The Derivative - Straddles, SVXY, and (Gamma) Scalping with Logica’s Mike Green

Episode Date: August 27, 2020

With a Top Gun-like bio of working with billionaires and big hedge funds, Michael Green is one of the top prospects in the alternative investment game. BUT, all we hear him talking about these days is his passive thesis, to the point where he jokes – that may end up on his tombstone one day.  We’ve heard all that elsewhere, so wanted to get into more – like what he has going on at Logica, if he loves straddles as much as Wayne Himelsein, how he views the current volatility landscape, his killer SVXY trade, The Princess Bride, adding fragility into the market, the tail wagging the dog, Coit Tower, Twitter business partners, opportunity cost vs covering the bleed, Zoom due diligence, and Gamma scalping. Chapters: 00:00-1:34 = Intro 01:35-38:01 = An Epic Beginning 38:02-58:54 = Talking Strategy 58:55-1:30:50 = Passive Investing, the Fed & What’s going on right now 1:30:51-1:35:54 = Favorites Follow along with Michael on Twitter and LinkedIn 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. I tend to look at options as a source of non-recourse leverage on events that I think have a very different distribution in terms of potential outcomes than other people do, right? The XIV was just, or SVXY was just the extreme version where the options were being priced

as if it was a black-sholes distribution, a log-normal distribution, meaning the higher it went in price, the lower the probability of going to zero, right? The irony, of course, is because it was an inverse product, the higher it went in price, the lower the underlying price was getting, the easier it was for it to go to zero.

And so the right way to think about that distribution was you were effectively funding an increased go to zero dynamic. Right. All right. Good morning, everyone. That's not something we say often on this pod, me being somewhat a notoriously not a morning person, but here we are ready to dive deep in the weeds of optionality, elasticity, passive index flows, and more with the one and only Mike Green. Hey, Jeff. It's nice to see you.

Thanks for being here. So Mike's bio reminds me of the old line from Top Gun. It's quite long and distinguished. With stints working for and with a few billionaires, billions, and now with Logica Capital. And one of our favorites in the space, Wayne Himmelsheim. So I'm excited to hear some more stories from his past as well as some thoughts on all of our futures. So again, welcome Mike. Thanks, I appreciate that. It's always strange

to hear your background described as Top Gun-like. I'm not sure if that makes me goose and I'm about to die in this episode or if... Yeah, no. Well, you're a little bigger than Tom Cruise, but how about... He's just a jerk. But anyway, okay. All right. Yes, I can play that role. Okay. What do you got going on behind you there? A little old school? Yeah, so when the Zoom era popped in, I was looking for something that conveyed a little bit of my personality and my background and originally put up a bookshelf of mine that

somebody had asked me to take a picture of and that turned to be a little bit too complicated resumed a process so instead I found an old map of the San Francisco Bay Area which is where I'm from and where I moved back to in 2017. And you're up over your right shoulder there you're in Marin? I am in the Marin Middle Valley area. It's, uh, I'm actually in a town called Kent field, um, which, uh, is on a technically it's actually, uh, Kent field, but it's called green Bray. It's a hill that looks out on Mount Tamal Pius. Got it. That's where you get those $5 million studios and whatnot.

Uh, that would be Manhattan, but yeah, it's, uh, the Bay area, the best thing to do if you're going to move to the Bay Area is move from Manhattan. It's the only way it feels like a relative bargain. Yeah. We've got friends in Mill Valley. He's got some huge multi-million dollar house. They have no air conditioning. Well, you don't often need it.

So I'm actually staring out at the fog-covered hills right now. So we have our own microclimate here in Greenbrae that it's usually nice and warm and sunny, but it's been an unseasonably cool winter. Yeah, me growing up in Florida, I'm like, you don't have air conditioning? What are you doing? And then when the fires came and they couldn't open the windows, so that was an issue, I think. Yeah, well, it's all going to burn down and fall into the sea eventually. So let's start with some really serious stuff that Professor Plum Twitter handled, but Princess Bride Avatar. Are you confused? Are you trying to trick people? What's going on with those two?

So they're a mishmash of historical components. So I adopted the ProfPlum handle 27 years ago as an avatar when I was at the University of Pennsylvania. Actually, it's slightly longer than that, 28 years ago now. I was going to say Twitter wasn't there 27 years ago. Yeah, exactly. So in the early email and online days, I tapped on something that hit my then interest in academics. And the last name of Green. So Mr. Green was too obvious from the game clue. And so I went with Professor Plum. Yeah, that was going to be my question. Shouldn't you be Mr. Green, but too obvious. That would be too obvious from the the game clue and so i want that was going to be my question shouldn't you be mr green but too obvious that would be too obvious correct so so that's that's where prof

plum 99 comes from um the 99 obviously just makes it easy in a world of internets where everyone has already thought of the original idea and then um the vicini avatar i talked about this on another podcast but for me it's just a reminder of that classic scene where the sicilian is in the death match against the dread pirate roberts and the real challenge is that he doesn't understand the game that is being played right he's so confident in his own intelligence and capability that he doesn't consider the possibility that both chalices have been poisoned and as a result he of course, loses. Anytime that I have had significant challenges in my career in terms of losses, it's largely been a function of the fact that I didn't actually understand what other people were doing or were capable of doing. So I

just use it as a reminder to be humble. And he has one of the best lines ever. The classic blunder never get into a land war in Asia. It's exactly right. Yes. No, it is a fantastic character. It's a nearly perfect movie with the exception of the terrible rodents of unusual size in the, in the fire swamp. So. So how's everything else? How's the pandemic been treating you? You've been mainly working from home or what's the, what's your status?

For me, I've had very few changes. I had commuted from home to Los Angeles for a couple of years actually with I'd originally moved back out here from Manhattan to work for Peter in San Francisco. Chose the location I'm in because of his proximity to the commute to the Presidio where Peter's offices were. Unfortunately Peter decided to relocate down to Los Angeles, which meant for about a year and a half I was doing the commute down to Los Angeles. That's ultimately where I met Wayne. And so the pandemic has just meant that I no longer get on a plane and travel down to Los Angeles once a week or once every two weeks. It also means that I can't go to New York or Chicago

or anywhere else I'd really like to go and have anyone meet with me. It's not that I would care about getting on the plane and going out and traveling it's just there's no one who actually wants to do the meetings right so yeah in a lot of ways it's been fantastic because it's meant that is logical we've been able to focus on communications like this and with clients over zoom which means i don't have to get on the plane to travel to singapore i don't have to get on the plane to travel to australia i don't have to get on the plane to travel to hong kong even which i get on the plane to travel to Hong Kong, even which I wouldn't do these days. You know, or New York for that matter, it both saves us money and it's actually proven to be remarkably efficient. The downside of course, is that the traditional forms of due diligence are often

impaired, right? And so it's going to be interesting to see how allocators ultimately choose to change that process in evaluating new managers when they may not physically be able to go visit them. I think that's going to be a permanent change out of all this. And I've already seen some hedge fund guy moved out to Jackson Hole, another one who's going to be in Montana. They're just saying, I think it's going to be a new normal where Zoom due diligence is just fine by a lot of allocators. I hope that's true. I think that would be a genuine improvement.

Right, because we've seen it. Business hasn't stopped. People are still doing the meetings and they're getting just as much, if not more. Yeah, I would actually argue that everyone is, you know, having done this for a number of years, everyone is pretty distracted when you come into the office, right? you don't actually get a reasonable sense for what anyone's actually doing what you do end up doing is is capturing a lot of time that could be spent doing other stuff right so yeah and you i think the only thing in the finance world you miss out on the steak dinner and the stories and the but if anything that might favor the smart people over just the

entertainers and i'm more than happy to make a fantastic steak dinner for anyone who wants to come visit me at my house. Done. So I'll be there next when we get a vaccine. Excellent. You're not going to need the vaccine, but we'll do it regardless. So you touched on Peter. We're talking Peter Thiel there. Your other pieces of the background include some Soros money. So tell us some of the University of Pennsylvania Wharton School of Business. Developed an expertise as a management consultant advising corporations for strategic acquisitions or divestitures working with their corporate strategic planning departments. That actually led to the realization along with a couple of partners that there was the opportunity to create a software package to codify the valuation techniques that we were using.

This is the early 1990s. They weren't nearly as broadly distributed. Tools like Excel, for example, actually had just really come on the scene. Most people were still using some form of Lotus 1-2-3 when we initially did this. Did you need valuation metrics in the late 90s? No, this is the mid 90s. And yeah, valuation metrics actually mattered at that point, right? And it was very interesting, though, because when we transitioned away from the corporate strategic planning departments and into the asset management space, which was actually done at the request of Mitch Julis of Canyon Partners, who became an employer and has been a long-term mentor of mine. When we made that transition in 97,

what we found was that the majority of the questions asset managers were often asking us were, can you explain, particularly in the 98, 99 time period, can you explain the valuations of a Yahoo or a Cisco? They were very confused trying to understand what was actually going on. And the quick answer was that, of course, we couldn't, right? I mean, they were valuations that made very little sense. There were elements of it that were particularly attractive, right? You had companies like Dell or Cisco that were doing a phenomenal job of managing their working capital relative to many traditional businesses.

Dell, for example, had a negative working capital business model that allowed them to quickly replace inventory at a lower cost given the falling cost dynamics. And so there are all sorts of interesting things that came out of it. Real quick, have you seen the comparison chart between Tesla and Dell? It's making the rounds on Twitter. It's unbelievable. Dell was like 40,000% or something. Tesla's up 8,000% or something. So it's got, you know, 5x left to go. This is fantastic. Sorry for cutting you off. No, no. Look, I think that there's a lot of similarities between that period and this period. but I think it's important to understand that valuation is never really what drives something unless it forces somebody to take action. Part of my education in this process has been moving beyond, through my career, has been moving beyond the truisms that earnings drive stock markets.

That's just never true because earnings have no mechanism to actually make their way into secondary prices. The perception of earnings, right, the reaction function of people to earnings in terms of whether they're willing to transact, that can influence prices. And yes, higher earnings tend to make people more comfortable with paying higher prices. But unless there's actually a mechanism for paper to shift from one holder to another in some form or fashion, I don't understand how things are supposed to drive prices. Like a coupon or something you're saying? Yeah. I mean, a coupon can affect, a dividend payment can affect an option price, right? Because ultimately the price

of the underlying security should reflect that cash payment. But there's almost no mechanism that I can imagine in which, you know, these theoretical dynamics are supposed to drive prices unless they force people to transact. And I've gone on record on saying this. I think people just need to always be aware that what you're looking at with the history of markets is actually a history of transactions. And those history of transactions can happen for any number of reasons, right? A risk manager can tap somebody on the shoulder. Somebody can receive an inheritance and decide that they want to buy, right?

You can change the managers that you've used as an allocator, right? Firing a small cap manager and hiring a large cap manager. And those are going to affect transactions that have to show up in the record. It doesn't really have anything to do in most situations with what were the actual earnings or what was a dividend or

what did the management team say, et cetera, unless those spur actions. Right. And you see that in real estate prices, right? A death or divorce or something, they sell the house. They didn't care about really the fair price or getting the max price. They just wanted the bulk of the money out of there as quickly as possible somebody had a great quote on twitter actually earlier today where they were talking about you know the house that sits at a discount and doesn't sell right it's because that house has problems right what you want is not to find the house that has problems you want to find the seller that has problems. You want to find the seller that has problems, right? Somebody who's forced to sell for you for non-economic reasons, right? Just get it out of here. If you can find that player, then you can get a good price, an attractive deal typically.

Or you just find my dad who's four times divorced and has been at the bottom of every real estate cycle for 40 years because of that. His luck will change on the next one though. Yeah, we're hoping that doesn't happen. So sorry, so Wharton building those models, and then what came next? Wharton building those models, when we went, we sold the company in 1999 to a firm called Holt that was then in turn acquired by Credit Suisse.

With that transition, I moved over to the buy side. I joined one of our clients, a firm called Moody Aldrich Partners, focused in small cap value. My analysis of the market at that point in kind of the middle of 1999 said that we'd reached these extremes, similar to the discussions that you've heard me have with Rob Arnott or Cliff Hasness in terms of what is cheap, what is super attractive. I was really fortunate in that I stepped in to the buy side, you know, kind of only six months left, maybe nine months left in the tech bubble. If it had been three years, I probably wouldn't have survived because I came in with a very strong view that valuation is what matters. And, you know, spent the first

six months basically getting my teeth kicked in. I've told many people the story of February 2000. Our largest client said I was the dumbest man alive, right? And we ended up getting fired. And so those sorts of experiences were critical in terms of understanding. Performance, I did very well in the period from 1999 through 2003 that led to me getting recruited by a firm called Royston Associates down to New York City where I ran mutual funds focused still in small cap value. And were you mostly short with that good performance from 2003 or just finding bargains? That was the opportunity set, right? So, you know, as you went into 2000,

March 2000, you know, the Russell 2000 value had basically been forced, small cap value had been tossed aside and actively redeemed relative to other segments of the market. The primary reason why I've concluded that was, was because of the structure of the market itself right so you had market cap weighted indices not float weighted indices that meant that small companies or companies that had low float relative to their market cap were being purchased at levels you know that you were trying to buy at the quantity of shares that didn't actually exist right and so their prices were being pushed higher that in turn was actually causing wholesale abandonment of the small cap space, the small cap value space in particular, with no significant force to buy all of those underlying securities. Right. The total market indices like the Vanguard total market index had not yet grown to the size that they were exerting significant buying pressure on these names. And so, you know, we went into 99 and just to highlight this, like any

advance of the largest housing bubble we've had in the United States and certainly a very long time, you were looking at situations in which, you know, home builders were trading at half of bulk value and then fell further, right? I mean, things got really, really, really cheap. In March 2000, you saw that reverse itself. And so, you know, I was very fortunate. Our portfolios were up like 168% from March of 2000 through July of 2002 when we encountered kind of our first significant events associated with the recession at that point. And we came out of 2003, you know, up even from those levels. Right. And so just being long and small cap value is enough to actually offset much of the risks that you had associated with that bear market. So I've seen a study or heard a talk once on, if you could go back in time,

what trade would you put on? This was in 08, but same thing in 2000. And he said selling at the money puts was actually the most profitable strategy because so much premium was built into those prices, which seems mind boggling, right? You'd think you would buy the puts. Well, so that was, yeah, I don't think, I think it's counterintuitive, but again, I think it is a reflection of how these things are actually calculated, right? So we had a period of very elevated VIX

from, you know, give or take 1998 through 2004, that again, in my analysis is a function of the indices being improperly constructed, right? So you have these low float securities that were large in market cap and represented a disproportionate share of the volatility in the index, right? That didn't really begin to retreat until they changed the methodology of the index in 2004, 2005. But, you know, we were in an extended period of time where volatility was at levels similar to where we are today through the entire window. Right. I mean, in 1999,

people forget that it was very, very profitable to sell volatility. First it was upside volatility too, right? Two years of upside, four years of downside volatility. Right. That's exactly right. And so that was, you know, that was an aberrant time period. I, I tend to agree with that. Although many of the vol harvesting strategies really didn't exist at that point in time, right? So the popularity of things like call overwriting, etc, has exploded in the past decade, really. Yeah, and I think this talk that

I heard that was circa like 2013, where the guy, his endgame was actually to convince this audience to harvest vol and sell vol yeah that would make sense because yeah the best time period yeah it you know it had a period right from 2013 basically through 2018 there was an opportunity and i was a huge vault seller from 2008 through 2000 from the end of 2008 through you know basically the end of 2013 in large part because vol had been so bid up by the dynamics of the global financial crisis and the changes in regulation that had led to both dedicated vol seekers in the form primarily of variable annuities and very few vol sellers. When I used to go around and talk to people in the period post the global financial crisis

about the opportunities to short vol, because you had things like 10-year variance swaps that were still printing in the mid-30s, nobody was able to execute the trade. I was incredibly fortunate that Canyon Partners allowed me to do that. And it was unusual, to say the least. Did you hide that experience in your interview with Wayne? Did I hide that experience in your interview with Wayne? Did I hide that experience in my interview with Wayne? So you were doing what? Selling vol? No, actually. So Wayne is very similar, right? You know, both of us have looked at the dynamics of what is the return associated with selling volatility. And if you are, there are certainly time periods where if you can identify a

structural feature of the market that is saying, here's why vol is structurally mispriced, either too expensive or too cheaply, you know, then you have the opportunity. I think one of the things that's important about what we do at Logica that's different than what many other people do is, you know, we're trading Delta as much as we're trading vega right we well we will use and we always are running long volatility the objective is not to build a position in the vix or the ux futures or anything else that many other people are doing we actually just look at the options themselves and think that they are mispriced because of the features that exist in the market right so i i allow myself to stay sane by saying I'm still a value investor.

I just transact in different properties, securities. We'll dig into that some more in a bit. So back on track with Teal. So you went to run a macro fund for him? Yeah. So finish up at Canyon Partners. So following the global financial crisis, so I joined Royce and Associates and was recruited by Canyon-asset place. I went into Canyon Partners basically an equity guy, came out primarily as a macro guy, ran their hedging platforms as well as significant sources of short volatility,

whether that was synthetic credit or other types of exposures. And then in 2013, the guys at Soros tried to hire me away from Canyon they said you know when I turned them down I said I already have a job they interpreted that to represent a negotiation and said well would you be interested in running your own firm and I obviously was I've been an entrepreneurial individual for a very long time. Unfortunately, that was an unmitigated disaster, right? Not for performance reasons, but for business reasons. And I think that's one of the things that's really hard for people to understand about

this business is that it's not just about successfully managing portfolios. It's also about managing a business, right? And so we opened this conversation talking about the due diligence process, meeting with investors, the time that's spent on that type of process, the creation of all the legal documents and legal entities and the actual execution and auditing of trades, managing of people, et cetera. That's hard, right? Some people are very, very good at it, but this industry tends to be the dynamics of herding cats. At Ice Farm, I was very unfortunate. An individual filed a malicious lawsuit against me asserting fraud and that I'd stolen all of the investment ideas, etc.

I ended up winning that lawsuit, but it was a pure victory because the underlying dynamics of the industry are that if somebody has sued a startup manager for fraud, nobody can invest, right? You're never going to pass a due diligence dynamic. And nobody wins a lawsuit, right? Even when you win, you lose, right? So I spent several million dollars, put my family through a tremendous amount of distress. And then unfortunately, just as we won the lawsuit, the CIO at Soros left and Soros fired all the external managers that he had brought in, right? So while our performance was at the top of the external managers at Soros, we were just too small. They didn't want to bother with it. And so I was

immediately faced with the dynamics of the economics of the business that I had built became extremely, you know, became extremely unattractive, and I was forced to basically say, okay, I'm going to have to hang up my spurs on this one. Up in there. Yeah. Most of us have in one form or another. And did you get to meet Soros? Have you ever met him personally? You know, it's funny.

I actually never met George. I've met his sons repeatedly. But most of my experience was actually tied in with the CIO and others at Soros. Where do you put his breaking the pound trade in the pantheon of all time best trades? So it really was. It's interesting. So the CIO at Soros who brought me in is a guy by the name of Scott Besson, who's over at Key Square. He was actually the analyst who was behind that position. And so that trade made a lot of careers for a lot of people. And it was truly, truly brilliant trade. Yeah. And part of me wants to pan it of like, was it that was it kind of just basic trend following and they did it at science? No, it was something different i mean you know it's similar we saw similar dynamics with the

break in the um floor on the euro swiss right and you know i think george you know stan has told the story quite well which is that he put the position on he had it in what he considered size and george looked at and said well wait a second you can't actually lose significant amount of money. And if this breaks, you could make, you know, an almost unlimited amount of money, you should really size this up dramatically. And George forced them to go roughly 10 times the size, right? So, you know, I think it was a truly, truly brilliant trade. And I don't think that there was a lot of luck or trend following associated with it. You know, they just did really, really well. Point taken. So then on to back to the Bay Area and Peter. Yeah. So, so took a year off, basically spent a bunch of time evaluating the world as I had seen it to that point. Right. So this is, you know, early 2016, I would say that I was still

very much focused on the idea of two separate components. One was that valuation mattered, right? And two was that, you know, the world was more than capable of losing its mind in a variety of ways, right? Something really important had happened for me at Ice Farm in the period of 2014 to 2015. I had had a view on China that it was stressed and yet we were watching the stock market melt up in China. And so as we dug into that and really tried to understand what was being bought, how was it behaving, we stumbled on the fact that what was actually driving the movements in the Shanghai was that you had stocks that were going limit up without any transactions. Right. And this was one of these fascinating experiences where you realize that what

people were actually doing was trying to put money into China through futures. They didn't want to actually have to do the work of either becoming a QDII so that they could invest directly in China or like lookalike contracts. Yeah. So they went into the lookalike contracts, those in turn, they were trying to buy in China and they just, the transactions weren't actually happening. And there was this constant scramble, right? That insight allowed me to go back

and look at the dot-com period with totally new lens. And to say, look, what actually happened in 96 to 2000 was a by-product of the influence of index investing. And as I dug further and I started to peel back the layers of the onion, I began to develop many of the themes and theories that have powered my investing since. Like Shrek, many layers to that onion. Yeah, I guess I have many layers. I do look more like Shrek the nice man, by the way. But the other thing that, so after developing that, I was fortunate to re-meet Peter Thiel. He had actually been evaluating investing in Ice Farm and was,

you know, dissuaded because of the lawsuit and the distraction. And by the way, I totally understand that dynamic. I don't hold it against anyone. Paul Tudor Jones has a fantastic expression that he'll never invest with anyone who's going through a divorce or a lawsuit. And I completely understand it. It's extremely distracting. So anyway, Peter asked me to come on board in December of 2016. Moved out to California in June 2017 after my kids finished the rest of their year in school and worked with Peter until 2019. You know met Wayne early in 2019 and started the process of you know exiting and transitioning in December 2019 when I then launched the Absolute

Return Fund in January of 2020. And this is what I'm doing. I like it. So I want to go back to Teal for a second. And you were famously or infamously one of the two on record at a conference arguing with the creator of the XIV short VIX ETF saying it was a doom product. And then around the same time, Teal disclosed a big put position in SVXY. And around the same time, you were running that macro program. So what, you got any stories that you're allowed to tell around all that action? So it's actually been very well told, right? You know, this is one of these weird situations where you realize occasionally, you know, truth is stranger than fiction, right? You know, Zero Hedge picked up the story and literally had it almost perfectly, right? Including the recording of myself and Chris Cole getting into an argument with Nick Cherney, the co-founder of Velocity

Shares and XIV. And in that argument, you know, Nick, so this was Chris and I were on stage at the EQ Derivatives Conference in Las Vegas. Both of us were concerned about the short volatility exposures in the market at that point. We told the story of this i highlighted what i called the money tree which is a position in which you were simultaneously short vxx and short xiv which meant that you had a neutral vol position but the vol drag associated with those two components the high volatility drag component which is created when something goes up 10 percent and then down 10 percent or up 10 percent down 10 percent you're still losing money right so shorting those two um had created conditions in which this trade had become extremely large and positioning had become extremely stretched and the beta of the vix itself had begun to morph relative to the s&p

and so when classic tail wagging the dog. Exactly, right? And so when those products were launched in 2011, the historical beta of the VIX to the S&P was somewhere between 6 and 8x, right? So 600 to 800% leverage in terms of that overall position. As we came into the summer of 2017, that beta had risen to 22X, right?

And so the product had roughly three times the volatility levels that it had historically experienced. A 22X beta means that on a 4% decline, the stock will fall 88%. And in turn, the XIV had a force majeure clause that allowed Credit Suisse to unwind it if it had an 85% drawdown. And so that was actually the analysis and was the source of my observation to Nick, which was, look, I think your product's going to zero on a 4% decline in the S&P. And it went to zero on a 3.9% decline in the S&P right and we were all over that writing

blogs and whatnot I had never dug into the prospectus to know that knockout level we were saying the tail's wagging the dog be careful out there you know mainly from customers in our space that were using option seller and you know premium collection strategies and just hey be careful but uh that that to me was the coup de grace of finding that language that was. And so do you think absent your own experience, do you think other traders actually pushed it to that level to hit the knockout? No, no, I don't, I don't think so. And you know,

I think that there were a couple of interesting things. So, you know, based on the analysis that we had done we, you know, ended up taking a large position in SVXY puts. SVXY was a lookalike analog to XIV that was offered by a firm called ProShares. XIV, Credit Suisse had not facilitated the underwriting of options. And so that was at least one of the saving graces associated with it. But the-alike product offered that opportunity excuse me and I know for a fact that we were the largest holders and you know I was actually quite active in managing my counterparty risk by convincing my

counterparties and this is again part of the reason why this story came out as I was I tried to be the good guy and basically say to the people I knew don't hold this risk I know this feels risk-free to you, but this is totally mispriced. You're going to get killed if you hold this thing. Um, and so fortunately they listened to me and that meant I got a lot of phone calls afterwards saying, thank you. Um, and, uh, it ended up getting picked up and it was one of those weird things where, you know, I've been in the industry for a very long time and doing a lot of things. And it's those weird, it's similar to the pound story, right? For Sean Druckenmiller or Scott Besson. When those things happen, suddenly your name goes out and people suddenly realize

who you are, right? And so I was well-known in the industry for a long period of time. Nobody had ever heard my name outside of it until two you know, two years ago, my, uh, if you did a Google search, the thing would come up first as a lawsuit. Right. Yeah. Well, at least you've got this great trade up there above the lawsuit now. So exactly. Uh, and then we wrote some posts around that time too, of LJM was the $900 million mutual fund. That was basically a, I don't know what they were doing, but mostly short ball options.

They were going to dynamically resize and it looked like they just kind of rolled down the exposure and it caught them out on that same day. So I don't know which drove which, but they were both. That's the whole point, right? It doesn't actually matter, right? The causality is, you know, there's, I've guided other people to a book by mark buchanan called criticality right and others have talked about uh these dynamics as well but you never know what straw is going to break the camel's back right but if you have loaded the camel beyond its normal carrying capacity that's not a you know that's not a something to be proud of

right you're yeah that animal's about to die um so you just always have to be thoughtful about those dynamics right and so that was the opportunity set in my opinion like when we did the math we basically came to the conclusion that had a 95 probability of going to zero over the course of two years it was rather cheap to buy those options right it was extremely cheap to buy those options and that's you know the the the underlying dynamic and options people forget this right or you know most we talk an awful lot about the implied versus realized spreads right so most people that are in options are in the process of option arbitrage right so they'll trade relative value ball or they will trade

you know they will Delta hedge their positions to try to capture the implied realized spread. And as many other people have talked about, most of the time options are priced at a premium to the realized levels of volatility precisely because market makers and options realize that they're exposed to these tail risks they need to make, you know, similar to Warren Buffett, they need to make a lot of money on a consistent basis so that they can afford the occasional catastrophic loss. Which I've seen hedge fund decks where they're defining their edge is that options have a premium to realism. I don't know if that's an edge. It's just a fact. That's how most people think about options. I tend to look at options as a source of non-recourse leverage on events that I think have a very different distribution in terms of potential outcomes than other people do. The XIV was just, or SVXY was just the extreme version where the options were being priced as if it was a black-sholes distribution, a log-normal distribution, meaning the higher it went in price,

the lower the probability of going to zero, right? The irony, of course, is because it was an inverse product, the higher it went in price, the lower the underlying price was getting, the easier it was for it to go to zero. And so the right way to think about that distribution was you were effectively funding an increased go-to-zero dynamic, right? So the bottom line was you saw it as a 95% probability and the markets were pricing it as zero or 5% or something. Yeah, exactly. All right, that's the longest bio on record for the pod. We covered a lot of ground there. I like it.

So I want to dig into the strategy a little bit. We've had Wayne on before, excuse me, giving us the Logica elevator pitch, but I'd love to hear it from you and get a little bit of a different feel on how your brain and your experience sees the opportunity and why you decided to join Logica when you could have likely gone anywhere in the world that you wanted to. Well, it's nice for you to say that, you know, for me, the opportunity at Logica was actually to do something really unique on the back of what Wayne had built. And so, as I said, I met Wayne in early 2019, we actually met each other over Twitter, which is, you know, significantly more strange than any other introduction that I've had to a future business partner. I initially was looking at Wayne from the situation of working

for Peter and saying, should we allocate external capital? And as I dug into Wayne's approach, what I realized is that he had largely systematized something that I was doing on the qualitative side, on the discretionary side. So I had looked at equities for an extended period of time as being influenced by this passive dynamic. To me, that meant that it had both upside risk and downside risk, right? The upside risk was the underlying dynamics of a melt-up associated with the continuing bid for passive regardless of valuation. The downside, however, was the other component of that, which is that stocks increasingly were behaving as a single entity. That high level

of correlation raises the probability of the sort of significant risk-off events that we saw in March, right? So everything goes down together. When I looked at what Wayne had built, he had built basically the exact same thing, except he'd done it on a quantitative basis. And this is really important because at the end of the day, human beings on a discretionary basis, particularly those that are intellectually curious, get distracted. It's really, really hard to actually do this on a consistent basis and manage these types of positions if you're trying to do it on a discretionary basis. Wayne had systematized that was really important. The second thing that I noticed as I looked at what Wayne had done was that he had focused long volatility on the traditional framework of downside protection. So the product that Wayne had created was our tail risk product. And in just simple terms,

it had two units of down capture relative to one unit of up capture, right? And so it was skewed to the downside. I looked at it and I said, hey, Wayne, this is a mistake, right? You know, you can certainly fills what you're trying to do here, but the much greater opportunity is to take advantage of the fact that options are mispriced in both directions, right? And so increase the up capture, i.e. buy even more options than we're buying at this point and use that to create an absolute return product which has two features one it has a much larger overall market than the tail risk product it becomes a standalone that is much more attractive to somebody to put into their portfolio and the second component is it should generate significantly higher returns

because i think the core problem is is that the options themselves are mispriced right and it helps limit that bleed on just trying to buy that downside. That was actually Wayne's innovation was that he recognized that he could pursue a value-added and alpha creating upside capture program to offset the cost of his downside program. He had created the equivalent of a low to no cost carry put? Unfortunately, the demand for that is far less than something that actually makes a lot of money on a consistent basis. And so adding the up capture has been-

The investor demand, you're saying. The investor demand, correct. The second thing that I would describe as what we're doing is, I mean, look, we don't know. I guess it should be clear from my descriptions. I don't know if the market's gonna melt up or the the market's going to melt down at any point in time. I think that there are reasons why that happens. I think understanding the structure helps you understand the probability of those events are both higher. It's fragile in both directions.

And that's what we're really trying to do. So we're running a straddle. Our payout looks like a straddle. Our returns look like a straddle. So we show positive correlation to the S&P when the S&P is rising. We show negative correlation to the S&P when the S&P is falling. And that creates a, you know, what to many people would be a confusing return stream that looks very uncorrelated. But it's actually ironic because it's correlated positively and negatively as you would expect in the straddle. Our objective at Logica in terms of alpha creation is raising the quality of that straddle and lowering the cost associated with that straddle so that it doesn't suffer from the high cost associated with running those types of positions as you would normally think of. And I think we're able to do that through a combination of the skills that Wayne had embedded into the system,

as well as an environment in which we just think those options are actually mispriced. And so for you personally, it was, I believe these options are mispriced. All of my experience has pointed to that. Here's a guy who's figured that out and who's also operating on that premise.

Well, the irony was, is that Wayne hadn't thought about it so much from the options are mispriced as much as he had thought about it from the dynamic of, I have a way to defray the cost that doesn't dilute the downside component. So most people who are long volatility are doing so by shorting another type of volatility. So it's a relative value trade. Yeah, which is the classic we see in the vol, our quote unquote spaces, long S&P, long VIX, or short short. Right, exactly. And so the challenge for most of those actually becomes capturing those gains, right? Because simple

example, if you've gone with a put spread as compared to a put, right? Or even more extreme, you've done something like a one by one and a half put spread. Right. Where you have defrayed the cost associated with owning a put by selling further out of the money puts. Right. So you've taken on risk of a very deep decline. The problem there becomes when the market falls, how do you monetize? Right. Because the put spread or ratio put spread has failed to deliver the vast majority of the gains that you would have received if you just bought a put, right? And so it becomes very hard. Tesla in March, I owned the like 300 to 50 put spread in my personal account and was holding and then it whipped right back and yeah, yeah, so and that's that becomes the challenge right when that occurs

your immediate reaction is okay i don't want to sell any part of my put spread you know because i just could go to 100 exactly my time decay will take it you know to fair value right um and so wayne had actually dispensed with that and i think that was really critical the second component though understanding that the actual buying of options themselves now offered positive expectancy was not something that he was fully aware of, but to his credit, the minute I presented it to him, he went, turned around, did the research and said, oh my gosh, you're right. And so, you know, we were able to get the product up and going in record time. That was part of the objective. And we've been just very fortunate in terms of how it's played out.

And explain for any newbies listening quickly, the straddle. So straddle is where you own simultaneously puts and calls, right? And so the most you can... Typically at the same strike? We don't do them at the same strike. There's some... But I'm saying typically a straddle... Yeah, a straddle itself is typically at the exact same strike, right? So you are effectively betting that the stock is going to go in either direction by more than the implied volatility associated with the pricing of the options, right? Most people would manage a straddle by delta hedging, right? I.e. buying or selling futures or the underlying

in proportion to the Delta of the option position. And what you're typically trying to capture then is the pure Vega expression, right? Or how is the volatility priced versus where it's realized? We're actually trading directionally, right? So we're using the options without Delta hedging and care far less about the dynamics of implied versus realized than we do about, you know, the characteristics of how far does it actually move, right? Does it trend effectively? Yeah. Right. And so you can experience very low volatility. 2017 is a perfect example of this, right? You can experience very low levels of realized volatility. But if the market trends

or drifts, those options can actually be quite profitable. Yeah, because you're paying very little for the straddle in that scenario. In a low vol scenario, you're paying very little for the straddle. And even more to the point, you know, if a stock goes up 25 basis points every single day, it's experiencing the same level of volatility as a stock that goes up 25 basis points, down 25 basis points, up 25, down 25. But the one that is up 25 basis points every day, that's going to be a super profitable call position relative to the one that went absolutely nowhere. And so the tail risk program still exists? The tail risk program still exists.

Two times the downside exposure exactly so that's that's very useful for somebody that's running their own long program right that has a long biased portfolio and is looking for something that can provide a form of hedge without the costs associated with the traditional hedge all of our products are targeted institutional and high net worth individuals, right? So you need to be accredited or qualified to gain access to them. You know, our account sizes are over a million in terms of minimums typically. And so like it's a fairly rarefied space, right? The tail risk product is targeted at institutions that are looking to hedge underlying portfolios without the costs associated with it. And how do you think of that in terms of their, what they should allocate or like versus a universal or something or a

Taliban or right. Who's saying like, Oh, just put 1% over here and I'm going to lose it every year, but it may return. I don't know what he was quoted in March up 6,000%. Exactly. 4,000%. You know, it's been interesting because we've had an awful lot of interest from investors who were very angry by that representation, right? Of that 4,000? Yeah, the 4,000%, right?

I mean, look, there were securities that were up by 4,000%, but the portfolio, you have to think about it from the dynamics of exactly as you said, you're going to put down, I believe his number is 3% every year, and you're going to expect to lose 100% of that every single year. And then make it up. I'm like, if you believe that 4,000, you've lost 100% for each of the last six years. Correct. And so it's just not, to me, it doesn't feel like a very honest representation. The challenge that we have, of course, is because we run a much less levered expression of that in our tail risk. You need to allocate more to it, but we don't have the negative carry profile, right? So we work very well for an institution that's looking to do an overlay, you know, where they're allocating a fairly significant quantity of capital, but it's a levered expression. We run the tail risk product with a roughly minus 0.5, 0.6 correlation to the S&P, right? So it is

a very consistent payoff in the opposite direction as you would expect from a put. And it doesn't have the characteristics that you experience with many of the extreme high levered products where you need a 10% or a 20% drawdown before that return starts to show up, right? So it tends to contribute fairly quickly. That's a function of you guys being at the money versus a lot of those other classic tail risks are way out of the money, right? Correct. In our analysis, while Taleb told a really, I actually could show a chart on this, but Taleb did a really good job of telling a story about how the tails were

undervalued. Right. And that was, what's up? Both sides, both tails. Well, so he focused on the left hand side. Right. And there's the, for, for what it's worth, I actually think that that's very true. I think XIV is a perfect illustration of this, right? The history of all the products we have are a history of products that have had successful results up to this point, right? Whether the returns are as good

as we'd like them to be or not, they exist because- Talib's turkey, we call it, right? Exactly, Talib's turkey. That's exactly correct, right? And so there is a left tail event out there somewhere where those tails are mispriced. In the aftermath of 2008 though,

in particular the failure of AIG, a significant component of the provision of those tail, of that tail insurance went away, right, and many on the institutional side are no longer able to provide that type of insurance, right. So the prop desks at Goldman Sachs or Merrill Lynch or JP Morgan that would have historically offered those products and retain them for individual trader P&L now really can't do that. And so the distribution has shifted quite dramatically. SKU has priced significantly more richly post 2008. So there's no one willing or able to take on that warehouse at risk, you're saying?

It's very, I mean, it's rare, certainly relative to what we had with the scale of AIG, right? I mean, AIG was at an enormous scale and there's no player out there that's quite like that today. But it feels like maybe that's somewhat better for the world, right? That maybe they had too much of willingness to take on all that on? Yeah, I mean, the irony is um you know so talk about background i was the the teaching assistant for at at wharton for gary gorton who um did all the uh cds modeling for aig's financial products group right and gary's models were astonishingly good on a hold to maturity basis, right?

The problem is you couldn't get to maturity. You couldn't get to maturity, right? And so as the contracts began to mark against AIG, AIG was faced with capital calls that ultimately they were incapable of meeting, right? It's like the buddy that you had in college who comes to you with, hey, I've got the perfect strategy to go play blackjack

in Atlantic City or wherever, right? You know, you just double down every time. Yeah, martingale. Exactly. Make it a pure martingale, right? And it's like, oh, that's fantastic until you get 32 losses in a row. Where are you going to get the $50 million

to place your next bet, right? And by the way, that's why they have table limits and that's why margin calls exist. My girlfriend, well well i'm married but a friend that's a girl is uh in new york is thankful for all that because she lives in the old aig building they like renovated all that and made it condos it's beautiful there's like a bowling alley and movie theaters everything in the uh just for the residents in the basement the elevators are the bond street building you're talking about yeah that's a great building yeah um yes that was there were benefits associated with that although in the era of coronavirus i'm not sure how how

well those yeah that's likely all those perks are shut down for their six grand a month or whatever they're paying. Exactly. So what, back to the strategy a little bit, what in the absolute return, it still is a long vol product. Like you're still going to perform better when there's expansion. When there's long volatility. Are there spikes in vol or what, how do you view that? So both are positive, right? A spike in vol is always better because the easiest way to think about what we're doing is we're warehousing volatility, you know, building up a warehouse of volatility that

we have sourced. We have strategies that allow us to lower that average cost, what we call gamma scalping, where we basically have algorithms that try to make the decision that, you know, this is not the big move. So let's harvest a little bit of a move and continually add to those positions. Dig into that real quick if we can, because that's the trader's dilemma. If I take off too much and it runs, I have an opportunity cost. How do you weigh that opportunity cost versus covering the bleed, I guess, without giving away all the secret sauce? Yeah, exactly. There's a variety of ways that we cover the bleed. The single most important one that I would just highlight is that we split our upside and downside, both in terms of products and strikes.

Our upside tends to be expressed in a momentum biased single stock framework. Our downside tends to be expressed in the form of S&P puts. And so we remove much of the basis risk. And what we really think you're buying with the S&P is underpriced correlation when you buy near the money. The top side, we are not buying out of the money options. We're buying in the money options. And so you've seen this, obviously obviously because you've studied our returns, but we have a more quick response rate to the top side and more quick response rate to the downside because of the way we've constructed our portfolio than would most in the long vol space. Right. Yeah. June is an example. So, I mean, June, we were fortunate.

And there's no other way of saying this than just the simple facts, like the period post-March. I mean, your commentary on this is probably better than mine because I can only really see a few of the seats that I have transparency into. But being long vol post-March has been extraordinarily difficult, right? I mean, we've seen a collapse of volatility of, you know, roughly 60 points in VIX terms. We have seen the curve re-invert, you know, so it's back to a contango type framework in terms of volatility, which makes carrying long vol positions more difficult. And we've been very fortunate that we've been able to navigate that well, but it's, it's, this has been, you know, the beginning part of the year was super easy. And the second part of the year so far has been

more challenging as we managed through it. It is interesting to me that we seem to be stabilizing in a level of volatility that is consistent with prior recessions, right? So the mode of the VIX, this is actually going into our monthly letter, but the mode of the VIX in recessions is about 23, which is almost exactly where we are right now, right? So, you know, the VIX itself, this goes back to the SVXY discussion, has a bimodal distribution, right? If you're in a recession, the, you a recession, the average is around 30 and the mode is somewhere around 23. If you're not in a recession, if you're in an expansionary condition, the mode of the VIX is like 12. It's really low. We're at that point where the market is basically deciding is the recession over

my high school math teacher had some funny thing with the mode and all apple pie a la mode but i'm not going to remember it now i can't remember it either but i know what you're referring to yeah as we look at 20 plus different long ball managers and it's been not surprising but uh i can't think of the right word, interesting or exciting to see the asymmetry there, right? Like it's been almost as much of a spike down as it was a spike up. But the return, some of them are down, some of them are flat, but there's not, you know, up 40, down 40. You know, there's up 20 to 40 and down zero to five or zero to 10. Oh, that's good to hear. All right. Well, that's the,

so most people then have figured out some variant of how to manage it more effectively. I mean, we have, I've heard worse numbers than that, but you obviously have better trends. Or maybe we're just looking at the really good guys. Yeah. I hope that's the case. I'd like to be included in that. But you know, the exciting opportunity is that we have been able to largely restock and rebuild the vol positions that as you know, we had exhausted in March and have done so without costing our investors anything. And so that's

encouraging. In all candor, it's better than I would have expected we could do. And is that a known blind spot or weak spot in the strategy of, you know, mid-March there, end of March, you monetize a bit. And then if there's a second or third leg down, how do you get into a new warehousing of position? So that is part of the difference for us, right, is that we don't have a crisis, you Is that we don't have a crisis alpha mandate and we refuse to accept that, right? So we're trying to trade for profits. Yeah, yeah. Because if you did, you would buy those at those high levels and bleed to death. Exactly.

And so, you know, again, I don't know some of the more extreme versions of that, but I would guess that a strategy that returned 4,000% in March would not hit the criteria of only down 5% in the past couple of months. I would agree with that. Yeah. Moving on next, this is probably the longest you've ever gone without being asked about passive. Yeah, I have started to joke that my tombstone is going to have to say something about passive on it at this point. That is one of my questions here, actually. We can start there just from a personal standpoint, like, why is this the hill you want to die on? And I said, what did I type up here? Is this what you want on your tombstone or just an opportunity to make

money that you've identified? So I think it's a, I think that there is initially, it was very focused strictly on the making money component, right? That this was an insight that provided opportunity. Unfortunately, as I've dug more more into it like this is one of these existential features of the market that i think we are going to have to figure a way out of it right we created something that we didn't mean to do um and we thought that was innocuous um you know uh easiest way to compare it is you know somebody becomes addicted to prescription drugs right you know initially we're taking them because you thought it was the right thing to do and it was a good thing and suddenly it becomes the dominant feature and destroys all other aspects of your life

unless you get it under control unless you recognize that you know it has severely adverse consequences um that was gonna be my question of like ignore the why for a second. And just, you know, what, why should I care? What's it going to do to us? Like, what's the downside? Well, the problem is, is that we have lost the thread of what markets are supposed to represent, right? And so the reason why we have public markets is to facilitate the process of capital formation. Whether that is in providing comparables for new companies that need to raise capital or whether that is in providing a cost of capital to businesses, a measure of the cost of capital to businesses that want to invest in their existing businesses.

That's what the objective of markets are, right? And so, you know, I've recently taken to helping people understand the dynamics of, stock markets are similar to the phrase that you hear in cryptocurrency, you know, it's proof of stake, right? I am putting my money up into Coca-Cola and expressing my point of view

that what Coca-Cola does as a business is likely going to be a good thing and lead to increased profits and dividends that I can receive in future periods. You contrast that with markets are for providing me a return? Yeah. So the reason why markets are capable of providing returns is because of the performance of the underlying businesses or because people are willing to buy stuff from you at a higher price, right? The idea that I can go into a market expecting a return based on some historical return to an asset class to me just is silly, right? I mean, like nothing in life delivers what you expect of it, right? You know, it delivers what you've either earned or worked for or lucked into, etc., right?

And far too few people, I would argue today, really even think about markets as meaning anything other than kind of a casino. Yeah, I was going to say it's become a gamble. I put my money in there because it does this, not tied to any corporate structure. A hundred percent. For me, one of the eye-opening experiences, I have a niece who, you know, is a drama major in college and called me after she had left the field of dreams that is drama and moved into an administrative position and started to make a little bit of money. And she called me up and said, you know, hey, I'd like to start saving for my retirement. And a friend of mine told me about this really good company that is basically

just a bet on all the companies. I forget the name of it, but the ticker is SPY, right? Oh my God. She called it a company. She called it a company. Right. And I love her to death. She's, she's, you know, 4.0 student and brilliant and really a wonderful person. But like, it's not a company, right? Likewise, people would tell stories about XIV is, it's a company that just makes money, right? Yeah. You know, that's not what these things are, right? right and i tried to get my son involved back in march at the lows i'm like hey you've got these savings these companies are all really cheap you should start looking at them there's an app called loved and so you go through there but it actually forces you into an etf yeah so it was

like what do you what do you what interests you like health care right automobiles yada yada and he chose the cloud tech in the cloud and it put him in some tech in the cloud etf he's done so then i was trying to yeah and i was trying to be like yeah he's killing it he's like annualizing at 80 some percent but but then i said okay but you also know companies out there in the world right like you know starbucks and so then he also chose microsoft and ea sports because he plays a lot of FIFA and MED. So it was exciting. But to your point, like I'm getting, if you're new to this, you'd kind of just get forced down that path into the ETF.

For the vast majority of people, the first experience that they have in the stock market is the withholdings that are done in their first paychecks, right? And so this is one of the points that I make about passive and it's part of the dynamic that's changed so much. Very little of the behavior in stock markets can be described as intentional today, right? It is your contributions are a function of you having a job, your job taking a 5% withholding from your paycheck, that money going into a target date fund that has been selected for you by the HR manager based on your birth date, you know, and some assumption that at 65, you're going to retire. Like, that's what's driving the vast majority of the investment decisions that happen today. But do you have

stats on that versus right used to be you they company hire some investment advisor for 30 bips or something, and they put the menu of eight mutual funds in the plan, and then you choose from those options. Yeah. So the DOL fiduciary rule in 2016, which went into effect phase one in January 2017, had a huge impact on this, because it took what had been a company discretionary process and created liability around it. It changed the rules so that if a company didn't offer index funds that had the lowest cost or that potentially didn't track the best, the language was so crazy that companies became liable,

not just for the excess fees that could be charged by active management, but also became liable for the potential underperformance. But I thought they sort of punted on that rule, or they just punted in terms of making RAs, or RAs are already fiduciaries, but stockbrokers fiduciary. Right. They punted on the second half of it, which would have actually, so the first half of it was that went into effect in phase one in January 2017 was that corporations had to be subject to those rules for all new hires, right? So anyone new that was hired in,

they would have to offer a strict menu of basically passive funds or be subject to this type of liability the that was vanguard and blackrock like lobbying the heck out of that i don't know the backstory there but i'm sure they must have been right well either vanguard or blackrock actually wrote the legislation or you could believe that it was written by the woman who was in charge of the department of labor's process at that time, who was an English school teacher as her background. So I'm fairly confident. I actually know for a fact that Vanguard and BlackRock actually wrote the

legislation. Yeah. Which is standard in energy and the banks. That's how the country works. That's how the country works. Right. I mean, the expertise resides with the institutional and the corporate dynamics and the access that they have because of other donations or a public persona that is very carefully husbanded. You've seen BlackRock come out and say, oh, we're all about ESG.

We're the good guys, etc. That narrative has given them, along with the money that they've generated has given them a coveted place at the table and they're largely in charge of selecting you know what securities are put in front of you um the other i think of it as eisenhower's like warning was it eisenhower beware of the military industrial complex yeah it's the same thing industrial complex yeah it's it's it's literally the same thing. We have an industrial complex. Yeah, it's literally the exact same thing. I encourage people, there's a really good book.

Many have heard of it. Matt Stoller has come out with a book called Goliath, which is a study of monopoly. Other books that have been written on this, The Myth of Capitalism by Jonathan Tepper, et cetera. We are very much in an environment in which many of the decisions that are made are actually the result of regulatory capture. Right.

And they can seem innocuous. It can seem to be in the best interest of investors. And I actually believe that the people at Vanguard believe this, right. That what they're doing is in the best interest of investors, but they also have a very active, you know, they have a very, very active process to deny any impact on the markets, right? They, by definition, they need to be passive. They need to not influence the markets and they are just empirically they are. So let's come back to the why it matters. So it's a problem. Every passive is too big. It's

going to blow up the market. Like what's the what it does is it contributes to fragility. Right. So a robust ecosystem and Nassim Taleb has, to his credit, has done a remarkable job of introducing this language of robustness versus fragility. Right. Anti-fragility. Anti-fragility, he calls it, right? So, you know, the underlying dynamic that we have is as markets become more and more concentrated with passive investors who behave under a somewhat uniform framework in terms of how they buy and sell, they initially supply incredible amounts of liquidity to the market through two components. One saying in just very simple terms, if you give me cash, I'll buy, right? Yeah. And two, they don't hold in any cash so if i put a hundred thousand dollars with a traditional mutual fund versus a hundred thousand dollars with a vanguard etf or index mutual fund the net cash deployment

is going to be greater into the passive vehicle than it would be through the traditional vehicle, right? Explain why that is real quick. Most active managers carry somewhere around 4% cash. Oh, got it, got it, right. So it's just, right, 100% of what you gave me is going into those. Yeah, right. I mean, one of my favorite statistics is Vanguard Total Market Index. It's a single mutual fund that now has about $1.6 trillion in assets across this etf and index forms right yeah it has five billion dollars in cash that seems like a crazy amount of money that's a lot of money right until you realize rounding it's around like that's that's no money right because jim and accounting went home early or something and forgot to yeah it's it's actually more because they took in a couple billion dollars that day and yeah you know didn't have the demands or you know whether that's in the form of dividends

etc but you know so those sort of characteristics actually influence the market um and the reason why it matters is because we're raising fragility and when you raise fragility you increase the probability of events like march right and there's a reason that that happened in a way that we've never seen before. Right. My analysis. But did the, all this passive make it snap right back to like, so maybe it's not that big of a deal. Maybe we add fragility and it goes down. But if I'm right, I look back at the 99, the bubble,

if I put a million dollars in the NASDAQ and it went up to six and then it came all the way back down to two i still doubled my money right yeah so so that is a super valid point and again i think it's it is important to recognize that the problem is of course that one markets operate um so that not everybody who puts in that 1 million ends up with two. Some people put in a $6 million valuation and end up with 200,000. Agreed. I was cherry picking my timeframe there. Exactly. And so, and the other component is, is that we saw this actually with the dot-com cycle right that it um creates a tremendous misallocation of capital because you had a ton of people that you know launched zero value ipos and took in some

individual wealth you know and hired a lot of uh you know network programmers and encouraged a lot of people to go to night school to become you know managers of information systems because that was going to be the future for everybody if you remember back in 99, 2000. And a lot of those resources were misplaced. And so that becomes the problem when you manipulate markets in this way, you change the technology in this way, you change the regulation to favor one type of investor versus another. You can unintentionally, meaningfully change the dynamics of how market prices are actually being used for the allocation of capital. And so your worry is a grand scale 1929 type crash brought on by the passive, by too much fragility. One, basically one trader doing one trade, right?

Which if that goes the wrong way, it creates all sorts of problems. And then also infecting the real world, infecting the real economy. Well, so a really simple example that I would just put to that is Vanguard and BlackRock are measured in the trillions, right? Yeah.

And so let's imagine that there is a very simple realization at Vanguard that the target date funds that they've put together, which are, you know, their target date funds are roughly a trillion dollars, which are, you know, their target date funds are roughly a trillion dollars in total size now across white label and traditional.

You know what? We need to change our allocation to equities. Which is probably a very real conversation right now with yields at zero, right? Correct. How do you put bonds in a target date when they're at zero? Correct. So actually, they have a lot of bonds that are negative yielding because of the way that they've structured their bond indices, right? So, you know, you have those sorts of things. And when they become so large, those seemingly innocuous positions, let's increase equities

by 5%, let's decrease equities by 5%, that has a huge ripple effect through the market, right? That should never have happened, right? Nobody should ever have gotten to the size that that type of choice be the difference between a market crashing and a market melting up. If it's only the two of them exist in the world and they decrease 5% and they read the market would go down 5%, very simplistic example, but as they get bigger, their,

their movements are going to move the market to what they're doing. Correct. 100%. And the problem, of course, is that your measure of elasticity then becomes important, right? How does the market react to the attempt by a giant player to reduce their positioning by 5%? You know, this is the sort of stuff that unfortunately is just now coming out into the academic literature. There's a white paper that's pending out of Chicago and Harvard that looks at this dynamic of what's called macroelasticity. And so the underlying assumption under most models of the market is that the market is highly macroelastic, meaning you can put almost unlimited amounts of money in and not influence prices to any significant degree. The data that's coming out actually is suggesting that the macro elasticity is quite low, i.e. macro inelasticity is quite high. And the data that I've seen suggests

that a 1% shift in allocations can cause a 10% plus shift in prices. Wow. Right? This is super intuitive for traders, allocators, right? We're always saying, what's your capacity? When are you going to get slippage market impact? So yeah, which is, which is phenomenal, right? When you stop and think about it, like if you were to look at, at Logica, you know, we conservatively think our capacity is a couple

billion dollars, right? To pursue the strategies that we're pursuing, pursuing. Here's 1.5 trillion. Will that do anything to option prices? Exactly. That becomes part of the problem also is that you can't just react to how you're going to influence it. You also have to understand that other people are following the same strategy. In the case of Vanguard, BlackRock, et cetera, more than 100% of the money that's coming in is following those strategies. I mean, on a net basis, all of the money that's coming in is doing that, right? And again- It's almost like mutually assured destruction, right? If they don't flinch, it just keeps pushing things always to new highs, new highs, new highs. And that then creates a second dynamic,

which is if you look at the structure of savings in this country and in other countries, right? The simple reality is, is that financial assets tend to belong to the old and the old ultimately need to convert those into consumption. The rules of converting those into consumption, particularly for things like 401ks and IRAs is that it's percentage of the nominal price, the notional value, right? And so as those prices go up, the withdrawals begin to rise while the contributions are a function of incomes, right? And so you end up in this situation in which eventually it overwhelms and you need to take money out. And then there's no mechanism for anyone to absorb that because you've destroyed all the active managers whose job it is to do that yeah so i have two one question on that of like do you get pushback it comes across a little as or does it come across as like oh here's a hedge fund manager

who wants his two and twenty and is upset that vanguard's charging four bips or whatever for the index fund so yeah so so the quick answer is sure i want my 220 um you know and i could care less what vanguard is selling their product for i think that there's a number of things that are really problematic again about how the way about the way that they present that so you know they are not making money really from managing funds at four basis points they're actually making money by lending securities yeah yeah right and so you know etfs run levered right the average vanguard fund is running somewhere around eight to ten percent levered right all of those things matter if you think that there is the opportunity for discontinuous market events similar to what we

saw in march we saw a number of Vanguard strategies, BlackRock strategies as well, but Vanguard in particular, that deviated dramatically from their NAVs. Right. And that was seen in the bond, junk bond ETF, things like that. Not just the junk bond ETF. I mean, actually take a look at something like BND, which is the investment grade and government bond ETF, right? That had a 7% discount to its NAV and 70% of the- Which makes sense in a bond ETF to me, right? Because it's not as easily transactable. I guess BND should be those securities, but-

BND is 70% treasuries. Right, it seems hard to imagine SPY where you could just go trans-acquigate, but that's to your point. Like when it becomes so fragile, it'll definitely disconnect. That's part of the irony, right? I mean, things like the equity ETFs, you know, part of the argument for why they're more stable is because they can be redeemed in kind, right? Instead of

giving you cash, they can actually give you shares. Yeah. Well, you know, I'm somebody who desperately wants to sell my SPY because I think the world is coming to an end and you give me shares. What do you think I'm going to do with those shares? Yeah. Oh, thanks. That's good. I'll, I'll just take the shares to the grocery store. Right. So paper to the bathroom. Yeah. You end up shifting the responsibility to somebody. I mean, imagine that scenario, right? Imagine all these millennials who have never bought a single stock.

Your son is younger and is part of the next generation. And he's in a privileged position because he has a father who's willing to talk to him about what it is. But imagine all of a sudden these millennials that owned VOO are suddenly faced with, okay, here's your Apple shares, here's microsoft share like what do i even do with this yeah jets right was yeah um but to that point right you've got dave portnoy what's his ddg dave davey day trader global and like this is easy just buy these names uh howard lindsen's always out like you don't need these indices etfs just by the top names so do you see any shift from like behaviorally so we're starting to see it in the option space yeah we're starting to see it in the option space in particular and again I think that this is you know like everybody figures out variance of the game as you come to the end of it right um you know we've all we've all played uh you know various board games with people who don't really understand the rules. And as they understand the rules, the game moves faster and faster and faster.

And then all of a sudden it's over. Right. And then you need a new game. But you need a new game. And, you know, I would argue that what you're seeing is people are recognizing you're seeing this in the surge in call volumes. You're seeing this, you know, that people are recognizing that they want to have access to this, you know, sort of unrestricted leverage. Now, you know, the, the dynamics around the, the Dave Portnoy type stuff seem to have calmed down fairly significantly in the past couple of weeks as some of the bankrupt securities headed towards their bankruptcies and, you know, cruise lines and airlines and various other stuff have backed off following, you know, Jerome Powell saying on 60 Minutes, we're going to print, you know, and run the money printer on June 8th. So, you know,

it feels like some of that has gone away, but it generally feels like people are still struggling with the narrative of what is actually going on, right. I really wanted him to get taken out in a stretcher and just lose like 30 million bucks. Not in a bad way. I think he's gained a hundred million dollars. I don't know if there's a good way to do that, but yeah. Well, I think he's gained like a hundred million dollars in advertising out of it, right? So I think he's winning no matter what he loses in the account, but just to show people, because he's literally saying like, stocks only go up, this is easy. Well, and as I've said elsewhere though,

there is a component of truth to that, right? I mean, the dynamics of moving from active to passive, as you've heard me say elsewhere, are that markets really do actually only go up. The only way that a investor, quote unquote investor in the form of Vanguard or BlackRock can be satiated if their model is, if you give me cash, then I buy, is for you to sell them shares at higher

and higher prices. I mean, one of the analyses I was walking somebody through the other day is comparing the difference between a Vanguard ETF focused on small caps, right? So VB is the Vanguard ETF. IWM is the etf that we think of when we think of trading small cap right yeah and one of the measures of demand that you can use is the percent trading at ask right so what fraction of trades are happening at the bid or at the ask right a trade that happens at the ask indicates that there's buying pressure yeah and so somebody is saying whatever you offer it to me at, I'll take it. And if I look at Vanguard products,

they consistently trade at significant premiums in terms of the percent trading it asks relative to the rest of the market. And what that means is that you're getting low cost funds, but you're paying a premium to get into the fund. So it shows up as underperformance for the individual investor relative to what the index

or underlying itself is generating, right? And the ETF price itself doesn't reflect that. No, the ETF price just shows whatever the last transaction was, right? And that's subject to arbitrage dynamics as well. But if you have products that are index in nature that are consistently trading at the ask, that creates buying pressure. Right. Because the market maker in an index ETF is incentivized to create that ETF share and then quickly go out and replicate it with the creation redemption basket that can then be brought to the sponsor. Right. In exchange for

an actual share. And so, you know, those sorts of dynamics are everywhere in the market and are just slowly causing this melt up that Dave Portnoy, you know, has likely identified and said, hey, stocks only go up. Which the iron, I mean, just very quickly, we all know how silly that is, because we just saw a 33% decline. Yeah, it's literally a month after saying stocks only go up. Right, exactly. Real quickly, you're talking about like basically there's all these forces that are just pushing this higher. Yep.

What about the Fed put? So even if everything you say is totally true and this is fragile and we're going to blow up one day because of this, the Fed's just going to come, right? It's known there's what you've said before, there's like 17 trillion or something in it. It's a lot of dough for the Fed not to just come in and say, or government or regulation and basically know these ETFs are all good and all this retirement money is good and we're not going to let it go down. Yeah.

So I'm more sanguine about the Fed than most people are. I do think the Fed can influence things by facilitating the government's belief that it can just print money. Right. And that ultimately is a transfer from the public balance sheet to the private sector income statement. And some of that flows its way back into speculation in the markets. Some of it flows its way back into profits in the corporate sector that then show up as buybacks or various other things. Some of it goes to that CEO at Kodak. Some of it goes to the CEO at Kodak, right. And that's actually a pretty good illustration of some of the dynamics we're talking about, right? Where a company that the vast majority of people had never even thought of suddenly catches a news headline and catches a loan and people who were short it thinking it was going to zero are forced to cover creating additional buying power etc um look i think the fed does something different than most people think right so most people are very focused on the idea that the fed quote-unquote prints money and that then flows its way out into the markets.

I don't think that's what actually happens. I think that the Fed creates collateral. All right. So when the Fed buys bonds or lowers interest rates, what it's really doing is raising the price of bonds. Right. And in a balanced portfolio that is split 60-40 effectively, you know, and I'm just using that as an example, you know, the 60-40 portfolio would see the equities fall and the bonds rise in price. And so it would become a 50-50 portfolio, right? Well, what happens next? You want to rebalance it back to a 60-40 portfolio. And so in the case of Vanguard, and this goes back to the dynamics of passive, the way they try to do that rebalancing is they just divert all the incremental inflows into equity purchases, right? So they don't actually try to go out and sell

bonds. They'll just start buying more equities, right? And so that then causes markets to experience increased buying power and the market begins to go up. Unfortunately, I think the Fed thinks that what it's doing is far more fundamental in nature that it's influencing economic activity, right? By lowering interest rates, theoretically, they're lowering the costs associated with companies that want to go out and make investments or hire people or do various other things, effectively influencing it through the consumption channel or the investment channel. And there's just no evidence of that. There's just, you know, there's just none. As a matter of fact, the evidence is the opposite, that in response to lower interest rates, people end up saving more, not spending more.

That's crazy. And I get my last bit will be, what happens if you're wrong on this whole thesis? Basically nothing, right? We just keep going as we're going. Well, so I think it depends on what you mean by wrong, right? So I would split it into two separate components. Am I wrong that passive is growing as a share of the market? No, that's an empirical fact, right?

Could I be wrong in terms of the influence that passive has and that this is being caused by something fact, right? Could I be wrong in terms of the influence that Passive has and that this is being caused by something else, right? Maybe this is a rational move, right? You know, maybe there's the land of milk and honey is right on the other side of this. It's possible, right? And if that's the case, then I would, you know, I mean, it can go in two directions, right? The securities that we are buying call options on might not be the right securities if what we're seeing is not a momentum influenced melt up. And that would lead to underperformance of our funds relative to others. It would mean that, you know, we don't raise the capital that I think that we can ultimately raise.

And it would mean that, you know, I don't look like a really smart person anymore, which I wouldn't do the first time. As I said, you know, at the start, I've been the dumbest man alive before. So it's easy to go up from that. I'd get that frame. But it's not like you're going out and right, quadruple levering and saying this is happening next week

or next month or next year and saying like we're buying all these puts because this agility brought on by passive is going to blow everything up yeah i i would say the exact opposite right i mean yeah you're identifying it as a force that you need to be cognizant of yeah i would think about it more as a like the way we describe it internally is it's it's a right? And like the value factor, and I think it is the factor. I think combined with the influence that the Fed has in terms of its reaction function via what is commonly called the Fed put, but as I pointed out, I think is misdiagnosed in terms of its dynamics. I think those are the two most important things that are going on right now.

For sure. The other uncertainty, of course, is the dynamics of the fiscal support, which is making its way through incomes. And we are seeing the dynamics of increased incomes associated with a variant of universal basic income that's kicked in. That's going to be an interesting question. Do we continue and maintain that after this? Or do we have to go through periods where we decide we're going to be quote unquote fiscally sober, right? You can already hear, this is, we wrote a piece in March, which I know you're familiar with,

that hypothesized that people were very, very bearish and very concerned because prices were down and yet we may not have fully understood why that was happening And therefore we wouldn't fully understand when prices went back in the opposite direction, which is what we thought was going to happen. And I think that's largely true. People are looking around and saying, well, the stock market's at new all time highs. Clearly this must be Jerome Powell or this must be, you know, you know, the start of a new wonderful world in which stock prices only go up. Right. Yeah.

I think it's more of this concept of we've accelerated the tech shift in the next 10 years into these 10 months. I think that's possible, but if that's the case, if people believed that, then what you would actually expect to have is lower valuations, not higher valuations. Because you would have pulled forward. You're accelerating that growth to now. Right. Instead of a steady stream of growth.

Right. And we see the opposite. Right. We actually see growth expectations. The S&P, you know, sales yield, price to sales has hit new all time highs. Right. People's expectations embedded for growth have actually gone up. And I just think that's silly. Yeah. It doesn't fit a fact based narrative is the easiest way to put it. embedded for growth have actually gone up. And I just think that's silly. Yeah. It just, it doesn't fit a fact-based narrative is the easiest way to put it.

Right. This has been interesting. We've hit a lot of stuff. Let's quickly go through some of your favorites like we like to do here. You're kind of a foodie, kind of a cook in your spare time. What's your famous meal that you cook or what's your favorite thing that you cook? My current top of the charts is probably my carnitas. I make a really, really good carnitas. All right. What's it going to? Soft taco? Burrito? It starts out as soft tacos, ends its way through nachos, into soups and everything else. Oh, wow.

When you make carnitas, you make a lot of it. It's got a multi-purpose. Exactly. And then we were talking a few weeks ago, your son's a big swimmer you got a and you were a swimmer i was i i was a swimmer like back in the stone ages i think i was wearing one of those wool striped suits right um so favorite favorite olympic swimmer uh i mean it has to be michael phelps but um that's one of my favorite uh the longest putt ever drained in competition is michael phelps like 158 feet in a pro-am in scotland no way yeah that's crazy the video it's awesome it's

like eight seconds it's on the green you're just counting like that is crazy wow no i mean you know what people uh what i love to see in my youngest son, and I have three children, all of whom are amazing. My younger two are very serious about their athletics. And the thing that makes me most proud is what they're most focused on is actually the effort that they put in, much more than the output. And they've been both very fortunate in terms of the output. My daughter is committed to Division I. She's actually committed to Penn for Division I volleyball. My son is heading to Division One, she's actually committed to Penn for Division One volleyball. My son is heading the same direction for swim.

Hopefully they get to play and it doesn't get canceled, right? They're starting to cancel some of these non football sports. And what year were you at? Well, we'll talk about later. We might have a common friend, but favorite billionaire you've worked with or managed his money, if you're allowed to say. Well, I have to say Peter. I mean, look, I've been very fortunate to get to know a number of people. You know, I'm extremely fond of Mitch Julius and Josh Friedman. You know, Peter is an iconoclast and a brilliant, brilliant thinker. And I'm incredibly thankful for the opportunity that he gave me to develop a lot of the thought process that i put forward you know via logica um so i've got his book on my what's his book zero to one or something zero

to one yeah i haven't found my list um favorite tourist spot in San Francisco? Probably, I mean, I would say either the Golden Gate Bridge or Coit Tower. I've always been partial to Coit Tower because of the dynamics of the Work Progress Administration and the paintings that are in it. So if you've never been inside Coit Tower, it's incredible. Where's that? Up on the hill there? It's up on the hill. It's the Greek slash Roman architecture that the inside of that is actually painted with the Work Progress Administration artists. And so in the 1930s, part of the WPA was to offer employment to people in Medici time would have been thought of as patronage right and so you had these incredibly talented artists that were working for the government

you know painting these incredible murals yeah we need more of that um and lastly favorite Star Wars character oh boy um I'm not gonna be particularly, probably Han Solo. Han Solo, I love it. I'll take it. Can't get much better than that. We had a guy from China who said Jar Jar Binks. So as long as you don't say that, you're winning. I think that says so much.

But anyway, a character that didn't really exist that everyone else hated. Yeah, exactly. He's like what's that guy's name like oh boy uh well thanks mike this has been fun um jeff yeah all right i'm coming to get some of that carnitas next time we're out there excellent i look forward to it all right take care 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,

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