't count on it. And so you guys talk about your attachment points from time to time in your stuff. So this comes in at the same level?

It's tied in with monetization? It's tied in with monetization, but that's not the only one. No, because sometimes it gets, I told you, there was monetization at the first level. So you have to monetize once you get to the first attachment point. But then you have to know how to replace because a second attachment is all possible. And many times you've got to monetize along the way.

You just can't because you might not get there. What happens if you're too short with the first attachment point and then it disappears? The market doesn't let you do cute stuff. Cute stuff, it's cute, but doesn't make you money on a systematic basis. You might be lucky. I told you, don't be resulting. There's always one lucky guy who says, oh, I have the best trade ever.

That doesn't mean anything. It means the process. What's important is the process, the process which is repeatable, that you're not relying on luck. If there is luck, it's always great, but you can't rely on it. So therefore, on the first attachment, the second attachment are monetization windows. You need to replace it. So you need to find something to replace. If you have only one asset class, how are you going to replace it?

I don't know. The evidence is there. But if it's multi-asset class, multi-structure, more diverse you are, the easier it is to replace. That's the replacement theory, number one. I think it's also very, very important to realize that you need a method, monetization method that goes along the way. You cannot wait only for attachment points because you might never reach there and you miss the opportunity. And the concept of attachment points is, I don't care if my attachment point is negative

20%. I don't really care what the market's doing between zero and negative 10%. You do care, right? Everybody cares. But the attachment point is that that's a target return. You should make money along the way, but not always. Depends. Yeah.

But the attachment point gives you a benchmark of what you could be. And those are bigger events. A small move, many times is random. The vagaries of the market. Mentioned earlier, you have basically a set premium spend that you're going to spend each year. And then do investors have to re-top off their investment? So a difference in some funds that say, hey, put it here. We're going to offer this tail protection.

We're going to try to limit bleed. And you just put in the money and it lasts for 10 years. This seems more like this is an annual premium spend to protect your portfolio. Andrei Illarionovic Yeah, but we don't look at premium spend. We are going to minimize, we are going to work on it, but you might not be able to, you might not have to top it up, but you should always top it up. You should always rebalance your portfolio. Let me give you an example. Let's assume that the portfolio uh the hedging was perfect didn't lose any money but your equity is one up 30 you need to top up because if you want

to maintain a 97.3 you need to rebalance the rebalancing between the portfolio and the hedge is extremely important and allows you also the hedge went up a lot and the equity is going up you move it back that rebalancing the portfolio is a huge moneymaker. And it's like gamma trading in that option. Yeah. And this is similar to Universal's model from what I understand, right? I'm not sure of Universal's model, but our model is very different than their business model. I mean, just the 97.3 was what triggered it.

Yeah, yeah, 97.3, yes. But again, I'm just using, it could be 97.3, it could be 98.2. Again, it depends. But yeah, it seems to me- You need to be systematic and you need to be methodic and you have to have a system and do it right. Because you don't want to,

the beauty of it is that if you do it right, it is, we've seen in our hedge, right? That for 10 years, right? From 19, 2010 to 2020, right? With the biggest bull market. Forget about 2008, 2010, 2020. If you did it right, not only did the, what you call, not only that the hedging was accretive, didn't cost you any money, you actually made money, your stats are much better.

And that's assuming that you rebalance only once. If you rebalance more, you're getting much more money. So you're assuming the rebalance every year, rebalance by COVID. But if you rebalance in 2018, in 2011, you made a fortune of many more. But it is, if you are methodic, you're going to make money. A good hedging strategy, we don't believe in the model of spending money. Because spending money is buying insurance. Insurance is not investments. Our belief is that a hedging strategy has to be accretive that at the end of the game

right doesn't matter how long it is if you're systematic if you're methodic you're going to make money so the hedging not only doesn't cost you money it makes you money and gives you tons of opportunities

to rebalance the portfolio over what time period? over five years? ten years? I would say over a market cycle. Market cycle is the rally with default. Let me give you an example. If you went in our funds at the worst time, 2010, the beginning of the bull market, and

you did and you rebalanced, even if you only rebalanced once a year and once in COVID, you made over that year, your portfolio made more money with accretive, much better stats. So you basically got it all for free, plus you made money. It made you money over 10 years. The return over 10 years is more money. But not only that, if you rebalance more often in 2011, in 2018, there were many opportunities, your returns would be off the charts. St think that's what more or less sophisticated investors would say. Oh, I don't believe in this full cycle thing. I want it to be a creative year over year over year, which that's tough to do, right?

Not only tough to do, that's not a reality. You realize that people, because they do that, look at Warren Buffett, right? You make money, like Einstein said, we cannot ever, ever underestimate the power of compounding. You make a lot of money and people say, wow, I made every year. And then you lose all. What's that? This is called the made-up effect, right? Every year you made money. Every year you all said, oh, I made every year. And then you lose all. What's that? This is called the made-up effect, right? Every year you made money.

Every year you lost that all. So then, okay. You want to be at the end of the game. The end of the market cycle is that you look at the market cycle when the world comes, when everybody else is losing money, you made more money, and you have money to invest and make even more money. Imagine, you rebalance, if you bought the second, so it's amazing.

So the year by year return is very, very short-sighted. And that's why the market provides you opportunities because most of the people who do that are going to lose a lot of money. And in the end, they'll be the biggest losers.

Yeah, but I think they even want it out of their tail hedge, right? But I think you guys have done a brilliant job of, hey, this thing, we think it's accretive over the full cycle. That doesn't mean you're not going to lose most of it in between that when the markets spike down. But you have to make sure that you don't waste your budget. We don't believe in a spending budget.

We believe in accrual. But again, I cannot underestimate hedging has to be number one accretive, makes you money at the end of the game, gives you opportunities to really buy it the best time possible, and in the end, gives you much better stats. Preston Pyshkoff Yeah. And you talked a little bit of like, don't view this as insurance or put buying. So compare and contrast a little bit to kind of classic put buying insurance, volatility arbitrage, CTAs, trend following. It's different, right?

Put buying is very expensive because put buying can only make money if the market crashes. If it's diversified, number one, you could make money along the way because a lot of stuff make you money no matter what. Number two, the second leg on a put buying is very difficult because once the first leg happens, volatility is too expensive. Number three, it is notoriously expensive to do it unless they get the timing right. Because everyone knows about it.

Because everyone's in that game. Yeah, but not only that, you're buying puts and most of the time it goes to dust and you have to be lucky to have the puts at the right time because you might be retired. That's number one. Then the volatility arbitrage is great, but you realize that most of the times

if there's a crisis, the best trades are the ones that lose you the most money. If anybody remembers Porsche-Volkswagen. In 2008, there were two trades that you made money, made money, until it came to the point that everybody lost everything. Volkswagen, the famous arbitrage between Porsche and Volkswagen. And oil, crude versus banks. Everybody's making money by being long crude, short financials, until the market just took the opposite, crashed oil, and the financials just went zooming, and everybody was taken

out of the game. Yeah. Which means to say that this foul arbitrage, it works in normal system, but when there is a real systemic risk, the shorts look at long-term capital, right? Where they log money with the best trades. The best trades always lose you more money.

And the reason is because of the crowded movie theater. What's it called? The crowded movie theater. What's it called? The crowded movie theater analogy. I love that. I'm going to borrow that, by the way. We're going to tie in Top Gun Maverick into that, right? Top Gun Maverick is a huge fire hazard. Trust me.

And I can do a lot of movies which are fine. If it is a fire, you have enough time to get out. You could even watch the rest. I'd sit in those theaters and think the same thing of like this is i have a greater chance of like someone shooting up the place or someone do it right the more people in there getting coven like all sorts of yes that's exactly it so those are the traits so our arbitrage is great but you have to be careful that at some point in time this this whole thing just, and it's called the liquidity event. And the liquidity event, the baby goes on the best water and the good trades go down

a lot more because people monetize the good trades. Preston Pyshko, And are you saying, and so in Vol-Arb in a naive sense is short volatility in some places, long volatility in others and trying to capture that. So you're saying the good trades, that short rips in your face way more than the long will pay. Yes. And the longs, exactly right. The market tends to do that because of the good trades, everybody's in, the bad trades are very short. Called the crowding effect. And along those lines too, where are you at on institutional vol selling? It was big coming into volmageddon in 2018. It subsided

a little. Do you play in that game and see those flows or no? We see that flows but again, that has been much more tamed. But now people are doing that right now in the market. You see that in a very not on outright vol but if you look at the valve

structure, there are parts of it that are being outright sold. And the reason is because of different reasons, but the same phenomenon. Robert Leonard Sent over, I don't know if you had time for your hottest take we end everyone with your hottest take so you one of them might be that michael burry was just lucky so we'll take that as hot take one but you got any other hot takes no i'm not saying he was lucky don't tell me that i'm only saying don't confuse luck and skill i'm sure he's skilled i'm not going to judge on him yeah i think the issues that i would say is the biggest contrarian trade is I love gold right now. I think it's a garbage asset.

I'm probably going to miss price one day. I'm going to wake up and this thing is going to be. So it's something that you have to realize that is the most important. But on the rest of it is I keep for myself. I think the most contrarian is that I think that your life, you keep for yourself. You don't put it on social media. Yeah, I love it. So you're not big on Twitter?

I'm very big on Twitter, but it has to be curated information that you send, right? Not on your personal life. Gold, yes, who cares? But the personal things, keep it personal. Yeah, which is, I struggle with that, right? You got like Ben eifert on one side he's posting pictures of his kids and his bike rides and everything but still doing great work um so i can see the modern man yeah yes i for myself family and life it's not for public

consumption i agree that's that's the old school. Maybe that's contrarian, but it has worked for the past couple of years. I'm continuing with that. Well, no need to change now, right? That's exactly right. Awesome. Any other thoughts on Penso or this market before we leave? No, I just wish people good luck because luck is always important. We can't rely on luck.

That's good to have. So that's a good take, right? Luck, it's great to have, but it's very tricky because you start counting on luck, luck goes away. So luck is great. It's icing on the cake. So I wish people good luck, but I'll tell you,

never rely on it. Do a lot of work. Don't, you can say also, don't look for an easy life, look for a meaningful life. Stuff which is hard is good. Hard is good. Easy is not. Okay?

Meaningful life, fun, yes. Easy, no. I love it. Well, thanks so much, Ari. This has been fun. My pleasure. We'll talk to you soon. We'll look you up next time we're in New York.

Okay. You're invited to come and anybody invited to come and visit us yeah and enjoy the heat and the humidity I love it thanks Ari bye 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 Alts and visit our website to read our blog or subscribe to our newsletter at rcmalts.com. If you liked our show, introduce a friend and show them how to subscribe. And be sure to leave comments. We'd love to hear from you. 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 Thank you. 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.