The Derivative - Wayne Himelsein: The Human Behind the Hedge Fund

Episode Date: January 27, 2020

Wayne Himelsein is a hedge fund manager, President, and Chief Investment Officer at Logica Capital Advisers. Beyond that Wayne is a 25-year veteran in the trading space, and we're talking about hedge funds, his quantitative investment strategies, and even his own non-profit, Informed-by-Nature.  On this episode we're covering the oddity of a volatility trader living somewhere where there is no volatility (in the weather), reading the world’s longest book, hoping this is the big one when your car is in midair, J-Curve the rapper, and overpaying by 1000% for out of the money options. Make sure to follow Wayne on Twitter and LinkedIn, and check out the Logica Capital Advisers and Informed-By-Nature.  Don't forget to subscribe to The Derivative, and follow us on Facebook, Twitter, or LinkedIn, and sign-up for our blog digest.  Disclaimer: Due to industry regulations hosts and participants will not discuss any company funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinions of RCM Alternatives or any of their affiliates. This podcast is for informational purposes only and should not be relied upon for investment decisions. Visitors should not act upon the content or information found here without first seeking appropriate advice from an accountant, financial planner, lawyer or other professional. For more information, visit rcmalternatives.com.

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. One could be long vol all the time and have a positive upcapture, i.e. make money consistently the way everyone else would, you know, whatever a reasonable return is. Then you are like everyone else in the world on the upside. But when things blow up, you do the best by far.

I mean, there's just nothing, it's incomparable. That's the holy grail. I'm your host, Jeff Malek, and excited to have our first ever guest here today, Wayne Hemelsine. Wayne is a hedge fund manager, president and chief investment officer at Logica Capital Advisors, and beyond that, a 25-year veteran in the trading space, where he's developed quantitative investment strategies across asset classes, and he's even started his own nonprofit, Informed by Nature. Okay, Wayne, thanks for being here. My first question is a little odd one. Why do you spell

Logica Capital Advisors with an E? Thanks for having me. To be honest, there wasn't that much thought put into the spelling of advisors. But for the heck of it, I'll say just because it's a little bit different. And I like being different. Maybe your South Africa roots? It could be my South African slash British roots. It would be more fitting. Do you ever get back to South Africa roots? It could be my South African slash British roots. It would be more fitting. Do you ever get back to South Africa? I do, in fact. When I was younger, I used to go back quite a bit, family and such, but not in the last many years. Last time I went back was 2010. Yeah, so a while ago. Got it. And Santa Monica is home now? Santa Monica is home. I have a little trouble trusting someone to understand fat tails and volatility

when you live in a place that has no weather volatility. Yes, that is a conundrum. But I do understand fat tails and vol, and I do live in Santa Monica, so I'm one of those anomalies. Perhaps being in such a stable environment enables me to think more about instability okay I'll take it so how'd you get into this crazy world of being a hedge fund manager and it all started back in 95 I was lucky to get a job or an opportunity at a trading desk. It was a really cool environment. I sat at a place called Carlin Financial. I was on a floor where I was the kid out of college and

sitting on all around me were really... Which floor? This was in... Or their floor? Their trading floor. It was in Midtown Manhattan. I forgot the exact address, somewhere in Park. But the idea, or not the idea, the flavor was that there were just so many interesting people in the room. And like the guy on my left had been a 15-year trader of options on the floor. And the guy on my right had been a fixed income trader at Lehman Brothers for seven years. And so there's just this tremendous variety of experience. And for me, I was just, I don't know, fish in water. I loved it.

They were a prop group. They were trading their own money. It was a mix. There were people there who were trading their own money and the firm's money and then people just trading the firm's money. So it was a whole mix of different setups. There were some smaller hedge funds there. And I just, I got just a tremendous amount of experience from really the most exciting part was so many different types of trading, a lot of arbitrage, a lot of mathematical type trading, which worked really well or played well into my background. And this is like late 90s? Kind of mid 90s. And then I did that for many years

into the late 90s, where by that time I had built my first model. I was in statistical arbitrage. It worked really well. So I left the trading floor to open up my own hedge fund. I saw the opportunity. And so that's interesting. You've been kind of, your growth in the industry has mirrored that of the automation and AI and machine learning and all that. And becoming more quant over time. How have you experienced that transition? Versus your first model that you made versus making models now. Is it night and day? No.

I haven't transitioned much into the ML or AI world. I'm still doing it the way I used to do it. I'll tell you, we were doing early versions. I remember when high-frequency trading came along in the 2000s, we were trying to do some higher-frequency trading. And what's really funny is I remember trying to – we had this one trade that made a lot of sense near the close in the market, and you had to get off hundreds of positions within the last 20 seconds before the markets closed.

And we were struggling with executing at that speed. And I remember we found the software. It was called QuickKeys. It was just a general software program for typing stuff, creating a macro that would type what you want to type really quickly. So we used this off-the-shelf software, Quickies, and then dropped in this Excel sheet of all these symbols to have Quickies type in the symbols quickly for us. And so that was the early version of HFT. And so yeah, I was there, quote, in the beginning of it. But as I guess it's advanced, yes, we've advanced, but I still, as of the last five years, I see that most of the work is still in the thinking and the human side of it. And really,

the sophisticated technology is just really how to execute and implement some of the ideas that we put together. Right, like you're developing, you're backtesting a model now, is it half the time, a tenth of the time? Oh my gosh, oh my gosh, it's a hundredth of the time. I'm exaggerating, but yes, that's the, in fact, I remember once there was a model that I was trying to, or some idea that I was testing

and I was trying to get done. This was in the late 90s and I had to get it done. I remember it was a weekend, and it was where I would go, and I'd hit the button to run it in the evening, and I'd wake up in the morning that it had been run. And the worst thing is if something happened in the night, you hope it didn't freeze, then you have to go and do it again. Now, I mean, we have this eight-core processor. we're running files of hundreds of gigs, and it finishes in, you know, 47 minutes. You know, it's just it's incredible. And it's so much more data, so much more processing. It's got to free up your time to think also, right?

Absolutely. And the danger is, you can almost like run stuff too much, we you can test and test and test because it's so easy. So you almost don't want to do that. You want to spend more time thinking and drawing board and brainstorming. I do a lot of that with my peers or my partners, I should say, at Logica. So we, yeah, but the processing time is just beautiful that we can have an idea. We could hit some buttons and then see the output very quickly. And you were, you see Berkeley, did you have a math degree or a math background or it was just you had an aptitude for it and did

it as a Korean? I definitely had an aptitude for it. There's a little bit of a backstory there, which I'll share, is I did not have a math degree. Actually, I was English and creative writing. You're speaking to a philosophy major. Yeah, so there you go, right. So mine was that I was really advanced in math when I was younger. So I grew up in Santa Barbara, California. And in high school, I had gotten past, I guess, like calculus I did, I think, as a sophomore. So I was past what my school offered. So I started taking math out at UCSB, UC Santa Barbara, to do higher level math. So I was out there as a high

school student at a UC. And so I was like that young kid in the math class. And I did that. By the time I actually graduated high school and went off to Berkeley, not only was it perfect, because UC credits transferred to UC Berkeley. So it was a perfect transition of my math credits. But I was just kind of sick of that. Or like, I didn't want to be that, I was that younger kid in that college class, and I was, I really wanted something totally different, so when I got to Cal, I said, you know what, I don't want anything to do with that, and so I went totally the other side, and did English and creative writing, and because I had all the math credits, I was able to get through Cal in three years, so it all worked out really well, but when I graduated Cal, then I

went back to my natural interest, which was mathematics. Coming back a little bit to the AI and machine learning, we just touched on that a little bit. What are your thoughts of the industry in general? Like, are we going to be 100% computerized AI? All models are created by AI within 10 years? I really doubt it. I'm not a big AI fan just because I think I'll boil it down to overfitting or not understanding the mechanisms behind the strategy. And, I mean, we use like AI slash ML techniques a little bit, but it's in this like final step where we know exactly what we're trying to achieve.

And we're almost like optimizing that last three bips of alpha, if you will. But I feel like if you start with AI or MLS and just, you know, find a pattern and I sure think something will be found, but it's not reliable. It's not understood. And I just don't know that. And there's so much of an arms race there and the big institutional power behind machines and the money behind it. I don't know how anyone without that level of resource can compete. And even with that level of resource, the competition will just drive it to,

just like with HFT, it became a latency arms race. And so once you can get the satellite trading in nanoseconds, then what's the point, right? So we're already so close that it's going to be, I think you still have to innovate with your mind. And I think by the time AI ML gets to human level, that's 10 years to me seems like nothing. I feel like, you know, that's going to be maybe one day. I don't know. I saw a crazy movie about it, but I don't know if that's the real world yet or anytime soon. Back to your personal life a little bit, you founded a non-profit. What's going on there? What do you do there? Yeah, so that was back in 2004. I founded a nonprofit.

I had found that I fell in love as a student, and just being younger, I was always very curious, and I had this math feeling, and I remember when I was a kid in high school, I was getting tennis lessons, and this tennis instructor was telling me about how, like when the ball, you want to, when it's coming here, you have your racket here and you move and you want to hit it. And as soon as he was mid-sentence, I said, oh, you want to hit it right there because that's the maximum of the curve. And, you know, so I just saw things in this kind of analytical, mathematical way. For me, it was obvious where you had to hit the ball at what rate to get the maximum power. And so just looking at the world in a analytical, mathematical framework, I fell in love with knowing how things work in physics and in general science.

And I felt that over the course of my life, that view, that worldview and that way of thinking did so much for me, helped me so much advance and has contributed so much to my success. And it did early on that I thought that that should be shared more with the world. People should know how valuable that worldview is and that the way of deeply understanding things and learning.

Our motto was sharing the beauty understanding brings. And so I started a nonprofit to do that, to share the beauty understanding understanding brings and that was in 2004, it was called Informed by Nature and for many years we've done lots of different things we worked with students building little solar cars more recently as of just right now we have three projects we're working with one is to help science journalists better share, I guess, stories or latest innovations within science. And it's like a journalism camp to be a better expressor of scientific ideas, which are oftentimes very boring. So you want to make them palatable and exciting for consumers to get masses interested.

Consumers being the kids? Consumers being everybody. I mean, I think, yeah, kids for sure, because that's where it all starts. But I'm a big fan of lifelong learning. I think everything comes from just learning and education. So it starts when we're young, but it continues on throughout our lives, and it should.

And so there's also, in fact, a science camp that we're engaged with that does science for kids. And there's also an organization called COPUS, which is the Coalition for the Public Understanding of Science. They're a group that gets together once a year that people from all different, you know, somebody who works at a museum who's trying to get a science museum in Chicago, perhaps, and somebody else who works at a lab at MIT, and they all come together as the promoters of the different things that they're doing and find ways to find synergies in what they do.

And I love that because it's cooperative and it's broadening the public understanding and more so appreciation of the scientific endeavor. That's great. We'll put some links to all that in the notes. Sure. Just a quick thought there on your tennis racket example. It always amazes me, right? If you're going to build that robot who has to analyze the flight of the ball, how much to bring the racket back, how much to get that arc,

but the human brain can do it in nanosecond. In nanosecond, it's incredible. And it's just an amazing machine we have up there. Exactly, yeah. It took a long time to get there, but now it's amazing. Yeah, could the Creo magnets hit a tennis ball? Yeah, yeah, who knows? Maybe not at the right spot.

Right. They were always long. Yeah, they were, yeah. Went over the fence. Let's get into your strategy a bit. Just start. Give me the elevator pitch. You're in the elevator with a stranger.

You've got 30 seconds. Tell them what you're doing with your strategy. Yeah, my strategy is the highlight word is long volatility. And volatility is, to me, everything, every asset class is, no matter what you trade, you're trading vol in a sense that everything just moves. And so whether you buy stocks or bonds, if you're not sitting in cash, you're buying something that has movement. And in that movement, there are consistent behaviors. And so by being long volatility, it's got the additional benefit that when things go wrong in the world, volatility tends to spike. So you're on the side of being what today many people call anti-fragile, or more robust. In other words, when everything's going wrong, that's the one thing

that goes very right. And the rest of the time, if you can make money trading it, there's some interesting patterns that are behavioral aspects that exist just like they do in stocks and bonds or in other asset classes that you could try to make money trading them. But when bad times happen, you're still on the right side of the trade. Or not still on, you're always on the right side of the trade. So that's what I love about volatility trading is it's got its own interesting characteristics to be able to trade, and it puts you on the right side of disaster, which to me is the most important part. Ding. Floor one. Yeah.

That was good. You think they got that, the stream? I hope so. We need to work on that. Maybe like, right? It's a, yeah, I'll work on that with you. Right? We got to have a one-liner of like, it's the thing you said.

It's the thing that does well in your portfolio when everything else is doing poorly. Okay. And the why is because it's long volatility. Oh, okay. Got it. Right. You want the surfer guy in Santa Monica to be like, cool. Cool.

Okay. So I have a hard time with that $20,000. But we'll get there. Well, that's my next question. Okay. Now you're off the elevator walking into the institutional investor's office. Sorry. Say what I just said.

Who gets skew and gets volatility and everything. What's the pitch to him? How do you explain the 30,000th of view of the model to that investor? So there's a lot of volatility exposure out there and vol arb for the premise of protecting portfolios, right? So the idea of owning right skew or owning vol is very important because most things out there are short vol. Most of the hedge fund world, arbitrage, all forms of arb are short vol. It's mean reversionary. And when things go wrong, they all get hit. So being on long vol is being on the other side of that. It's crucial. The reason people don't

want to do it is it's expensive. So traditionally, the idea of expensive is mitigated by financing long volatility with short volatility. So most of the world who grows up in vol, who wants to own vol, tries to find some other form of vol, something else on the vol surface or some idiosyncratic vol that is, quote, expensive to be able to finance that vol they want to own. And at the end of the day, their portfolio might be net long vol, but there's short and long everywhere. I looked at that high level, and I thought I was very troubled by that, because I felt that it was counter thesis.

By counter thesis, I mean that you want to own insurance, so why would you be selling some of it? The idea, the analogy that comes to my mind is you buy car insurance, and so your car is protected for a total wreck, and that's fine. But just to finance some of that expensive car insurance, you sell minor incident insurance, right? So what this means is that you're on the freeway, and some truck in front of you slides over, and you're about to – your car starts pivoting sideways, and you lose the back. And while you're midair, you're like, I hope this is a big one, right, because you want to be covered. So that's not the way – that's not how it should be. Odd that that's sort of where our health system has gone, right? Of like the premiums and minimum amount you have to spend every year.

Yeah. The consumer is actually kind of financing the tail risk. Exactly, exactly. And then you get these, the other part of it is higher deductibles on insurance, right? I won't be covered unless it's really bad. And then so you don't sell insurance, but you just have a really high deductible. So nothing, unless the market drops 20% or unless in the health insurance world, unless you're just, you know, your life's on the line, then you're covered.

But if you break your arm, no, you've got to pay for it. And so for me, it's the ability to be, if cost was no object, you want to be at the money, so you have no deductible, you want to be front month, so you're most sensitive to any event. And you don't want to have any sell, short or selling of insurance anywhere, because you don't know how that can confound the upside when an event happens. So if you have those three requirements, well, if that well, that's really expensive. That's hard to do. So if cost one is no object, though, you would do that. So I thought to myself, how can I do that in a way that could somehow make money and not be as terrifically down or negative as owning the best thing out there would be? And we achieve that

through trading. So I have a long-term decades of experience in trading and understanding the markets from a trader's perspective. So the grand idea was infusing a trading expertise on top of vol, where we could effectively scalp. So we're, what we called gamma scalping, or just scalping, buying low, selling high, on instruments that are protecting your portfolio. And real quick, so you weren't always a long ball person.

Were you a long ball way back at Carlin? You know what? I didn't know it as much. In sheep's clothing? But in sheep's clothing. I was a trader, and I was trading. I was finding positions. I was finding setups and patterns of names that I wanted to go long or short.

But if I broke it down today, looking at it with my current wisdom, I'd say, that's interesting. I was looking for long vol breakouts. I was trading right skew. I just didn't frame it in that way at the time. I was a trader who looked at it much more simply. But that's really what we're all... We all want asymmetry in our favor, right? That's the definition of a good trade. Yeah. I always say, like, what are we all doing here? It's because we have a problem. We're all short vol. Even if we don't outright own stocks, the economy, the government, everyone's basically short vol.

Everyone's short vol. And when there's a 07, 08, everyone feels the pain. It comes out to play, exactly. You asked about my past. It's interesting because my very first strategy in Steadarb, I differentiated from the crowd in being long vol versus the traditional short vol approach. Steadarb is the typical way is there's some statistical outliers. So let's say Coke and Pepsi is some pair of names,

and they're trading three standard deviations away from each other in a relative space. So you want to go long the under and short the over because they, quote unquote, should come back together. That's a short vol positioning because the things are apart for a reason and the momentum may continue. My initial way of doing things was to go long those two for that anomaly to continue, which ironically was long vol, but expressed in a Stadar portfolio. Did you come to your current program as a result of your wisdom and feelings or of investor appetite

of, I need to meet this investor? No, it was just, No, it was much more me. I realized that, oh my gosh, this is a really good thing for investors, and that made me really happy. The appetite should be there, but it was truly a function of my growth and experience over just doing this for a long time that this is the only way to do it. It's magic. If one could generate, one could be long vol all the time and have a positive upcapture, i.e. make money consistently the way everyone else would, you know, whatever a reasonable return is, then you are like everyone else in the world on the upside. But when things blow up, you do the best, by far.

I mean, there's just nothing, it's incomparable. That's the holy grail. The holy grail is the free call option. The free call option. Put option in this case. Right. In this case, right. It's a free put option while making money around trading what you can to stay always with that free put option. And of course, the skill is in that trading to make sure it works. But quickly, we're coming at it at RCM from a different perspective of that investor appetite, and they're getting sick of, okay, this trend follower is supposed to be a crisis period performer, but there's a lot of ifs involved. If we didn't come into it with long equities, if all the other markets aren't

highly correlated at the time, if there's continued volatility, right? It's had to be an extension of the move, not just a move. Right. So we're coming at it in programs like this are highly attractive of, okay, it's going to deliver when the investor feels it, when they want it. Yeah. And you mentioned in your deck a little bit the, you know,

some of the issues you see with these normal crisis period programs, tail risk funds, CTAs, and Volarb, if you could speak to that for us. Yeah, I mean, so everything what you're talking about is aptly called path dependency, right? So everything has a path, everything, most things in the markets are path dependent. We all, there's a trade-off, right? Every trade or every strategy has a trade-off. It does well during certain times and won't do as well during other times. The question is what you're trading off, right? So if you look at CTAs, which you were just talking about, or trend following, the trade-off is it likes a trend, right?

But it doesn't like the opposite, which would be I would call high vol-a-vol. And so if there's vol-a-vol, it's going to get whipsawed too much and will not be good for it. But in a time like 08, that was a trending down which CTAs did fantastically. So the ifs you're talking about are really what are the paths that we do best and what are the paths that we do worst. And Volarb, to me, that's one of the weaker side of that is the counter thesis side of the path, where let's say one is short one leg of an option chain and long another leg. And typically, you're short closer to the money and longer further out of the money because you're tail protecting. The problem is that the

correction is less if it's a 12% down move, not a 22, then you get more hurt on the one you're short than you do on the one you're long. So your insurance is not just your rest of your portfolio is down, your insurance is down. It's counter thesis. That's an original issue we were talking about a few minutes ago. So with every different type of strategy doing this, there is a different path risk. I believe that in being long vol, there's the least amount of path risk. Of course, I have path risk. I don't like, you know, in reversionary trading, if a market just bleeds up and up and up for weeks straight, like the last two months, that's hard because there's nothing much to trade.

The market's just going up and you're holding long puts and there's very little area to trade them. That is a path risk. But the question is how much that path risk can really hurt. If that path risk can be minimal or capped and you could be down a few percent, but when the market does what you're waiting for, you can be up tens of percents, well, then it's a very worthwhile trade. So the idea being that everything has its path, but how much does the path risk give you in pain for the reward you're waiting for?

And my belief is that being long vol is the least amount of path risk. It's the most what's called ergodic of the different formats or strategies or styles of protecting from market downside. You missed the no ergodicity sign on the door. I did miss it.

I didn't, yeah, I wasn't looking far enough. Yeah. So didn't the industry came out with tail risk funds right like so what's the difference there there were a lot of tail risk funds in the mutual fund space and hedge funds that were kind of trying to accomplish this where do you see the failings in those um well tell us at all they've generally haven't performed well but it's generally been they've bled too much right yeah so the bleeding comes from a more naive buy and hold of towers if you buy and hold tail you're so the problems are there's

many problems so one problem is if you buy and hold naively number one you're you're you're you're gonna bleed but number two you're getting any other way to buy and hold? Yeah, to trade, right. Besides naively? Yeah, right. Of course. Thank you. Well said. So well corrected. What I would say is that the problem with naive holding or buy and hold is that obviously you're going to bleed. But the worst problem is as the market runs away from you, the market's up higher and higher over some number of weeks or days or whatever it might be, is you get further and further away from the money. So not only do you bleed, you get less protected. One of our mandates is to keep on, I'll use this word, chasing the market. So we want to be at the money. So the market runs up and we're going to roll up to be

at the money again, because that's where the best protection is going to start. It's got the highest gamma or the highest convexity is at the money, just mathematically speaking. So let's say you're a tail risk fund and you're buying some disaster at 20% out of the money puts, right? Number one is if the market goes up 10%, now you're 30% out. So now you need a real smack them to get touched. Not just that, but if the market, so you get further away, that's the problem. Number two is you're, if the market comes down only 10 or 15, you're not paying off enough over there, right? So that's the deductible issue, right? You have a high deductible as you get further away. So I think,

what was the third thing? There's a third thing that was on my mind, which is also buying further out, there's less clear pricing. So of course, there's been, I could put it at the extreme in this way, if you bought 50% out of the money puts, if looking at the last 100 years of the market, you'd get paid twice, right? 1929 and 08, maybe. So you're just going to bleed for years and years. So the further out you go, the less events there are that are going to come into play. And not just that, but the further out you go, the higher the relative price is for that protection. That's what's called the IV skew or the IV smile, that you're paying up even more than you should for those further and further outs.

So you're- Because that's what everybody wants. Well, they want it because it's 10 cents, because it's cheap, quote unquote, right? And I say, quote unquote, cheap because it's not- Because it's worth one cent. It's because it's worth one cent. Exactly. So you're paying over by a thousand percent. Mathematically, it's worth a penny. Not just is it worth a penny, but you can't even really price it because there's so few events that occur there. So there's no statistical value on it. You could just...

In a normal distribution, it's worth zero. It's worth zero and it's normal. But even a fat tail has infinite variance at the tail. So you can't... There's no real price to be determined. But no matter what, you can just look at the number of times these events happen. Don't go as extreme as 50, just say 25% of the money. It's so infrequent that you're going to bleed for just years and years and years. So the risk of never being paid off is huge. The other big piece I'd like to talk about is the monetization versus tail risk funds.

So tail risk funds have a mandate to be tail risk protective. So in other words, they own 20% of the money. The market comes down 20%. They can sell that position, but they have to immediately go buy another 20% out in case the market continues because their mandate is tail risk. What happens there is when the market's correct at 20 and they're going and buying a deeper 20, they're paying up skyrocket prices because now the IV is spiking through the ceiling. And not only was it expensive before,

but now that it's worth a penny, they're paying a dollar for it. Yeah, it's the guy in L.A. selling fire insurance when the forest fires surrounding your home. Exactly, exactly. It's going to cost you. I love that analogy. It's going to cost you. I love that analogy. It's going to cost you triple. Right.

So the mandate causes us to overspend, whereas by buying at the money, you're buying really the cheapest part of the SKU. And when you monetize on the way down, if you reset to your new position at the money, you're actually buying more favorable pricing. You're buying lower skew. So it's a better way to monetize and trade optionality, in my opinion, versus those others. I read a report once, there was a talk, and that guy was saying,

if you could go back in your time machine beginning of 08 or even right as the crash started happening what would be the most profitable strategy to take advantage of that and everyone's like buy puts and he's like selling puts if you sold the puts every month because the right it was so high if you sold the far out of the mines, yeah. As a trader, I was actually doing that. In 08, as the market was from 30% down and lower, I was selling 20% furthers. But even, I think, as the monies were so overpriced. Yeah, that to me would feel, they were surely overpriced, not as extremely overpriced as the tails at that time. To me, I'd be buying at the monies and selling the tails because of the just relative pricing. But yeah, I mean,

sure, with hindsight, all you ever do is wait for 08. And on January 1st of 08, you buy lots of puts. But we don't have hindsight. And that's the problem. So it becomes a struggle to own the best protection and trade it in the best way possible to minimize that cost to carry. One of the things with your strategy that I don't particularly love is using the proxies for that. So some of these terrorist funds, they'll say, okay, I understand that it's too expensive. It's this, I'm going to own gold, or I'm going to own treasuries that should, quote unquote, should pop during a crisis period. So A, is that a problem with some of those tail risk funds? And B, how do you handle that? Because you are using some of those as a proxy, correct? We do a similar thing. So we do it. I mean,

I understand both sides of it very well. Yes, the best thing is own a put option. There's nothing better. But when that gets too expensive and just too ridiculous, and in our case, we want to monetize that. As a trader, I say, hey, this thing's just gone up 200% or some, you know, in option land, some ridiculous percentages. And you want to take that off the table. So others in this type of strategy would start to short options at that or short the vol at that point. And in 08, IVs at 70 shorted. Yeah, the problem is it went above 100, right? So to me, there's a huge risk to short it. I can't do that. So I can't make money that way. I don't want to buy more on the long side, but I have to stay protected. So what I do is I buy something that's going to potentially act like a put, but is not

going to have that IV crush or the cost of owning if the market should bounce back. And there, things like gold or treasuries or even the dollar versus a weaker currency basket, will protect you in tremendous declines or in, let's say, counter equities behavior. Not as perfectly as an option, but that's why you have many of them. You have multiple lines of defense. So you could say, I'll just buy gold. Gold could not be the thing that pays out. So you buy gold, and you buy treasuries, and you buy some currency baskets where you have

three different things that if each one has a 60% probability, well, now your joint probability by owning all three is you're going to more likely have some form of payoff if the equity market should continue falling. And, you know, one could argue, well, treasuries don't always negatively correlate to equities. Yeah, you're right, they don't. Not always. But in times of crisis, conditionally, on equity markets falling heavy, they do, right? Because there is this flight to quality. At the end of the day, we're all humans. And when our portfolios start dropping like crazy, and, you know, people get scared, and they go into treasuries. It's just what happens. Institutionally,

it's the, I don't know that it can ever stop. And I'm not like a, you know, I understand mathematically that you can't rely on probabilities. But it's not a probabilistic thing. It's a, at the back of everything are people who need a flight to quality assets. They want to feel, there's flight to safety. So if you own a bunch of that safe stuff, you're in a better position to take advantage of that. But you could see a world exist where they're flight to renminbi or bitcoin

or something, right? That there's a phase shift somewhere down the line of like US treasuries aren't that vehicle. Absolutely. But to that point, sure, let's call it

flight to bitcoin, right? Yeah. It feels strange saying that, but no thanks. But let's just say that becomes the thing, right? Flight to Ethereum. Is that then, so what we do ethereum um is that then so what

we do as a firm is constant r d so we're looking at other assets all the time what has this potential flight to quality exposure if it does become ethereum then our portfolio will be gold treasuries dollar baskets and ethereum right and then there'll be four lines of defense you know the japanese yen has some of that behavior sometimes. The point is you keep on looking, and if it is something else, you include that. You don't drop others because the joint probabilities get better of having something in your book that has that payoff. Right, but if you test and fine art always rallies or something, you're not going

to add that because there's no liquid market. No, we'll not add the horses. There's got to be a structural. Right. There's got to be a rational backdrop. Yeah. Which a big part of that is there's got to be a futures market. There's got to be outright because if you're in the thick of it and you're on that prop

desk or you're wherever, you're going to fly into something that you can quickly move in and out of on your platform. Exactly. And the beauty of those flights of quality assets is that they, not just that they rally against equity market collapses, but they have actually convex behavior, right? So they will accelerate their up. I mean, they look at treasuries and gold in 08, and not even as extreme as 08. Look at August of 15 or January of 16. Those assets just shot up J-curve style. They look like an option.

They behave like an option. So not only are they flight-to-quality assets that will cover you, they'll have some of this option-like behavior. They are, in my mind, I call them synthetic puts. I wouldn't trust them like I do a put option. But if a put option is too expensive, then I'll take some of those to replace them. J-curve should be a rapper's name or something, I feel like. It should be. to replace them. J-curve should be a rapper's name or something. It should be. It should be. We'll call the rapper Gamma. Even better.

Let's talk risk in your strategy. So how are you controlling the risk standpoint? It's a little different than most managers we talk to where there's some directional bets and whatnot. But just broadly speaking, how are you controlling the risk in the strategy? Yeah, I mean, there's two main risk caps. One is that, you know, we're in options. So we're capped by premium, right? Well, it's a small percentage of our book, of our notional exposure will be in coverage. So the worst that happens is you lose a bit of premium and you're

done. That's one big piece of it. That's the kind of the safest backdrop of it. The second piece of it is that we're always market agnostic. I don't know what's going to happen tomorrow. So I'm on both sides of volatility. I am long calls on the market concurrently to being long puts. So if I was just long puts, then I'm just betting on the market. I'm short the market all the time. But I don't know that the market's going to drop tomorrow. It may not. It may go up like it did, has been in all year, amazingly. Decade. Or decade, I should say. Yeah, what am I talking about? Just a year. Of course. So the point being is that I want to be on both sides of that. I want to be agnostic to the direction of the market. So I'm

going to own long vol not just on the market falling, but on the market gaining, right? So by doing that is no matter what happens the worst on one side, I'm benefiting on the other side. And so it's the risk profile, if you think of it in simple numbers, if you own two options, a put and a call, effectively at the money, it would be called a straddle. So you own a straddle, you spend a dollar on the put and a dollar on the call. As soon as you've covered that, if the one side jets against you, you lose your dollar. The other dollar is worth either $1.50 or $9 at the extreme. So you're maximizing your loss on one side of your trade, and you have theoretically infinite upside on the other side of your trade. So it's asymmetry in your favor with a capped downside. And so by being both market agnostic

and by maintaining a fixed premium exposure, you're very risk controlled. But your main risk is that your trading doesn't work and you bleed out, so to speak. The cost of owning those puts is more than the trading offsets. Certainly. I didn't want to get into the fact that I could be wrong. Yeah.

I try to discount that. My the fact that I can be wrong. Yeah. Right? I try to discount that. My main risk is I could be wrong. My main risk is I could be totally wrong. But that's what I want to know. Okay, you are wrong. What does that look like? Is that down 20%?

Yeah, so that's the thing. So, yes. I'm going to assume you're going to be wrong at some point. Sure. And I'm going to assume I'm going to be wrong. You can't be right all the time. Let's just assume. I would argue that I have an edge. And let's call that. And the edge in a trading world is never extreme. When people say they have a trading edge, maybe you're at 54%. That's amazing, right? Versus 50-50. So it's not like anybody has an 80% edge.

That's just total ridiculous. So we have an edge. We believe that. We've seen that in our research and in our experience. So let's say that's 54%. That still means, or even 53% or 52%, that still means that 48% of the time we're wrong. And I know that. So what does that mean? That means that where are we wrong? We're wrong because we're trading both sides. And so one day where we think that we want to sell some calls or we want to take some calls off the table, and then we come in the next day and we bought some more puts and we took off some calls, the next day we come in and the market rallies up. And so we were lightly loaded on the upside and more heavier on the short the market side. So we lose on that trade. Our forecast was wrong. The nice thing about that is that that can

happen so many days in a row where the losses are contained because once again you're only exposed to premiums, so you're down 3%, maybe 2%, at the extremes 4%. It's still very mitigated. Just explain quickly what you mean by only exposed to premiums. So you're buying the options, all that's at risk is what you purchase. Is what you purchase. Right. So if you want a million dollars exposure to the S&P, you may only spend 50 grand, let's say, buying options that gets you that million dollar exposure. Right. So 5%, that would be the S&P. Like, let's say if you spend 5% on calls, the S&P dropped 30%. Those go to zero. So you've lost 5%. But if that happens, well, you have some puts and those are worth a thousand times what you paid. So that's

fine. So the problem really is the middle band. There was a month, a couple of months ago where, I think it was May, where the market started to drop a little bit and then bounced up and then went. So it had this swing or this range of maybe plus minus six percent it was like right in this band where it was you had to have really good uh timing on trading it where we were wrong a bunch of those days timing it so but our loss was still only a couple of percent if it had broken one of those pieces either instead of being down six broken down to down nine, then we'd start paying off quite convexly because we still have those puts sitting there.

So you get this window of, I'll call it the middle world, where you can be wrong in your forecast and the market could be trading but not make a big enough move for either side of your optionality to really pay off. I view it a little as the old market axiom. You take the stairs down. No, the stairs up and the elevator down. Yeah, the cliff down. You're kind of the, sometimes we take the stairs up, sometimes the elevator up, and there's like a handicap ramp down. Yeah. Right. So your risk is just that slow. Choppy. choppy. Well, it's actually not exactly the slow choppy. It's the slow choppy and a wrong forecast. Sometimes in the slow choppy, if our forecasting is on, then we're trading exactly the right way of each chop. That just happened the last four days is on December 1st, the day before December. So the last day of

November, we got more put loaded. December 1st 1st the market dropped and then December 2nd or whatever it was the last few days it dropped two days in a row we took off some puts off the table and bought a bunch of calls and the next day the market rallied and so so we got the exact right side of all four or five days so that's purely systematic based on mean reversion you're not sitting there flipping a coin and no I think this is going to rally. No, I do have a very special coin that I like to flip once in a while

that has a 51% edge. No, I'm kidding. No, it's all systematic. It's the same program that we've tested and been running live for many, many years. We tested over decades, and it has a consistent... We do have an edge on that forecast,

and that's why we continue to do it. And of course, we always innovate. And there we look for, you know, wherever we have weaknesses is where we try to improve. I have a 100% edge program if you want it. Yeah, I'd like just a 10% allocation to that. Yeah, buy now. Yeah, sell when profitable. That's honestly, I value that strategy. Yeah, 100%. Let's talk a little bit the markets in 2020, where you see things going. Coming back to that proxy thing, I think there's a greater than zero chance interest rates go negative. If that causes the market to drop, then that proxy is kind of out of the picture. So just what are your overall thoughts on where we're headed for

2020? Yeah. As a trader and I guess market person for decades, I've come to have very little, not ability, but want or desire or interest or belief that anyone can forecast anything out into the future, hence my market agnosticism, my easy answer is I don't know. The things that I do know, and I don't believe anybody knows for that matter. You're still a human. But I have thoughts. Read the paper. Right, so I was going there.

I was about to go right. So I was like, yeah, yeah. I was about to go where my thoughts are expanding. So my thoughts are, obviously, we look at the last 10 years and QE and the massive passive investing gold rush. It's just there are many reasons

why this bull market has gone on, quote, too long. And I really despise that word too long because there is no too long in stat land. But in all frames of looking at the market over the last hundred years, it looks too long and it looks too steep and it looks too overdone. So for that reason, I'm more, if I had to tilt personally, I'm more on the side of something's going to go wrong sooner than we, you know, or more dramatic will occur. There's also the interesting, you know, the 08 happened.

And, of course, we recovered within a number of years and then just gone on to be so much higher as if, like, all that's gone. And I think there's still issues. I mean, yes, there's improvements. There's nowhere near the drama that there was back then. But there's so many different things surfacing that I read about things all the time. I try to ignore most of the news. But it still doesn't make sense to me logically that we could continue pacing at this speed of this bull market without something correction-wise happening. And the fact, I mean, it happened in December, December of 18.

Of course, all back in January. It's just unbelievable the rate at which we recover. You talked earlier about the stairs up and the elevator down, and now it's an elevator down and elevator up, right? And it's almost unbelievable to watch as someone who's been in the markets for 25 years. But also like in a six flat or something, right? It's not a long way down. Yeah, yeah.

But I look at all that and I say to myself, as a logical person who's familiar with markets, it just can't persist like this because it doesn't make sense. It can't be that good for that long. All these companies cannot continue to just keep on outperforming and you know, these rates of return don't look like this over long runs. And so I'd be more cautious than I usually am.

And that's from my- And if you're wrong in that, which you don't care if you are or not. And I'll own some calls. Right, it doesn't matter to your strategy. No. Yeah, that's the beauty. Yeah. Great, the beauty. Yeah.

Great. A little bit, I want to get a little bit more about your personality, who you are, a couple of your favorites. We'll just go rapid fire. Favorite investing book? Wow. A lot of them there. I'm going to go back to Peter Bernstein, Against the Gods, The Remarkable Story of Risk. Yes, read it. I loved it. Yeah. The other book, non-investing book. Non-investing book.

This is going to get a little deep here, but I wrote my thesis at Berkeley on Proust. It was called Remembrance of Things Past. It's an incredible work of literature. And that, it's the most amazing book I've ever read. I read it twice. What was your thesis? In your thesis? My thesis was that, so it's a very long book. It's three and a half thousand pages. Okay, we need a very short answer. We know, right. And so, but this is part of my thesis. That's three and a half thousand pages. Okay, we need a very short answer. Right. But this is part of my thesis. That's why I had to say that. And so, for example, he spends 50 pages talking about how he dipped a cookie in a cup of tea. But it's phenomenal. You can't even

describe it, but it's so phenomenal and how one could do that and what all the meaning behind it was, et cetera. So what I wrote, my thesis was that the book title, Remembrance of Things Past, is an older person trying to go back and remember the things in their past and their childhood that made them who they are and the things that changed them. And we talk about path dependency in markets. There's path dependency in humans, right? We go through experiences in our lives and they make us who we are of course um and so the uh the Gwyneth Paltrow movie sliding doors yeah there you go exactly and many of them

or Mr. Destiny there's been a bunch like that actually my favorite one is the Wall Street one which is Family Man um yeah yeah um anyway so um when you he's remembering these things in his past and he writes this book over three and a half thousand pages so what I my thesis was that he kept it he elongated it so much so that by the time you're on page

2812 and he talks about something you remember he talked about it on page 52 but it was so long ago that you read it that you feel the feeling. It's like your brother or something. It's been with you for years. It's been with you. So you're getting the feeling he's trying to convey

in remembrance of things past. He does partly by making it so long that you have to remember the way he's trying to remember when he was a child, right? So he puts you in the frame of struggling to remember that paragraph or that scene by extending his writing so largely. This might just be a humble brag that you've read a 3,000-page book. Yeah, I mean, we had a semester to read it, so that's a—

What percent of the population, I think, has read a 3,000-page-plus book? Yeah. It's got to be sub-1%. I wonder. I don't know um but uh yeah uh yeah favorite santa monica restaurant ooh um elefante elefante yeah where's that um it is on uh by third street promenade um it's and it's uh it's on a you kind of take this secret looking elevator and go up to the top floor and it's overlooking you see the ocean views and open it's really just a beautiful environment and really good food and nice social crowd let's go there next time I'm in town favorite

Star Wars character Luke Luke yeah all right and one more with a twist assume all your personal money is in a blind trust RCM picks the managers that are in there what other hedge fund or strategy would you hope that the pros at RCM put in there for you that's tough what other hedge fund That's tough. What other hedge fund? Yeah, we're just trying to avoid, of course, my own program, right?

Yeah, no, of course. Yeah. I mean, being such a heavy quant and appreciating mathematics the way I do, I would just, you know, I think some of the best strategies, there is no best. The best strategies, I think, are the ones that feel the best for us. Go back to the human thing is, you know, we should all do what we're comfortable with. And so for me, I'd go with a lot of the top quant shops. It's whether it's the Two Sigma, D. Shaw, Rentech, of course, any ones that are actually open. Right. That's my other thing.

The fine print. We have to actually, it has to work with your investment amount. And it's open. So now we're in a narrow world. Yeah. I mean, I would want you guys to use, to do what you do, to the thoughtful study of managers, knowing what you know to find people like myself that are sophisticated, that are thoughtful, that understand what they're doing and have good edges that are complementary to what it is that I do. And I guess that's who you are.

So I'd say just do what you do best. Done. And cut my fees. All right. Thanks, Wayne. Thank you. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel.

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