The Derivative - The principles of VIX trading with Alex Orus of Principalium

Episode Date: April 9, 2020

In this episode we're diving deep into VIX futures and using that instrument to gain convexity in a portfolio, we chat with Swiss hedge fund manager Alex Orus of Principalium who have a three pronged approach to trading volatility as an asset class. Our topics include  Swiss country music, personifying your trading models, the volatility of volatility, Roger Federer, negative interest rates hurting Europe’s youth, Jeff’s pop-up helmet invention, the good old days (2010) in the VIX, and why convexity matters. Take a Listen! Principalium Capital AG’s Volatility Strategy operates across three facets of the volatility trade:  1. collecting the roll yield premium present in the VIX futures curve, 2. Positioning the portfolio for spikes in volatility during a market crash, and 3. Capturing the mean reverting properties of volatility. The strategy systematically adjusts exposure to these different concepts dynamically, by combining 25 different individual models on different time frames applied to each of the three facets. Follow Alex on Linkedin Follow Principalium Capital AG on Linkedinand check out their website 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. And that's the interesting thing about volatility, because it's the only asset class that we found, it's not the only, but we found it to be an extremely efficient asset class for that convexity trend. Because volatility massively negatively correlates that. Long volatility massively negatively correlates the worse it gets exponentially.

So that's the convexity that we talk about. So I talk about, if I put it into one sentence, we are not a hedge, but a convex hedge with a carry. That has a mean reversion component too. Bienvenido a Miami. You're listening to The Derivative by RCM Alternatives, and I'm your host, Jeff Malek. Our special guest today is Alex Orris, who's half Spanish and half Swiss, thus the intro. Alex is the founder of Principallium Capital, AG, and 20-year market veteran, and more impressively for our purposes, an 11-year veteran of VIX Futures,

which has to be one of the longest track records around in that space. Alex started Principallium eight years ago and has just launched a new program focused on volatility trading. So let's get right into it. Welcome, Alex. Happy to have you on. Thanks, Jeff. It's a pleasure to be here. We walked into the studio here and you said it reminded you of a Nashville recording session. What's that all about? You're a musician? No, no, no. it my wife who's Swiss she did a couple of recordings in Nashville and so I went to see her a few years ago why she was recording so it was a lot of fun yeah so it just reminded me when I walked in about you know she's

a music star yeah well you can so, but basically limited to Switzerland. Okay, that's not nothing. And so you're in from Zurich, and tell us a little bit about what's going on in Zurich. We were just having an interesting conversation about you being in the militia. Yeah, sure. I mean, as you know, we have a militia, military, and I gave up most of the things that I had, the gun and everything else, you know, a few years ago. But when I was 23, I basically did some basic training and every two years I went for three weeks. So it was quite an interesting time.

It just reminds you that it's nice to have a house and, you know, some food and it's warm. When you're out there, it's quite cold and it's a different lifestyle. Do they train you on skis? There are different parts of the army that has, you know, the mountain green berets that are on skis. I was with the tanks, with the green berets and with the tanks. Nice. So that was fine. We had the M113, I recall,

and we had some of the large Leopards from Germany. Those guys were... So some American tanks and some German tanks. Exactly. There you go. The best of both. Absolutely. And so Prince Pallium is headquartered in Zurich? Yeah, we're headquartered in Zurich.

A small little town. We have two locations. But yeah, we're located in Zurich, Switzerland. What's the other location? It's about 20 kilometers away from Zurich. We have a second location. I'm going to have to come visit. And so how did you get into the hedge fund space?

What was your background before you started trading? Well, I started my career in building software. And then after 10 years, I went into the asset management world. I was always fascinated about information technology and the application of that to the asset management world. So I started working for some companies like State Street Law Advisors on the indexing side, moved over to a company based in Boston, GMO Grantham Mayo & Outlaw. That was a great experience working alongside Jeremy Grantham.

Yeah, he's a legend. Absolutely. It was fun. He's a superb guy to work for. He looks at the world in a very different way, very long term, fundamental. So that was great. But in 2009, I basically decided to start my own hedge fund. So that was Blue Diamond Asset Management, and what I basically started off doing was combining some of the fundamental valuation things

that we were doing at GMO with Momentum, so it was a global macro fund. One of the ideas I had there was that we were looking at LIBOR as being the benchmarks of a lot of these absolute return portfolios. It just occurred to me that it would be more interesting to look at inflation as a benchmark. So we started a Swiss real return fund that had Swiss inflation as its benchmark. Because if you think about it, at the end of the day, what the investor gets is inflation minus cost. And there's also a currency attached to it.

So it was a great idea. Most people are just using LIBOR as a proxy for inflation. Yeah. Why not use inflation? Well, nowadays with negative interest rates, I think the theme of inflation has been put, you know, put to rest. I don't think so. I think we will at some point in time go back to to have inflation. But certainly, you know, if you look at, you know, I think we will at some point in time go back to half inflation. But certainly, you know, if you look at, you know,

I think we have, what, $18 trillion of fixed income, which are in negative interest rate territory. Which, you know, if you think about what we did at Blue Diamond in 2010, what occurred to me was, okay, if I put on my fundamental hat on, I looked at markets, we created one of the largest bubbles in fixed income. Not you personally. No, not us personally. And equities were richly valued. That has gone on for a while now. But what we did in 2010 was

we thought about which asset class could be interesting in a market where the two major asset classes, from our perspective, were overvalued or on their way to being extremely overvalued. And that was volatility. And we definitely thought there was an opportunity.

We thought that the markets were going to be a lot more volatile. And we thought that it was an asset class that was totally different than the equity and the bond. So the drivers of returns of the two asset, of volatility are different. If you look at equities, the drivers of the equities will be fundamental valuations or whatever, you know, all sorts of indicators. If you look at the fixed income, it's the macro side or interest rates.

But if you look at volatility, it's different. It's just a different market, different asset class with different return drivers. I never knew that before. So Blue Diamond had a global macro bent in the beginning? Yeah, we started with that. But then very quickly, we thought that volatility in 2010 was the asset class that we wanted to specialize and focus on. And so that were separate funds or it was all a new...

It was two separate funds, but we basically stopped doing the Swiss re-return. And we focused fully on the volatility, on the volatility strategy. And then you guys ran that up to pretty big numbers in terms of assets? It was a strategy that closed at $450,000, or close. And, you know, we didn't feel that we could manage more money. But in 2013, I decided to part ways with some of my partners there and started to continue managing volatility with my own money and we started Principallium in 2000. And the breakup was amicable?

Absolutely. Yeah. It was setting up a hedge fund in Switzerland and I think in general in Europe is a costly endeavor, especially from the regulatory perspective. You need a lot of seed money to start a hedge fund. And the regulator in Switzerland and in Europe,

it's very costly. You need to have a lot of people on your payroll. In that, basically, I was looking for external shareholders. And those shareholders over time, you know, took over a very important role in the fund. So I decided to part ways with the guys there. But they continue to be extremely successful. Yeah, and they've kind of grown along with the volume in the VIX.

Absolutely. I think when we first started, you know, VIX futures started in 2004, if I recall correctly, and we were some of the first managers really taking advantage of or exploiting the risk premium, the curve,

and playing the volatility. In 2010, you know, things were, you know, calm. There was a risk premium of, you know, five, 6% every month that you could pick. So, but over time, you know, the, I think the space has become more crowded. Yeah. I was going to ask, what were those early days of VIX trading like? A lot of fun. Kind of the Wild West? Absolutely.

Not the Wild West, but it was fun because it wasn't a crowded trade. 2010, you know, it was much easier than I would say today. Or, you know, obviously the last three years, we've seen a very different and more erratic, more technical pattern on volatility. And I'm sure we can discuss that too.

Yeah, and what were the early, was that one of the limiters when you guys first said, hey, this is a good looking asset class, but what does the volume and the liquidity look like? Was there a period where you had to get comfortable with that? Absolutely. I think volumes increased massively at the CBOE. But those early days, you know, you would be able to not to trade the whole curve. And that was the issue.

You have nine future contracts of future volatility, and the first three contracts are basically liquid. After that, you have to be careful because the liquidity diminishes quite rapidly if you go to the fourth, fifth, and sixth contract within the VIX spectrum. And I always consider VIX futures, I call it a quadribative, not a derivative,

because it's a futures on an index that is an index of options prices on an index that's right there's four layers to it that's right so so basically uh if you look at vix vix is just a you know a lot of people call it the fear indicator so it's a it's non-tradable uh so it's an indicator that is basically made out of strips of calls and puts. So it shows you what, you know, currently the market thinks about, you know, what the volatility is currently. And then on top of that, you have these nine futures. And then you have also options on the futures. Um,

so what we traded, uh, in 2010 were the futures and we traded the entire curve, uh, more or less. And when, when did VIX futures launch? Uh,

fix VIX, uh, uh, futures launched in 2004, 2004. And the index itself had been around forever. Yeah, there was a different version of the VIX prior to that. Was that when the version switched, when they launched the futures? Yeah, that's when they launched the futures.

They basically changed that, yeah. And what is the reading of 15 in the VIX? It means what? So the rating of 15 in the VIX as an indicator, basically, is what currently the market thinks the volatility will be. The first contract is the future 30-day projection of the volatility. We call that the implied volatility that Mark is going to be in 30 days.

But people get, it's an annualized number. It's an annualized number. So Vic's reading of 15 is saying the market is expecting annualized volatility of 15% a year over the next 30 days. Exactly, correct. Got it. I think people often get confused with that of,

is it 15% this month? Yeah. Correct. Got it. I think people often get confused with that. Is it 15% this month? Yeah. That's a lot. Yeah, exactly. Exactly. Okay. And so then you came back and left Blue Diamond, started up Principallium. Were you getting bored or what was going on?

No, it was, I think in between I continued to manage volatility. I also started looking at allocating my money to other hedge fund managers. And towards the end of 2018, I met my business partner, Carlos Prieto, who is a short-term algorithmic trading expert based in Spain. He may or may not be in the room right now. Exactly. I think he's in the room. Anyway, so we met. And one of the things that I saw in the markets for the last, you know, prior, you know, starting in 2015, right after the elections, the Trump elections in the US, we, I felt markets were going to be more technical, more, more erratic,

regimes much quicker. And obviously, you know, we experienced the emergence of the tweet. And so I think social media and the tweets made markets very different. In addition to that, I would say also that the short-term algorithmic trading houses have become market makers. And so they're scalping anything that's out there. And so that also contributed to this more erratic move of volatility of the market. So I guess it was destiny to meet somebody that was an expert in the short-term algorithmic trading space, combining it with my 10-year experience trading, you

know, volatility, and merging the two disciplines. Just quick on Carlos, we actually had known about him. He had come over and done an Emerging Manager Expo and I think was part of a contest there. So yeah, we had our eye on that strategy as well from the RCM standpoint. So interesting that you as an investor were getting interested as well. Absolutely. I was, you know, I was, I was giving a speech at a conference in, in Zurich and Carlos approached me and we have a common friend that's also in Zurich. And then he said, you know,

he asked me what I was doing and I found out that he he had been uh trading a quite a successful cta uh over the years and i said okay i'm i'm looking for somebody that that has that know-how uh because we need to re-engineer the strategy uh if we you know if we want to go to market with a strategy we need to re-engineer it now and then was he in switzerland he was just for that day i guess he was just visiting uh coming to the conference um i was going to say you'd have the two spanish-speaking people in switzerland absolutely i'm as you know i'm half swiss half spanish and uh he's uh spanish and uh obviously uh we we i was able to practice my Spanish again and then so now did you did he move up to Switzerland he's he spends quite a lot

of time in Switzerland we he's going to be moving with his family in the coming months he's gonna be there based in Switzerland. We also have one of our colleagues too in Spain, in Valencia. He's one of Carlos's alumni. Carlos also teaches a postgraduate course at the Complutense University of Madrid. And so that was one of his alumni. So Carlos continues to be a professor there for that program. So I asked Carlos, is there anyone that you think we should be hiring?

So he said, have a look at this, have a look at Vicente. And so we hired him uh in december of 2 219 and what are what does that research process look like so then you said hey the markets are getting a little choppier i still know this fixed trade pretty well i need to marry those two together what did we'll get into the strategy now and just what did that early look like and what does it look like now? Well, I think early on what we were doing at Blue was and what I've been doing, you know, until I met Carlos was a Vol-Arb strategy that basically was pattern recognition on the curve, on the term structure curve.

And I'm sure we'll talk about what that that all is but it looked at the volatility spectrum and basically extracted the risk premium that's embedded in the volatility curve and what changed then in we started we started looking at re-engineering in December 2018. So the research process was basically on a piece of, I recall that fairly vividly, we took a piece of paper and Carlos said, well, tell me how this thing works. How's the curve move?

How does volatility move? And he wrote it on a piece of paper and I said, well, this and that and that. And, you know, he went back home and he kind of like started adding the technical factors that he had. He'd seen over a thousand models and he knew exactly what he needed to do and so we we arranged a neat

strategy and restarted in March 2019 to manage my prop money and so yeah we mentioned term structure and the curve if you want to just spend a minute explaining that for anybody that doesn't know sure um so how you view it sure the. The term structure curve obviously has, you start with VIX with the indicator, call it the spot. And then you have nine futures, which are basically showing you what the expected volatility is

for one, two, three, four, five, six, seven, eight, nine months out. And when the future volatility is higher than the VIX, so the first contract is higher than the VIX, second, third. And so we call that a term structure curve that is in contango. So when markets are going up, obviously, investors' fear is reflected in the curve that they expect volatility in the future to be much higher than realized volatility so that's that's the contango

you know curve and and the opposite of that is the the backwardation that is when markets start selling off VIX will jump up volatility will will jump up, and the entire curve, especially the first contract, second, third, will start moving up exponentially. And so VIX backwardation curve will have VIX higher than the first contract. So the first contract will be lower than the VIX and the second and third and so on. So that's what we call volatility. So what we basically look at is how this curve moves, how the different volatility regimes, you know, move,

and we extract certain things out of the curve. So what do you feel is the natural shape of the curve? More than 80% of the time, the curve will be in contango, which, you know, should be reflected in markets going up. So, you know, most of the time markets are going up. So therefore, you know, implied volatility will be higher than realized volatility. And that's why the curve is is in contango so that's the

natural state of the curve and does that also reflect time value of course yeah so just naturally the options nine months away are much more expensive because they have that much time value embedded absolutely um and even without the time value you would expect i kind of know what's happening in the next 30 days i have no idea what's going to be around in the next nine months so i need to build in a little yeah it's what the market players expect the volatility to be in the future right at the end of the day it's it's a reflection of demand and supply of you know what the future volatility will be. But there is obviously embedded in the curve

is what we call the volatility risk premium. So it's the insurance that people buy going forward. So the further out you go, the more uncertainty there is, so the more insurance people buy. Yeah, the costlier the insurance. Exactly. It's the cost of insurance. And what are your views on that?

Is that still around? Like seems 10, 15 years ago, there was, you know, that institutional money just kind of blindly buys these puts. And you could, a simplistic approach would be to sell them those puts and collect the premium. Absolutely. That's, you know, I mean, we always talk about the market being short. That's, that's, you know, I mean, we always talk about the market being short.

That's, you know, 10 years ago, that was there, that premium was there. So we were making, you know, certainly quite a lot of return. But over time, that's been a crowded trade. And so the minute that premium appears, there's a lot of people being short vol and basically taking advantage of, or, you know, getting that premia. But that, when you say it's a premia, is it because they're overpaying? It's usually, it's the uncertainty of the future where people buy insurance or a premia.

Right, but in theory, the option price should be mathematically the expected outcome, right? In theory, yes, but that's the human psychology the human psychology basically has you know if you look at behavioral finance you know you have this risk aversion human beings are you know you know afraid of the future so therefore there is a natural there's a natural reason why people buy insurance. It's like car insurance, right?

So most people are overinsured, right? And obviously that's why insurance companies make money, right? If you think about it, it's the same thing with volatility. Most people overinsure themselves because they think that the event is going to happen. Now, here's the thing, right? You can collect this and collect and collect and be short vol.

But if you look at 2018, then you get the spike and you may lose everything you've collected. So we don't, the aim or the objective of what we do is to basically say if the weather's nice, if the premium's there, we'll take it. We'll hedge ourselves, but we'll take it.

It's not being greedy. I think a lot of people have been in the past too greedy. I think you have to have excellent risk management on that trade because things can happen and spikes can happen at any time, especially now. Obviously, a tweet will set that off within minutes. You're too late. If the curve, if the market's down already, A tweet will set that off within minutes. You're too late.

If the curve, if the market's down already, it's too late to put on a position. You have to early on put a position. And so I'm going to come back for a second. That risk premia, or it's not even a risk premia, but just the value of that short VIX trade is, right, it's always there. It's just when is it overpriced? When are they overbuying the insurance or overpaying for the insurance is when ideally that's when you would be selling it to them. What we do base is that's where the real premium is in that over, you know, selling it to him for an elevated price.

What we do, though, is we go along with the market, which is one of, you know, an additional market player, a manager extracting that, you know, but we hedge ourselves. We hedge ourselves with the underlying in a very dynamic, algorithmic way. Because we know that the game might be over at any point in time. So that's part of what we do. It's very technical, the way we extract the premia. The second thing that we do, which is basically the most important thing that we do,

is when there is, before, there are some indicators as to when the weather starts, when the clouds start showing up on the horizon. And that is when people are complacent, when people say, well, nothing's going to happen, and there isn't that much risk premium in the front. So there's not much there. And that's when we basically, ahead of this storm,

always are what we call long volatility. So we'll be doing the reverse trade. So we'll be long in the front. We'll finance that with other instruments because there's always a negative roll yield in the curve. So if you're a long vol, there's no free launch. If you're a long vol, there's always a negative roll yield. But when that negative roll yield is not that big

because there isn't that much premium in the front, we'll be long there. We'll be long. We'll be waiting for the storm. 90% of the time, nothing will happen. So that trade doesn't lose much, but it's in early. But when something happens, when the turmoil comes, when the sell-off comes and the spike comes,

we'll be in with a long vol position. And we'll be making quite a lot of money on the way out. Let's talk about that, because it's not necessarily the roll yield, but the contract, even if you're in any month in the VIX, is naturally declining, right? Correct. So you have two factors there that are, if you just want to own long vol, you just want to buy the VIX and you can see that in all the ETFs that are down, you know, the long VIX ETFs are minus 99.9% since launch.

Yeah, exactly. They have to, A, roll, and B, it's naturally declining over the 30 days down to spot. Correct. Absent any event. There is a negative roll yet. So again, there's no free launch. Otherwise, you just buy your long vol all the time and you just wait for it to spike.

So there's always, you know, there's always a counter tendency, meaning that there's a negative role. So your long wall position will get eaten up over the years. And that's, you know, if you look at the industry nowadays, you know, if you look at the last 10 years, we've had a bull market, you know, unseen in history. A lot of people made money with short volatility or being long equities. That, you know, if you had a strategy that just continuously is in the market, like you say, with an etn that's long volatility um you lose your shirt because that that decay just eats up and eats up and eats up your your long volatility position so how do you guys solve that problem so you said you're financing it with some other instruments what does that mean without giving away too much of the sure no. Sure, no, it's a good question. So first of all, we're not in all

the time. We're just in when we see that there is an opportunity that the markets may reverse. So, and this is where, you know, my partner's know-how comes into place, which is you have to have some algorithmic know-how of intraday trading, right? So when we see that there is an opportunity to be long volatility, we'll go long in volatility. 90% of the time, it won't happen. So since it doesn't happen, and it's a fairly symmetric type of relationship, our hedge to that position,

then you don't lose much. Then you're out again. And then the system or the strategy is just looking for the next opportunities, basically saying, okay, we'll just wait. Maybe we'll have again risk premia, the curve will mount the opportunity again, and we'll go and capture that again.

So the one thing we do is, it's one strategy, but it's always looking at what is the volatility regime that we're in? What's the opportunity? If it's nice weather, we'll capture the premium. If we see that the clouds are rising we can go long vol wait for the spike for the sell-off and then the other thing that we do is basically volatility is mean reverting so um you know after you know a spike or an event you always have a return to normalization. So you mean revert. And so the third concept that we basically deploy

is the mean reversion of volatility. So the interesting thing is without forecasting volatility regime or timing, which neither me or Carlos has any ideas. We tried for many years, but market timing, I think, is left for others. So we can't do it. So without forecasting regimes or volatility, how do we basically capture, I would say, a big substantial amount of regimes, volatility regimes, right? We're going to capture the 2008 type of thing, which is a larger event where, you know, you have three months of sell-off, four months of sell-off. At the same time, we wanted to

capture the spike that we had on February 5th, 2018 or October. So how do you do that without forecasting regimes or working with some sort of filters? So what we decided to do was to basically diversify the three concepts into different time intervals. So there might be a system, we call them systems, and there might be a system that is basically extracting the premia, looking at the market at every 15 minutes.

There might be a system that's looking at a reversal that can happen in a couple of hours. So by diversifying time, having different time frames, slicingifying time having different time frames slicing those ideas into different time frames into different systems there's about 20 25 systems we have been able to look at different or and capture different volatility regimes. And those three... Ideas? Three strategies? Or no, 24 systems. So you're saying the three...

Concepts. Concepts of vol trading are one is collecting the premium. Yeah. Two is being there for a spike. Yeah. What's the third? Long volatility.

And the third one is mean reversion. Mean reversion. Got it. So on a spike, you want to be selling into a spike. Exactly. So, but you can think about, okay, the weather's nice. We're in contango.

We see that there's complacency. We see that in the front, being long-volatile is not very costly. We'll go long. Sell-off comes, ideally. And then we have the third Sell-off comes, ideally, you know. And then we have the third concept that's saying, okay, maybe we'll go back to normalization, so therefore I'm going to come in.

So you can think of these 20 subsystems basically entering. They all have a turn to enter when they see their opportunity. So there is a mean reversion system that basically looks at market reversals, which are very quick. So he'll get some budget, some exposure just to do that. There is one that says, okay, I am in a one-month sell-off. I got my trending lines are going down, so therefore we start shorting the market.

So by diversifying the timeframes of these ideas, this is how we found that is the best best best way to to capture as many of these different volatility regimes as we can that's hard for a lot of people to wrap their head around myself even a little bit of you're basically saying you're long and short volatility at the same time uh i'm saying that in the different models yeah I'm saying that each one of those 20 systems is going to take a turn when it sees the opportunity. But they could all be active at the same time? They can be. Some of them can be active at the same time.

But you're not going to see a risk premium extraction concept or system being in there and have a SPY concept take into effect. You may see still some risk premium trades, which are small, and then you'll see some long volatility. So you might see a combination of those. But the strategy is adaptive to the changes of volatility regimes. I think that's the investor's worry is, okay, I get it, you're going to be long, you're going to be there for that spike,

you're going to finance it with some short volatility. And the concern is, how do I know that you're going to be in the spike and that the short volatility component is not going to get run over? Sure, that's a good question. So think of it primarily as a net long position. And if nothing happens, it stays there, right? And it will not stay forever. If it sees that, oh, wow, markets are going back to normalization, it gets out. That convex position, that long vol gets out right away. It just gets out.

But in the meantime, because a lot of people fear a spike, and most of the time we're in with the long volatility, being financed by not the front month volatility, but some other second or third contract. So think of it when things really happen, when the spike really comes, the first contract will move much more than the second contract. So the first contract has a volatility just of 80%.

And the second really on average. So the second will have a much lower volatility. So yeah, when the spike comes, the first one makes so much money. And the worse that the sell-off is, the more money that first position will make, will lose a little bit on the second and third. But it's there because 90% of the time,

it doesn't happen. Right. So the basic trade there is long the front month, short the second and third month. Yeah, you can think of it, it's just a risk measure to have a second short or third short to finance that when we're wrong about it.

But what we don't want to do, touching wood, is miss it. So we much rather... We are a manager that is basically... Our objective is to be complementary to your 60-40 portfolio, to your equity portfolio. Why should you pay a manager the fees

to belong equities or short vol, right? As you pointed out, you could buy the ETN and it's much cheaper than doing that. So we are a complement to that portfolio, to a 60-40 portfolio or to an equity position because we are not only a hedge to that equity position, but when the spike comes or the sell-off comes, we have a very convex position, very positive convex position. Meaning you'll make more the further down it goes.

Exactly. Exponentially. And that's the interesting thing about volatility because it's the only asset class that we found, it's not the only, but we found it to be an extremely efficient asset class for that convexity trade. Because volatility massively negatively correlates then long volatility

massively negatively correlates the worse it gets exponentially so that's the convexity that we talk about so i i talk about if i put it into you know one sentence we are not a hedge but a convex hedge with a carry that has a mean reversion component too if you want yeah i'm probably yeah and so does that mean reversion component cap your potential upside that mean that reversion component because of the technical algorithms that are embedded into it, usually what they do is they dampen a little bit the risk of a reversal, of a normalization that can happen extremely quickly, for instance, or less. So to give you an example,

let's say we have our convex position, our long volatility, so we might be paying contracts long in the first spike comes in uh like february 5th for instance the the the mean reversion component will uh maybe put in three contracts towards the end of the day uh that might be short so your net long will be seven. So it's kind of like a profit taking, but only if the mean reversion sees

that there is a reversal in the market. So it will look at your, you know, very sophisticated technical indicators that will look at the market and say, is this really, is there a reversal here? And then we'll put that position on. If not, it will continue. We'll let the position.

But you're not going from long 10 to short 10. No. Right. That would be the danger of VIX goes to 40. You totally mean revert. You go to short 10 and it continues to 80. Absolutely. You're in trouble.

The challenge we have, and you're pointing out to a little bit of the challenge that we have is when the market goes back and forth, back and forth, back and forth, back and forth, back and forth, right? There's a tweet in the morning, there's a counter treat in the afternoon. So the market goes up, then it goes down, then it goes up, then it goes down. And that is a challenging environment. I think it's challenging for everybody, but that challenges us.

And so what we've done there is try to mitigate some of that challenge with things that are off the curve that are very, let's say, very tactical. They're switching off and on, but on the underlying, on the S&P 500. And do you only look at the S&P? We only look at the S&P for that trade.

And just coming back to your concept, and you said it a little bit before, the volatility of volatility. So there is the VVIX index, right? Yeah. Which is measuring the volatility of volatility so there is the vvix index right yeah which is measuring the volatility of volatility so you would rather that be low or high or increasing decreasing what's well the ideal situation it's you know we're we're low volatility vix really goes up and there's really the spike that goes from you know 12 to 20 yeah that's the idea for us um ideal is you know 12 to 20 yeah that's ideal for us um ideal is you know uh it goes to whatever it goes one day goes from 12 to 15 the next day goes to 18 the next go year you know day goes to 30

that's when that's ideal for us so anything that's smooth in a sense smooth anything that's not that back and forth that technical intraday is really good for us um you know smooth you know spike a sell-off so you know let's say market sells of two percent today tomorrow it says one then it sells of another three so uh for instance uh you instance, like August of last year, we like that. We like the beginning of August. What we didn't like is the second part of August where the curve went back and forth,

back and forth, back and forth. So when the sell-off was minus 4%, 5% in three days, we like that. We really like that. And the curve itself was flipping from contango to backwardation? Yeah, the curve does that. But yeah, it like that. And the curve itself was flipping from contango to backwardation? Yeah, the curve does that. But yeah, it does that.

And so that Vivek's in that scenario is high and rising. Yeah, exactly. Correct. Yeah. You know, in the past, we looked at Vivek, you know, the indicator. It's the vol of vol it it it doesn't work all the time because regimes volatility regimes are very different something new comes you know uh recall um i think it was i think it was was it was it may uh sell off I think, on the S&P.

Right? And we had a clustering of volatility at 17. You know, don't take the exact numbers, but it's... You expect, right, if the market goes down 6, you know, a few days... 6%, you're saying?

Yeah. You expect volatility to go to in the past, you would see a huge VIX spike. So we see things like that more and more. Now, don't ask me why. I have no clue. Which is exactly what I was about to ask. Well, I have no clue.

I have no clue. But you think that's prop firms, that's hedge funds, that's other players in the VIX space selling into those, right? They're only doing the mean reverting trade, perhaps? Yeah, it could be. And keeping a cap on it? Yeah, it could be also a certain complacency.

I think there's a lot of complacency in the market where people say, you know, people think maybe, you know, nothing will happen. Things are going to go normalize, right? I mean, look at what happened, you know, last Monday, right? We had a market sell-off. You know, we were Friday already. We started getting into a long-wall position. Sell-off, it wasn't a selloff, it was minus 1.5% down. You know, on a day like that

we would see volatility, the VIX went up, we obviously made some money, but it just reversed, the next day it just reverses. You know, and people are very complacent. People think that nothing will happen. I don't know if, I think, you know, my experience in 20 years

is that when people are really complacent, that's when things really happen. Yeah, I would agree. But we've had kind of nine years of evidence the other way, right? Absolutely, absolutely. Which almost proves more to the point that it's going to happen. Yes, I mean, if I put all my fundamental evaluation hat that I have or acquired the GMO,

I would say, yeah, sure, it's going to happen. But, you know, even Jeremy Grantham is looking at, you know, another mean reversion on average of six and a half years. We're looking at a mean reversion 20 years. You look at Ray Dalio and his debt cycle, you know, model, you know, saying, oh, we're in the seventh inning. Well, I'm not sure. I don't know.

He came out in December and basically said there's big clouds on the horizon. Everyone be careful. It's going to happen, obviously. He was very coy in saying this is coming. Yeah, absolutely. Next month, next decade? When, Ray?

I have a lot of respect for Ray and for Jeremy. And, you know, GMO, we were right, but not with the same clients, right? Because these things, there's some bets that, you know, we took at, you know, I wasn't there, but, you know, the Japanese mean reversion. I mean, 18 years from that. You know, bubbles, we analyzed, you know, whatever,

350 bubbles um obviously we never found out was it two three four standard deviations you mean revert i mean there's no there's no there's nothing we found no asset class that we found that doesn't mean revert with the exception of oil. Oil has different fair values that it moves. But most of the asset classes and bubbles that we looked at, you know, started with the tulip bubble, they mean revert. Now, is this a new paradigm? It could be. I mean, definitely if you look at Europe,

you look at negative interest rates. I mean, if you think about it, in Europe, Europe went negative interest rates in a growth period. That's pretty interesting if you analyze that. So it basically tells you many things, right? There are structural problems which are huge. The ECB, there's nothing they can do, except, you know, you can only put in a fiscal policy package, right?

I hope, you know, I'm knocking wood here, Jeff, that the U.S. doesn't go negative. What did you put the odds on that of? I have No clue. I think it's definitely greater than 0% chance that it happens. I hope they don't do it because I think it's the only currency around the world that has positive interest rates and store value as a currency. It's important. There's no need for it. the world that has positive interest rates and store value you know as a currency is important

it does there's no need for it um i read an interesting piece i was essentially arguing that it's not all that unnatural and especially because the demographics and the whole world is getting older and it signals that the they're valuing future spending power more than current spending power and they're willing to push it out except the negative rate in order to basically so the return of principal instead of the return on principal that it's there when they need it most after they retire and it's a bit of a stretch but interesting no i think i think that's you rightly point out to a big huge problem that the next generations are going to have, at least in Europe. And that is, you know, negative interest rates.

You know, my generation, that's fine. You know, we had a great ride. But the next generations and the retirement systems are going to have a huge, huge problem. And so, therefore, you know, look at the US. I definitely think that the US, one of the things that has changed, obviously, is that we've seen these mega caps. So these oligopolies being founded. So, you know, how many more apples will you create, right? I mean, the entries are a barrier to create an Apple company are extremely high, right? I mean, the entries of barrier to create an apple company are extremely high, right? So I think the battleship, the GDP, real GDP growth is not

going to be three. I think the battleship is going to, you know, maybe be at 2.2, 2. That's 30% less. Again, you know, big part of GDP is consumption. Different. Production is maybe 10. Industry production is 10. So it's a lot of services. So yeah, the world's being... There's a big move towards digitalization, even in our business, right? I mean, our business is...

I keep on saying, we're systematic and quantitative, but we have a very fundamental thinking behind what we do. It's not a black box. We can tell you exactly, we're based on exploiting behavioral finance. I think it's one thing that's not going to go away. I think human beings are going to be, you know, thinking the same way,

having the same fears. But we're exploiting that systematically with information technology. I think nowadays there's definitely a digitalization also of our asset management world. Well, yeah, the buzzwords are AI and machine learning. Yeah, well, you know, I work with my partner is one of the experts in that area. And I think we both concur that we have yet to see somebody with AI making money. I think the problem with AI is the overfitting. Yeah.

What do you stop? What kind of data set do you take? Right, if you get a room full of guys and say, come up with a model, and some are going to overfit, why wouldn't the computer do the same thing? Yeah, so we're certainly at the forefront of that with my partner carlos

um and we you know we may use genetic algorithms to find out and screen the market to see are we missing something is there is a factor that we didn't look at but i think we're far away from and i don't think it will work um i think the human brain is still much more capable. I think it requires non-linear thinking. And yeah, of course, you know, when I started my university career, I always wanted to start, you know, studying artificial intelligence, combining information technology and psychology. Fascinated me, right? But I think you can't replace a human brain and the way it's looking at the world and the conclusions that it makes. Then again, there's the other part, which is it's dangerous to be overconfident. I think markets are always right.

No matter what, they're always right. It cost me a lot of gray hair. Thinking that, you know, I could predict markets. No, I can't. When you have the macro chops, just from hearing you talk about GDP and whatnot here, so that informs your models a bit? Or you just use it as a reality check to say hey yeah i think well what it what it does is i think i'm always you know principalium is is principal for his

owner for in latin and we want to manage money for ourselves in the same manner we manage money for others i think there's a huge principal agent issue in our industry. So that's why we had the name Principallium put in front of our company. So when I look at the macro, the macro helps me to think about what is the challenge that the investor will have now? What is the challenge? Okay, so the European investor has negative interest rates, built the largest bubble in history on the fixed income. That's not long ago.

It might be going in the same direction, right, as the equities. And we're piling, you know, how many more multiples do you want to pay for some equity? 25? 30? I mean, people are paying, what, 40 for Nestle? Okay, fine. You can pay 100, right? So I'm looking, when I look at the macro,

and that really helps me, is to say, what is it that we need to do to help portfolios and investors diversify? To meet those challenges. Exactly. Meet their needs. We want to meet their needs. why, you know, we restarted, you know, I started the, you know, Principallium together with Carlos was, okay, I wanted to, I wanted to have, I was looking at my portfolio. I said, what do I want? What exactly do I want with my portfolio? And this is why we conceptualized it the way we did. I think it's a very challenging world. I think people have to think about if they have this 60-40, if they really have diversification. So you've kind of hinted around that. Let's dig into that a little more.

So you're implying, correct me if I'm wrong, if you think the 40, the long bond position, is going to protect you in the next crash, you may be mistaken because it's yielding negative and whatnot. Absolutely. Absolutely. Absolutely. I think, you know, the 60-40 portfolios are the risk priorities of this world. When you have, again, if I put on my GMO hat and look at the overvaluation,

because I think it's very important, you know, to me risk is losing money. It's perpetual loss of capital. That's risk. Yeah. So, you know, the bonds, I think, you know, in the U.S. That's risk. So, you know, the bonds, I think, you know, in the US, the bonds will do fine, obviously, because you have positive interest rates. But I think for investors in Europe, it's going to be very tough

for them because they're going to have to, you know, the only yield provide, you know, the only yield provision is the US fixed income for them. Okay, you have emerging debt. Okay, that's going to also provide some returns. But, you know, the only yield provision is U.S. fixed income for them. Okay, you have emerging debt. Okay, that's going to also provide some returns. But, you know, if you look at the risk adjusted.

You're not saying that it's not going to be a flight to quality in a crisis. It still might be a flight to quality. It's just that, hey, the rest of the time you have a negative yield. How is that adding to the portfolio? Yeah, and this is what is so interesting about volatility as an asset class because the drivers of it are different than the drivers of the fixed income or the equity.

So therefore, and it's very convex. The worse things get, if you're a long vol, the worse things get, the more it's going to, it's convex. So exponentially helping you in that respect so i very often say you know people ask me what are you and uh so we we're not we're not just a hedge right the the the objective is to to be a

convex hedge to to to help in turmoil the worse worse it gets, the, the, the better it should, you know, we should protect and do. So it's a dynamic, it's, it's a convex position, Hatch, that's, that's convex. I love it. And from my seat, talking to investors day in and day out, I feel like they're wanting that more and more, you know, in the old days it was, I've got the bond piece or then into classic trend following managed futures. And then, you know, people like me having to explain, well, yeah, there was a sell off, but it wasn't the right kind or the right time, or it didn't extend enough. So your managed futures diversifier didn't deliver. And they're kind of getting fed up with it. And like, I want something that I know is going to deliver

based on its structure. Yeah, exactly. And that's a great point you're making, Jeff, which is by design, it's not, you know, we're not a trend following CTA that, you know, should over time be long-vote because it's going to be positioning and it's going to be shorting the market, right?

When it goes, no, no, no. And that you don't know because, you know, it could be more of a black box. That works. You know, I think, I'm not saying it doesn't work. I think a lot of people, you know, it could be more of a black box. That works. You know, I'm not saying it doesn't work. I think a lot of people, you know, make that work, right? But what we are, our objective was to basically design it so that causality,

it's the cause of the design that will work in that situation. It's not just pure, you know, it's not random. Right, and it's not, trust me, it's going to work because it's how the contract is designed, how the math works. Exactly, exactly. Anything can happen. I'm always cautious about it.

But all we can do, right, is increase the probability of that, of working when that happens. And what would that look like in terms of numbers? So in another 08 type spike, you're thinking you're going to make 10%, 50%? That's very difficult to say, but we've run some hypothetical numbers

and certainly we'll do very well. We'll do very well in the 2008 scenario. Now, will it happen again? I don't know. Right, or a flash crash or whatever. But the idea is that it's, like when you're saying convex, it's not 1 to 10. It's something double digits and much higher.

Absolutely. But it all depends how that happens, right? Because if you are in a situation where markets are going down and volatility stays at 17 because we think december 18 was kind of exactly we we have we have that kind of there is there is always some random irrational thing that happens right um but yes i mean that is our objective and we ran the back tests. You know, you can think of it, you know, for us, it's just a decision-making tool.

You know, the real numbers is what counts. But do you see, so what was December 18? I can't remember. Maybe the market was down six and VIX was... Yeah, was it December? I think, yeah. Yeah, okay. But to me, there's... And back to the structure again,

there doesn't seem to be a... You're talking 218, right? Yeah, yeah. Yeah, yeah, sure. There doesn't seem to be a scenario where S&P could be down 30 and the VIX doesn't move. Impossible.

Exactly, right? So there's structurally... Because we're kind of saying two things. One, structurally it's going to be there, but then two, there's some weird periods where it's not necessarily there. Yeah. But that seems to be more, you know, that the VIX already moved, and then the market kept going back. And that comes back to the volatility of volatility.

So if the market stops going down as quickly, the vix could kind of normalize and stop going up yeah i think you always get periods where people where the vix will not move you know as fast as normalize as fast as we think because a lot of people's you know maybe obviously um it follows a sell-off so people are cautious then you had a periods of two almost three years of short vol right where people just basically said i'm just gonna i'm just gonna buy short vol because they were they were being accustomed to to a to a vix of 10 12 right you feel i feel like we're kind of creeping back into that environment where people are selling it at any cost kind of damn the torpedoes sell the vicks yeah i think i think it's very difficult to again you know we don't forecast regimes because we haven't found anything

out there so instead we we basically are pretty agnostic to that. We basically have as many drivers or many systems ready to go for as many situations as we can figure out. So these algos are just waiting, and each one of them is basically saying, I think it's my, you know, not I think, but it's my turn now to go, right? I love the personification of them. Do you name them?

I don't know. Maybe we should name them. Yeah, name them. Maybe we should name them. That could be fun, right? Jimmy, your turn. Get in there. Exactly, exactly.

That's pretty much. But you think of them as your children. Sometimes I call them our guys, right? Yeah. We call them the short-term intraday VRP guy. Go. Or the mean reversion, you know. One thing, I think we've found this legacy foundry. Sure.

You want to talk about that a little bit? What is that? Sure, I can. It's a company I started two and a half years ago with two other partners. I'm the chairman of the company. I don't spend too much time with it. But the idea is to bring to life as many inventions as we could and incubate those, create patents,

and create new, innovative ideas, disruptive. I got one. Go ahead. I want a pop-up helmet for these shared bikes all over and scooters. Okay. Something that fits in your pocket, you hit a button and it becomes rigid

and pops on your head. Okay. We got that. We got some rucksacks. We got the rucksacks in Switzerland for the avalanches. Yeah, they turn into the bubble. Yeah, exactly.

Look, we'll look at it. I'm working with a guy that's a pathological inventor. He invented a watch that basically shows time with microfluids. Think about that. Very complex. I don't even know what microfluids are. Well, it's basically, instead of having an indicator, it will show the liquid moving as time moves.

Wow. So it's really high-tech. I think he spent $60 million to develop this, and I think these watches are quite expensive. Of his own money? Yeah, no, no. I think he's are quite expensive. Of his own money? Yeah, no, no. I think he's a pathological inventor. I think he's not interested in money.

He's just interested in creating things. But that's something I always found extremely interesting. It's real. We live in a very intangible world. A world of quadribatives. Even though I'm extremely passionate for it, you know, I love it. I love markets. I love the market psychology.

You know, I could spend all day talking to my partners and also investors. I think it's great to talk to investors and listen to what they are thinking. And, you know, maybe, you know, I think great ideas come also from listening to others. Agreed. So that's fun.

Yeah, that's Legacy Foundry. Yeah. I'm going to ask you some of your favorites. Oh, man. I know you love this part. So, rapid fire. Anywhere but Switzerland, if you could live somewhere else, where would you go? Maldives.

Maldives? Yeah. I've never been. You've been? Yeah, absolutely. Many times? Fantastic. Yeah.

Well, you have to go because with the sea level rising uh i'm not sure uh there's uh no it's it's a great place um it's um it's a place where um you know you find your peace uh i like the sea too i like the mountain as well as like i like the sea too. I don't blame you. Favorite, do you listen to podcasts? No. No? No.

You've got to get on the bandwagon. I'll send you a list. Absolutely, yeah. So your favorite podcast is this one? Yeah, absolutely. Favorite book? Well, I did listen to some of the podcasts that you guys put out. The Mutiny guys? Yes. Yeah, I listened to that one. Favorite book? Well, I did listen to some of the podcasts that you guys put out. The Mutiny guys?

Yes. Yeah, I listened to that one. Favorite book? I think I would say there's a couple of books, but I really like The Principles, Ray Dalio's book. Yeah. I like some of those books that are more, you know, more technical. And I like that book quite a lot.

I think the management industry, I think character plays a big role in managing money. I think you have to be very detached from it. And so, you know, the second book I would say is is living in the now so you know I think you need to be you need to have your distance you know what is your you have to think about what's what's your relationship to money and and detach yourself from that so you know, I went through a period at Blue where it was very hectic, a lot of responsibility for making money for clients,

not just for myself, but for clients. And that is, for me, I started to look more, to get more spiritual, in a sense, look at more living in the now, less living in the past or, you know, I think health is important, living each day,

having, you know, doing, working with guys that you love working with, living life now, taking responsibility. So that book really has done a lot of work in that respect.

I'll go pick it up. Sounds great. Yeah. That's always been my mantra pretty much. It's from Tolle. It's a German. I think he's German. Is it in German?

No, no, no. It's in English. I read my's a German. I think he's German. Is it in German? No, no, no. It's in English. I read my books in English. Do you speak German? Obviously, yeah. I speak, you know, we have four national languages. So when you're at school, you have to pick another national language. If you're in the German part, you have to pick whatever Italian or French or Romance.

A lot of people don't know that we have a fourth language. And then within the German speaking, we write, hi, German, but we speak Swiss German. So we have about 22 dialects. Some dialects that German speaking people won't even catch up, catch up what we say. Favorite Swiss athlete? catch up catch to you know catch up what we say so so uh favorite swiss athlete roger federer yeah i didn't have to think about that he's a great human being besides being a one of the best players and it's unbelievable he could keep it going all those years

absolutely and i think if you you know i had the chance to meet him, it's mindset too. Yeah. I think it's, it's like you're managing money too. I think sometimes you really have to have the right mindset too. So this guy has an incredible mindset. To keep it at that level for 30 years. It's so elegant the way he plays.

You play tennis too? Yeah. Okay. Maybe we should have. Should have a round next time. I'm in Chicago. We have a tennis club. We'll take you over. You've got to play indoors in Chicago.

Absolutely. And I ask all the guests' favorite Star Wars character. I don't know if you're a fan. I'm not. I'm not. I'm not. I'm not. I'm not a Star Wars game.

It's very funny. I don't, you know, I don't enjoy, particularly enjoy that kind of movie. Sci-fi? Could be. All right. Maybe. I'll teach you some. Okay, great.

I'm looking forward to that. Boba Fett might be a good one. He's kind of somewhat computerized. Darth Vader, right? Darth Vader, yeah. Darth Vader, yeah. Darth Vader, okay. He's in it too, okay. He's evil, though.

Is he? Okay, now I remember. No, I'm just kidding you. Spoiler alert, but he turns good in the end. All right, Alex, well, thanks so much for being here with us today, and we'll put links to all the Principallium goodies in the show notes, and you can follow up with Alex at your leisure. Thank you.

Thank you, Jeff. It's been a pleasure. You've been listening to the derivative links from this episode will be in the episode description of this channel follow us on twitter at rcm alt and visit our website to read our blog or subscribe to our newsletter at rcmalt.com if you liked our show introduce a friend and show them how to subscribe and be sure to leave comments we'd love to hear from you