Episode #134: Chris Cole, Artemis Capital Management, “Volatility Is The Instrument That Makes Us Face Truth”
Guest: Chris Cole is the founder of Artemis Capital Management L.P. Artemis focuses on volatility trading through two private investment vehicles. Chris founded the firm following verified and substantial proprietary account gains during the 2008 financial crisis.
Date Recorded: 12/3/18 | Run-Time: 1:02:33
Summary: Meb kicks off the show by asking Chris to describe his nontraditional background. Chris studied cinematography in film school at USC, while trading options in his spare time. He eventually made a career switch and began in Merrill Lynch’s analyst program in New York, while trading in his spare time. With his trading, he eventually created $1 Million to start his firm.
Next, the conversation transitions to Chris’s work, including his take that “Volatility is the only asset class.” Chris follows by discussing how returns can be deconstructed to represent either “short-vol” or “long-vol” strategies. He mentions that the average institutional portfolio is a 98% short-volatility portfolio that will not perform all that well during a period of regime change.
Meb then brings up some recent events that have transpired to lead into a chat about short vs. long volatility, and some dangers when thinking about the strategies. Chris discusses how volatility can be expressed in both tails, for example, the right tail being high volatility and high asset returns, and provides an example that volatility was averaging around 25 in the late 90s when the market was going up 30% per year. He follows with a stat that at-the-money vol moved more in January of this year than it did in the February move most might be familiar with.
Chris then provides his thoughts about regime changes, what is possible, and what he sees in the market. He starts with his recent paper, Volatility and the Alchemy of Risk. In that paper, he uses the example of the Ouroboros, or “Tail devourer” as a metaphor for the current short-volatility trade. What he sees as a worry are the explicit short-vol traders, $1.4 Trillion of implicit short-vol strategies that are re-creating a portfolio of short options by financial engineering, and corporations using leverage to buy back shares, suppressing volatility. All together these scenarios represent a snake eating its tail.
Meb then asks Chris to talk about market pressures that have resulted in liquidity changes. Chris explains that this is the only bull market in history with less and less volume, and less and less volatility. He mentions that what was scary about February’s volatility was that liquidity vanished. He follows with a discussion of passive vs. active investing, and the role active investors play in the market.
Meb then asks about catalysts for stress in the market. He talks about the passive strategy not being understood by investors as something that could lead to de-stabilizing conditions, and that over 50% of the investment grade debt is in the lowest rated tranches, and over $2 Trillion of debt that needs to be rolled in 2019 and 2020. He mentions that what could potentially cause an issue is inflation leading to higher rates, a minor turn of the business cycle given the amount of leverage and gearing on corporate balance sheets, as well as the reliance of stocks and bonds being un-correlated if the markets enter a period where stock and bond correlations are in fact positively correlated.
Next, through an example of rental car insurance, Chris gives some background on implementing long-vol strategies by using quantitative analytics to help identify points in time where you are paid to own “insurance” against market declines, in addition to predictive analytics that provide an informational edge to help understand whether or not it might be productive to own protection against market volatility risk. Meb follows with a question on the Japanese Vol Monster. Chris describes the short-vol trade that has been going on in Japan for a long time. He then describes philosophically that volatility is the instrument that makes us face truth.
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Links from the Episode:
- 00:50 – Sponsor: Esters Wine Shop & Bar
- 2:03 – Welcome to the show
- 2:35 – Chris’s origin story
- 5:18 – Volatility as an asset class
- 5:32 – Volatility: The Market Price of Uncertainty
- 8:21 – In defense of a short volatility trading strategy
- 10:31 – Short volatility vs long volatility
- 13:47 – Dangers of playing in this market in light of current events
- 14:16 – Volatility and the Alchemy of Risk
- 20:43 – Dangers of the tectonic shift to passive investing
- 29:03 – Catalyst that will lead to stress in the system
- 39:26 – Whipsaw Song
- 39:28 – Sample long vol strategies
- 47:41 – The Japanese Vol Monster
- 48:12 – Tobias Carlisle Podcast Episode
- 50:25 – Understanding “Volatility as an Instrument of Truth” or “Volatility Time”
- 53:49 – Tom Dorsey Podcast Episode
- 54:15 – Most memorable investment or trade
- 58:21 – Favorite movie and/or graphic novel
- 1:01:23 – Best way to follow Chris – ArtemisCM.com
Transcript of Episode 134:
Welcome Message: Welcome to the “Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing, and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
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Meb: Welcome, podcast listeners. Today we have an awesome show with you, with the founder of Artemis Capital. He focuses on all things volatility related, his goal, as is many, is to profit during market turbulence, and given the recent market hiccups, it’s a great time to have him on. Welcome to the show, Chris Cole.
Chris: Thanks, Meb. It’s great to be here.
Meb: I think you’re probably the second person we’ve had on the podcast who got their career started in film, which is interesting, the other one being John Bollinger, who is a LA sort of film guy. But before we get into all things volatility hedge fund markets, I think it’s kind of fun to hear your glide path, hear your origin story, because you got kind of started right down the road from us in Manhattan Beach. You went telling the audience your beginnings?
Chris: You finally bring up Bollinger, because it’s true. He’s the only guy that I’ve ever seen that has a background sort of similar to me. I originally studied cinematography, and that’s the only thing I ever formally studied. And it was actually back in film school at USC that I began to trade options in my spare time. And picked up Layer McMillan’s book and read all about options trading, and kind of caught the bug. And coming out I just independently did the CFA program out of just pure interest.
Meb: By the way, no film student has ever said that in the history of film student at USC.
Chris: I know. So it was interesting because I’m sitting there and very early in my room, working on film sets, literally working on a Madonna film set, and also, I’m studying for the CFA. I was loading cameras and doing second AC work. I really caught the investing bug, and began just teaching myself. And then finally decided to make a career switch based on that interest. When I started at Merrill Lynch, that I went to the classic analyst program in New York, you know, where they train all the investment bankers and instructors and I was the only person in that program to have a CFA and the only person to have an art degree. So strange story. I worked in LA in the New York City, in structuring bond deals. I structured billions of dollars bond deals. And then derivatives, worked in a lot in the rate derivatives space. In the spare time, I began trading VIX futures and VIX options just for fun. You know, at the time the bank had no problem with that, because it was a statistic, it wasn’t on the stock, it wasn’t in the bond. Period between 2007 and 2009 exponentially compounded my personal portfolio and a little bit of family money running long vol strategies, and running essentially the beginning of the philosophy that I now run institutional money with. And out of thin air, you know, created the first million dollars that was used to fund my hedge fund, you know, went out on my own, and here we are today with institutional clients all over the world. It was a very non-traditional story.
Meb: Awesome. I love it. Well, if you think about it, film business is somewhat of a long vol business where you have, you know, some of these massive hits. And as I know, because I have lots of friends in the film industry that are basically at various stages of unemployment, you know, there’s a long tail of struggle as well. So let’s start broad, last time you and I sat together, had some beers. And now you’re located in Austin, Texas, and we’re still here in LA, and you think and talk a lot about volatility. So we’ll post these show notes if you let us but there’s a couple white papers you wrote, one called “Volatility, The Market Price of Uncertainty.” And there’s a great line that I wanted to use a jumping off point, because you said, “To understand volatility as an asset class is to value the forward expectation of uncertainty, which is much a function of human psychology, as is an expression of mathematics.” And you also say, “Volatility is the only asset class which is interesting,” because I’ve never heard anyone else ever say that. So maybe talk a little bit about that. Help us understand what you mean by that.
Chris: Let’s imagine that you are an alien from outer space and you come down. And you know nothing about finance, you know nothing about asset classes. The only thing you have to do to evaluate investments is to look at return streams, you’re just looking at returns. So you would find that depending on the asset you’re looking at, the returns look very, very similar. You have assets where their returns go up for a long period of time and then there’s huge drawdowns and declines when there is a change in the regime. And then you have the first few number of assets where it’s the exact opposite, they cost something or they have flat returns, and then they tend to do very well during periods of turbulence and period of change. So I would say that most people, if you look at asset classes, they tend to either be bets on the status quo or they tend to be bets on change. The institutional portfolio today is almost 98% driven by bets on stability, and those are strategies that I would consider for fall. So these strategies, things like value investing. Value Investing is one of the greatest shortfall strategies, because when you’re investing in a value stock, you’re making a bet on the assumption of stability. It might be a smart bet, but it’s still a short vol bet. It’s still making a mean reversion. When you’re investing in credit, you’re betting on mean reversion.
So all of these different strategies that people think are diversifiers and actually have this positive bent towards stability. Very few strategies actually perform very well during periods of regime change. In my view, there really is only one asset class. People say, “Is volatility and asset class?” I say it’s the only asset class. Because if you decompose the returns of all these different strategies into what they really are, they tend to either look like short vol or long vol. In that sense, you can simplify the institutional portfolio into those broad buckets. When you do that quantitatively or just qualitatively, but from a quantitative standpoint, you will see this if you run a dimensionality reduction on some of these portfolios. And the average institutional portfolio is just a 98% short volatility portfolio that is exposed to various degrees of football exposure that will all perform not that well during a period of regime change. This philosophy underlies pretty much everything of what Artemis does.
Meb: Well, it’s interesting, and I think you’d probably agree with this. Your comments I think are accurate. It’s not necessarily a bad thing like to say, “Hey, you’re a shortfall fund.” I think people in their head they hear short vol and they automatically think this is awful, but a strategy like Buffett’s, and they would probably be the first to admit it. Even monger goes as far as to say, you know, if you can’t handle a 50 plus percent drawdown, you have no business investing in listed equities. There’s still can be great strategies. It’s just a framework of how to think of how they actually behave.
Chris: Exactly correct. Warren Buffett is the greatest short volatility trader ever. But make no mistake about what he is. He’s a short vol trader. He’s waiting for a stock or a company to get below its intrinsic value, and then he buys it betting on the inversion. So that is a short volatility trade. It’s a trade that is always…or an investment. It’s a strategy that is always going to be based on the expectation of some degree of mean reversion. And it is a strategy that is subject to large drawdowns. And when I say that Buffett is the greatest short volatility investor, in many instances, he was explicitly short volatility. During the 2008 financial crisis, most people don’t realize this. On one page within your report, he’s a crafty guy, he’s a crafty guy. On one page of his annual report, he describes derivatives as weapons of mass destruction and venereal diseases. And then on the very next page, he describes one of the largest short derivative trades in history that he was executing. He didn’t call it that, he didn’t call it a short volatility or short put strategy, but that’s what it was. So, you know, it’s very interesting that people sometimes will think, “Oh, just short volatility, that’s bad word.” But most of their strategies have element that is either explicitly or implicitly short volatility.
Meb: It’s interesting, I laugh because having read basically all Buffett’s letters, laugh at some of his references in the sort of me to age, he’s starting to sound like an old perv in his old age with some of the references, but love him. Okay. So let’s talk about, there’s been some interesting events that have transpired since you and I last hung out that we can probably use as a jumping point to talk a little bit more about short vol and long vol in some of the benefits and drawbacks, because like many things neither strategy is perfect. They just have their sort of uses. And since you and I hung out there was a pretty dramatic event that happened in the option world with, well, there’s one right before we hung out in February then also one recently with option seller group. I wonder if you can maybe tell us a little bit about that, but also use that as a jumping point to kind of talk a little more about how you think about short volatility versus long volatility, some of the dangers therein when thinking about strategies.
Chris: When I talk about being a long vol trader I think most people think that that means I’m sitting around waiting for the world to blow up, but, you know, volatility can be expressed in both tails. And what I mean by both tails is that you can have periods where there is high volatility and high asset returns. Most people associate volatility with the left tail. We think volatility we think 2008, we think VIX jumping to 80, but I don’t think most people realize that volatility was averaging around 25 in the late ’90s, when the market was going up 30% a year. If there was a VIX index during the Weimer Germany, that index would have started around ’19, right around where volatility generally is in U.S. markets today in 1919. And by 1923 that Weimar Germany VIX index would have reached 2,000%, entirely on asset price increases during the hyperinflation. So volatility doesn’t always need to mean left tail exposure. It can mean left and right tail exposure. You can have higher volatility in high asset prices. And most people have really forgotten this.
Artemis tries to play both tails, we’re looking for volatility and volatility trend in both tails. So we’re looking to turn that volatility in opportunity for our clients. So this here it’s really amazing because most people talk about the volatility spike in February, you know, vol spiked up, but believe it or not at the money vol moved more in January than it moved in February. If you say that to most people, they think, “Oh, that must be wrong.” One podcast, it’s hard to show a graph. That’s what point movement in volatility was actually higher in January on the market going up than it was in February. So I think this is a really important thing to keep in mind that when you bet on volatility, you’re betting on change. But regime change can occur in both directions. But this year, we begin to see cracks in the theme of this low volatility regime that’s been persisting that largely started with Central Bank manipulation and compression of volatility that has led to a whole range of proliferation of institutional short volatility strategies. We’re beginning to see the very cracks in the theme of this coming from what we experienced in February this year and October of this year, but both of those corrections are very different in nature.
Meb: Maybe walk me forward and feel free to talk about either event, you could talk a little bit more about February, but more importantly I would love to hear your thoughts on sort of the last couple months in what happened with the option seller group, as in examples of probably how to think about some of these regime changes and what’s possible out there.
Chris: I can’t talk specifically about any individual group that has blown out, but I can speak in generalities about what I do see in the market. I wrote a paper called “Volatility in the Alchemy of Risk” last year, and that paper I think has been very widely quoted and in some cases copied. I talked about this concept of an ouroboros, and an ouroboros is that Greek word meaning tail devourer. And this is one of the oldest symbols known to humankind of a snake devouring its own tail. So this sign appears across cultures and it’s an important part of sort of the esoteric tradition of alchemy. So there’s a snake devouring its own tail. It comes from something that actually occurs in nature, where a snake gets overheated, it gets confused and it begins to see its own tail as prey and because the self-cannibalize. Well, I’ve used this vision of the snake eating its own tail as a metaphor for the global short volatility trade.
This represents about $2 trillion of financial engineering strategies that are simultaneously exerting influence over and are influenced by stock market vol. So in this regime where central banks have lowered interest rates to rock bottom levels, you know, used to be, if you’re a pension system, you used to be able to get your return, used to be able to get your actuarial return by just investing in treasury bonds. But now, we have to go further on the respect from further out of the liquidity spectrums. What we see people do is they’ve actually turned a financial engineering and the sale of volatility in order to generate yield.
This is a problem because vol is now an input for risk-taking and the source of excess returns in the absence of this value. What we have is a system where there’s now $2 trillion worth of financial engineering strategies that are using volatility as an input for risk-taking. So what this means is their financial engineering strategies where the lower vol goes the more they’re able to size, and the higher vol goes the more they have to reduce risk. This creates a dangerous reflexivity. And what we are seeing with some of these funds that are blowing out, this could be XIV which Artemis has warned about for, if you look at Artemis writings, we warned about the blowout in the VIX CPP is doing back, actually, as far as 2014 and even hinted back at it as far back as 2012. But some of these funds that have blown out by shorting options, by shorting posts, shorting calls, shorting options on natural gas, shorting VIX futures, these strategies are the weak hand of the table. These are kind of like the subprime lenders that blew out in the beginning of 2007. Like people forget about some of those. These are the over-leveraged dumb money they’re blowing out.
But there was a much scarier $2 trillion short vol trade that some of the smart money that will potentially blow out later, and this is the source of the systemic risk. So if we look at the ecosystem of the short vol trade there’s about $60 billion of what I like to call explicit short vol. This is the weak money at the table. These are things like shorting VIX futures or the dumb institutions that are simply writing naked calls and naked puts, and then some of the pension overriding schemes. That’s about $45 billion worth of pension systems that are shorting puts or shorting calls. These explicit short vol strategies involve the actual sale of derivatives, and they would be considered some of the weakest hands at the table. These are guys who have really good performance histories over the last couple years but blow out first, just like the initial subprime lenders did at the end of 2006 and in 2007.
The bigger worry is the $1.4 trillion, what I call implicit short vol strategies. These are strategies that even though they’re not explicitly shorting volatility, they may not be actually shorting an option. They are recreating a portfolio of short options by dynamic and by financial engineering. So these are strategies like risk parity, var control funds, risk premia funds. These are strategies that are replicating a short volatility portfolio by the way that they trade. And then we throw on top of that, we’ve had another $5 trillion of share buybacks which…someone might say, “How is that a short vol trade?” Well, if you think about what share buybacks do, many of these companies are borrowing money levering up their balance sheets. We now have $3 trillion at the lowest tranche of investment grade, all based on many of these companies that have been levering up their balance sheets and buying back shares. This has been a strategy that artificially suppresses vol, to smooth out earnings per share growth. It’s truly a self-cannibalization of the market. If you can’t make your sales grow and you’re a CEO and you’re being evaluated on your EPS growth, what you can do is you can issue debt at ultra-low interest rates, you can buy back your shares, reducing your shares, increasing your EPS, and smoothing out your earnings. This is transferring the risk to your shareholders and it’s artificially lowering volatility because every single time your company drops in share price you are buying it back. You were a snake eating back your own tail.
That then allows for the implicit vol strategies. The guys, the $1.4 trillion of risk parity funds, var control funds to them buy more equity, which then allows for the explicit short vol guys to come on in and short the derivatives. So this is all one big dangerous snake eating its own tail. But at some point, at some point, that self-cannibalization ends, and the snake dies. So what we’re seeing are the weak hands on the table being blown out. What we may see later, this is an appetizer, just like early 2007, you know, number one, you know, Bernanke said, subprime is contained. Well, what people are not saying is that there’s a much bigger implicit short vol trade out there to unwind violently if we begin to see either a sharp increase in interest rates or short-term down in the economy.
Meb: You talk a lot about some of the fragility of the system. And one of the areas that I learned quite a bit talking about that, I thought was interesting when we chatted was, you talked a little bit about this being a rare market that, particularly in the U.S. as you’ve had this incredibly strong stock market, I mean, 2017 arguably the lowest volatility market on record with every single month was up, but one of the things you shine the light on was talking about market pressures that resulted in liquidity changes. And this was something I hadn’t thought that much about. But you talked about how this is a market that over the years has become actually less liquid rather than more. Any thoughts on that for the listeners?
Chris: This is something that actually is even scarier. If you look at volumes, we are down to where they were back in the late ’90s. If you look at free flow chairs we’re back to where they were in the late ’90s, when he was snake eating its own tail, when you have 40% since 2009 and 70% of EPS growth since 2012 is driven by share buybacks, that’s because you’re reducing the number of shares, so you’re reducing volume. So you just pull up on Bloomberg and look at a chart of the volume and look at a chart of the free flow chairs. This has been the only bull market in history where we’ve had less and less volume, less and less liquidity. Liquidity is almost like the new leverage. I think one of the things that was most was terrifying actually, about February was not so much the fact that volatility exploded, but it was the fact that liquidity vanished.
So we had a relatively shallow decline in the stock market. I mean, the market dropped 4% and liquidity completely vanished. If you wanted to move 200 e-minis that day, which is not really that much, you would have moved the market multiple handles. We saw it as spreads and highly liquid ETFs blow out to 22 standard deviations. Our liquidity and options and future space was shockingly low. And this is just in the equity market. We’re not talking about what you’re seeing in the bond market. You look at it as effect of you’re removing the number of active investors. Somebody estimates, but JP Morgan says that over 50% of market is now gonna become passive. So you remove all the active investors whose job it is to provide liquidity during a market decline or they’re gonna step in and buy when the market is undervalued and sell when the markets overvalued. Now, the Fed has put active investors out of business, and now everyone’s moving to passive.
So you have this massive amount of passive investors combined with the lowest liquidity in two decades. And that’s measurable in both stocks and bonds, just horrific liquidity. And then an entire market that is driven by the need to systematically rebalance based on volatility as an input. This is a perfect storm, a perfect storm for a liquidity gap type of crisis, similar to what was experienced in 1987. And we got a glimpse of this in February in what was a relatively shallow drawdown. I was at a conference where I presented some evidence to this effect and someone called me out at the conference. So, you know, “Chris, you’re a long haul guy, you’re being hyperbole.” Then they went around and talked to some of the other managers. You know, one manager stood up and said, you know, “It’s 26 years in the business side of running money. I’ve never seen liquidity as bad as it was February.” The shocking assertion. Everyone who actually managed institutional money stood up and agreed and said liquidity was absolutely terrible. What’s amazing to think about is if liquidity gets that bad when we have a 4% decline in the stock market, what’s going to happen if you have a 20% to 30% decline?
All these guys stand up and they say that passive investing is the new way to go. Passive investing is the new way to go. You know, all of these Bogle heads, I’m stealing that line from Jared Dillion, but I think that’s exactly what they are. They say, “We wanna move to passive investing.” Well, guess what? Passive indexing has had the best risk-adjusted performance over 200 years of data. That’s something that was presented my paper from 2015. This is one of these points where passive investing becomes a form of liquidity momentum, it just becomes a form of momentum for you. Let’s just imagine that the market is entirely driven by passive investors. Well, then you’re entirely dependent on flow. I want you to imagine, you and I hung out the other day, we grabbed some beers. Imagine that we have a friend, and we’ll call this friend the passive investor. And that friend gets wildly drunk. It’s out of control drunk, and he’s chugging beers and he’s taking shots. And what happens is that that’s our passive friend, and you and I are active investors. So someone’s gonna pay us money to make sure that this guy gets home safe. So what happens is that every single time there’s an optimal path for him to get home, but every single time he veers too far in one direction or too far in the other direction, you and I push him back to the right path. That’s the role of the active investor.
But when central banks put all the active investors out of business, imagine that that passive investor, all of a sudden, the central banks have put all the active managers out of business, our passive drunk friend is now 20 feet tall, is incredibly strong, and you and I, as active investors, are too puny, we want to help them get home, he’s stumbling drunkenly out of control, and we want to try to push him on the right path, so he doesn’t hurt himself, but we are too weak to do it. We’re too weak. So what happens is that drunk passive fool stumbles out, he stumbles out of the bar, he stumbles across the road on the highway and he gets run over. When the market is dominated by passive investors and there’s not enough active investors to provide liquidity, the market becomes entirely driven by flows. Every incremental buyer sends the market up higher and every incremental seller sends the market down lower. So we’re at a point where the market is now pushing 60% passive right at the point when the baby boomers are gonna start retiring. Where are the flows? The flows are gonna be selling and there’s not gonna be enough active investors to push that drunken passive fool from running out in the highway.
And by the way, Meb, you can test this mathematically. You know, Mike Green, a friend of mine who I’ve done a couple real vision interviews with, this is his theory. He actually called me up and said, “I have a theory that the preponderance of passive investing drives higher vol,” and I said, “You know what, I totally agree with that.” And he’s like, “But the second part of my theory, Green’s theory, is that the more the market is dominated by passive investors, the less alpha there is for active managers.” I’m like, “I don’t know if I agree with that, Mike,” but he said, “Well, you should build your own role model and test it.” And sure enough, I built my own simulation model, and he’s absolutely right. He’s absolutely right. And it makes perfect sense. If you’re compensated for pushing the drunkard back in line, if you’re too small, the drunkard just overpowers you, you’re put out business.
If passive investors wanna drive the price of Tesla to $2 billion and there’s no active managers to push down that price to a fair value, it can wildly swing in either direction, out of control. It actually makes common sense, until the point where the active investors are put out of business. This is what we’re seeing, one active investor going out of business after another, everything being replaced by either passive or systematic strategies that are inherently replicating a short vol portfolio. Risk does not necessitate outcomes, but this is a perfect storm in a world that is highly leveraged and with a pullback of a set of accommodation.
Meb: You know, it’s interesting when you talk earlier about aliens coming down, you know, I actually use the alien analogy when talking about market cap waiting and why market cap waiting is decidedly odd and suboptimal investment strategy, despite the fact that it is actually the market. So I’ve heard quotes from Bill Miller that actually says, “If you take into account closet indexing funds,” so people that…don’t say they’re indexers but for all intents and purposes, have zero active share, and basically peg the benchmarks. A lot of these old-school mutual funds that have accumulated 50, 100 billion in assets and have no choice but to be a passive index fund under one and a half percent management fee. He actually pegs the passive up closer to 75% already. So you have the scenario that is fragile, like you mentioned, for a number of reasons, there’s less liquidity, I would actually add another problem and challenge, which is investors around the world have somewhat crazy expectations where we talked about survey after survey that shows that people expect 10% returns. Plus Millennials are up around almost 12, and most pension funds that are around 8. And you’ve had a period of passive there’s some articles, you see them every day now where they say 60, 40 portfolio in the U.S. has beaten every single Ivy League endowment for the past 10 years. So you’ve had the returns be fantastic in the rearview mirror and these stressors.
I wonder if you think, and this is getting into a bit of just sort of guesswork, and I don’t think there has to be a catalyst. But I wonder if you think is there any sort of catalyst in your mind that is some of the forefront of what might be the first domino to start this cascade? And you mentioned in one paper, you talked a little bit about inflation, but is there anything else that you see as a concern or something you would maybe think would be a catalyst for stress?
Chris: Let me first elaborate on the first thing you said. It’s so true. Just the irony of this Boglehead crowd is that they just count the efficient market hypothesis to support this passive investing kind of indexation while simultaneously completely failing to comprehend how the dominance of that strategy, and it is a strategy, actually causes the market to become highly unstable and inefficient. That’s the thing. One of Jim Grants rules is that Wall Street will find a good idea and everyone will crowd into that good idea until that idea becomes dangerous. But what causes the underlying? Well, at the end of the day you have to look at the situation where the amount of leverage that has been applied to the system. It’s been part of the same philosophy which is that, “If you can’t achieve returns then you use momentum, you apply leverage, you short vol in some capacity and apply leverage to that.”
We’re now at a juncture where there is the largest degree of lowest rated tranches of investment grade debt is now over 50% of the investment grade market. There’s about $1 to $2 trillion of potential investment grade debt that can get downgraded to junk status if there’s even a hiccup in the economy. This is occurring at a point in time where we are trying to normalize rates. I mean, by any standard of history, rates where they are today are still incredibly accommodative so, you know, at this point there is $2 trillion worth of debt that needs to be rolled over the next two years. It is a mountain of debt that needs to be rolled in 2019 and 2020 so it’s just a game of musical chairs.
And this is the difficult thing, as long as companies are able to access debt markets, continually leverage their balance sheets to buy back shares, you can extend this illusion for a long time. And that’s the danger of trying to be too bearish. But the thing that could potentially cause this is a simple…either inflation leads to higher rates or even if you don’t get inflation, if you end up having any meaning…like minor turn in the business cycle, given the amount of leverage in gearing that’s been on corporate balance sheets, this expansion of credit spreads could be quite damaging to this game of musical chairs.
The other thing I think that would be really dangerous as well, we have built trillions upon trillions of dollars on the expectation that stocks and bonds are anti-correlated with one another. You know, if you go down to your average investment advisor they say, “Oh, you just do a 60-40 stock-bond split.” Well, that’s worked fantastic for most of our lives, but if you look over 100 years stocks and bonds have actually spent more time correlated with one another than they’ve spent anti-correlated. You can see this in some of our grass from our paper in 2015. It’s on our website. There’s many instances across history, including the early 1900s, late 1970s, 1950s, where there would have been three-year periods where stocks and bonds declined together.
So, we’re looking at a situation where, if you’re gonna get the type of return from your bond portfolio that you got in 2008 U.S. Treasury, you’ll just have to go down to negative 2%. Now, that’s possible, anything’s possible but highly improbable. So you have all these people that are relying on the stock-bond correlation for their retirement portfolios. You have all these institutions doing that and you have all these risk parity funds that are leveraging the bonds. There’s a systemic risk if for two to three-year period stocks and bonds could climb together. You know what’s going to perform in that environment is volatility. The 60-40 stock bonds split becomes 100% loser, volatility can perform in that environment. But many institutions are too afraid to get into a long volatility strategy.
Can I tell you about a crazy strategy that has actually beaten the S&P and the average hedge fund by a tremendous amount, is a go take the CBOE long volatility hedge fund index. Take 50% of your bankroll and put money in that index and then take 50% of your bankroll and put in the S&P 500. The CBOE long volatility hedge fund index is an index, Artemis is a member of that index as is many of our competitors, but it’s actively managed intelligent, long volatility exposure. This long vol exposure explodes during periods of crisis, so what do you end up getting is a nice straight line. This strategy has beaten the average hedge fund by over 90% since 2005. It has more than twice the risk-adjusted performance of the S&P 500.
So one of the analogies I like to give is Dennis Rodman. A lot of people remember Dennis Rodman and think of him as tattoos and dating Madonna and Kim Jong Un. But back when he was a basketball player, Rodman was an incredible rebounder. In fact, he’s the lowest scoring inductee in the Basketball Hall of Fame. His highest scoring seasoning he only averaged 11 points a game. He was never a very good scorer but Dennis Rodman did one thing and one thing really well, and that was rebound the basketball. In fact, he was so good at rebounding the basketball he was six standard deviations better than the average NBA player at getting rebounds. Well, a new paper that’s come out has indicated that Dennis Rodman statistically, by advanced statistics, advanced statistical analysis should be considered one of the greatest basketball players to ever play the game of basketball.
How do they make this argument? How do they make this argument from a player that could not even score outside of five feet? Well, Dennis Rodman was so good at rebounding the basketball. When his teammates missed a shot, he was able to give a second and a third chance opportunity. What that did is paradoxically when you put Rodman on the floor with good offensive players he would make them great and we put him on the floor with great offensive players like Michael Jordan, the team would become legendary. Rodman on the basketball floor, the offensive efficiency of his team exploded through the roof. Rodman’s wins over replacement value was among the greatest in NBA history. So Rodman, even though he couldn’t score, created so many second-chance opportunities for teammates that he turned good teams into championship teams and great teams into all-time great teams. It’s one of the reasons he has five championships.
Well, long volatility is like Dennis Rodman. You don’t want a portfolio of long vol, that’s not gonna get… You need some scoring but if you have even mediocre scoring like the S&P 500, when those scores go dry, the long vol exposure comes in and performs and rebounds your performance in such a way that allows you to buy stocks when they’re at fair value or lower. It allows you to hold those liquid positions. It allows you to stay invested. So long vol exposure that’s convex [SP] is like Dennis Rodman. So to this extent, the CBOE long volatility hedge fund index, strategies like the Artemis type of strategy combined with the S&P 500 blows away the average hedge fund. It blows away the 60-40 bond portfolio, but you know what, people don’t wanna do it. You know why? The institutions would rather fail conventionally than succeed unconventionally.
Meb: First of all, I think it’s so true, we run probably some of the most atypical portfolios for any advisor in the country, a huge chunk, which is long vol. We also posted on Twitter today an old banjo song by Ed Seykota called “The Whipsaw Song” which kind of gives an example of a long vol strategy being…one of them being trend falling where you take many, many small losses, we’d end up some large gains, both long and short, but he plays the name of a song called “The Whipsaw Song” and we’ll post it to the show notes. But, okay. So let’s say everyone listening is like, “All right, Meb. All right, Chris. I’m convinced. I pulled my car over because I almost crashed it listening to your end of the world scenario with my traditional U.S. stocks-bonds portfolio. I’ve owned GE, it’s almost gone to zero. I believe what you’re preaching. I can’t even wait to hear the comments on the Boglehead forums.” That’s the biggest piece of advice to give anyone. Never read the comments in investment forums.
Let’s say they’re convinced. So first of all, they could obviously invest in your funds. You manage hundreds of millions of dollars in these strategies but also, maybe walk us through a little bit of a framework of just sample what you mean when you say some of these long vol strategies. I’m sure some people hear this and say, “Okay, I assume that means I’m just gonna go buy a bunch of puts on the stock market or I’m gonna go buy a bunch of random, you know, calls on XYZ.” What are some of the best ways to think about actually implementing a thoughtful investment approach in this world that may be kind of a useful example of some of these type of strategies and trades that you’re talking about when you say long vol?
Chris: We’re a little crazy at Artemis because we have a team of eight people that spends all day and all night focusing on these types of asymmetric trades and systematic trading strategies that can pay off during periods of change. And it’s not easy. You know, we have multiple PhDs on staff that are working in predictive analytics and machine learning to understand what drives volatility. We have domain experts on staff like myself that spend time studying the intersection of the drivers of prior crises to understand how that works. We have quantitative structures to focus on, how do we structure different trades that are long convexity and long carry? We have traders that focus on the execution and buying. How do we execute those strategies with the least amount of slippage?
This entire staff of experts in different areas ranging from machine learning to Olympic award-winning athlete to focus on execution, focus on domain expertise, to do this and to do it well, it is so much more than just buying put options and rolling it. There’s a dumb way of executing the strategy and then there’s a very difficult way to do that in a way that’s positive carry and positive convexity. And in one of the worst times, for what we do, this last centrally bank driven regime of low volatility, Artemis has generated a positive return where our competitors are down anywhere between 30% to 50%, but it’s very hard to do that. There are different strategies that we will employ and none of them are very easy to replicate.
I always look at this and say, okay, you came to Austin the other day, we hung out and had some beers. Let’s just say you come to Austin and you want to rent a car and you go to the car rental stand. Say, “You know, I’m kind of interested in renting a car,” and they’re like, “Great. Would you like to buy insurance?” And you’re like, “I don’t know. How much does insurance cost?” Insurance on your car is a little like buying a put option in the stock market. Exposure to potential changes and risk, positive exposure to that. You say, “I don’t know. How much does the insurance cost?” They say, “Well, what if I tell you that we will pay you $1 to carry the insurance for three days. Would you like the insurance?” And you’d be like, “Sure, of course. Why wouldn’t I?” In our markets, we can use quantitative analytics to understand points in time where we’re paid to own the insurance. It might not exist all the time but when it does we wanna be in that position.
So let’s just say now you go back to the same car rental stand and you say, “Okay, I’d like to get some car insurance. How much does it cost?” And they say, “Well it’s gonna cost $100 a day.” You’ll be like, “Oh, well, that’s a lot of money. I don’t know if I need that for that amount of cost.” And then the guy says, “Hey, look, let me tell you something. My brother works for the Austin Police Department and there is a gang running around terrorizing the cars in rental of tourists, the rental cars of tourists.” At this point, you have information that’s not public. I shouldn’t say it’s not insider trading but you have information that’s predictive, that gives you a predictive edge. So what we’re looking for is we use machine learning and predictive analytics to understand when insurance is expensive, it might be expensive, but we know it’s worth it because the predictive analytics are telling us that the risk of volatility is much higher. So these are two techniques that we’ll use to carry volatility in an inexpensive or a positive carry type of way.
The last technique I like to explain is the George Lucas method. What is the George Lucas method? Back in the 1970s, George Lucas had a science fiction film that he wanted to pitch to the studios and he took it around to Fox Studios, and Fox was kind of interested in doing the movie, “The Space Opera” movie. Lucas’s rate as director at that point in time was about a million dollars. And Lucas said, “Hey, you know what? Why don’t I take about $150,000 to direct this movie but in exchange I wanna own the merchandising and the sequel rights to my movie.” The executives at Fox were laughing at this, and it’s not for the reasons people thought, you know, because they had tried merchandising sequel rights before. There was a movie called “Dr. Doolittle” in the ’60s where they originally had owned different merchandising and sequel rights and they ended up writing down $200 million worth of stuffed llama toys. So the concept of merchandising was not a new concept, it just hadn’t worked.
So Fox Studios said, “You know what, that’s fine. We’ll give it. That’s not worth anything. You can take your $150,000 salary. We’ll give you the merchandising and sequel rights,” but of course George Lucas had the last laugh because for $150,000 he bought an option that paid off to the tune of $45 billion given the fact that that “Space Opera” became “Star Wars” and all the toys and all the sequels that came through. Well, George Lucas was a great option trader and he employed a strategy that we sometimes will do too. Lucas had some form of upfront carry, and that upfront carry provided him a salary, but he sold off the upfront carry to buy the second and third order moves. These are the merchandising and sequel rights on “Star Wars” that could pay off in the event that “Star Wars” became a tremendous success. So for those options to pay off, the merchandise and sequel rights, “Star Wars” needed to be a huge success. It couldn’t just be a, “This was a good movie,” but people forgot about it. It needed to be a huge success.
On the same vein, we sometimes will sell off the first movie markets, that first 3% or 2% down to buy the optionality on the 7%, 10%, 20% down move. Sometimes you can sell off that VIX move from 10 to 15 to buy the move over 20 with the vol of vol. This is that aspect where you have some carry, you sell off that carry to buy higher order convexity but you need the vol to not just go up. You need it to explode higher and stay higher. You need a 2008 type of scenario or a 1999 type of right tail moving markets for that optionality to pay off. But that’s the type of long vol trade that I think is oftentimes misunderstood.
So these are generally the three types of strategies that we employ with an entire team of experts both in quantitative structuring, machine learning and trading to pull off the type of positive carry, positive volatility exposure we seek to create. It’s not easy.
Meb: It reminded me of when you were talking about it, a couple of other examples. You know, Sylvester Stallone, famously kept a lot of the rights to his movies in “Rocky,” but also the Facebook, was it the Facebook guy that like did the Facebook mural, had equity in the company and ended up being…
Chris: The mural guy, yeah, that’s right.
Meb: It’s kind of a fun life analogy. It’s looking for times in life that present you with really big potential outcomes as far as long volatility in your life. And I think that’s actually a good analogy. I wanna do a couple of shorter jumping off points. Our good friend Toby, who’s been on the podcast before, listeners, one of my favorite podcasts. I was nailing him, I said, “Give me some good questions to ask Chris.” And there’s a couple questions that I don’t even understand really what they mean. So feel free to talk about these or we can skip if they don’t make a lot of sense. First one, said to ask you about the Japanese vol monster. What does that mean?
Chris: The Uridashi notes. So, you know, the short vol trade has been something that’s been going on in Japan for very long time. So it’s very popular because rates have been so low in Japan. What we’ve seen for over a decade has been these Uridashi notes, which are not being replicated in places like Europe, where what you do is you sell off upside exposure and you sell downside exposure to the market in exchange for a coupon. They’re not pitched to investors as a vol trade, but that’s all they are. They’re pitched to investors saying, “Hey, you know, Meb, would you like to…I’m your wealth manager, would you like to get a 5% coupon? And if the market drops 20% you’ll own the market, and if it goes up 10% you’ll get knocked out of the coupon paying instrument.” This is a structured note that’s very popular in Japan as an alternative to fixed income. And it’s all it is a big short vol trade. But when the strategies unwind, they can unwind in quite violent fashion. As a result, we see odd behavior in Japanese volatility where there’s extreme vol on vol, massive vol spikes, or strange occurrences where spot volatility and the market go up together. So in many ways, the Japanese vol monster is indication of it’s now happening in Europe, and it’s happening in the U.S., just the example of where these financially engineered short vol strategies become dominant and actually drive the overall flows to the market.
Meb: You did a pretty good wealth manager voice who’s trying to sell structured products. Structured products in the U.S. have a long history of being really expensive and fairly convoluted, 99.9% of which, you know, the average retail investor has really no business owning whatsoever in general. Usually is excused to be illiquid and charge you high fees. I’m gonna ask you one more, and then we’ll start to wind down to some fun questions. There’s two more phrases he mentioned that I, again, have no idea where you’re gonna go with either of these, one of which is the concept of volatility as an instrument of truth or the concept of volatility time. You can feel free to answer both of those, either of those or neither, but what either those phrases mean, volatility is instrument of truth and the concept of volatility time.
Chris: You know, it’s funny with Toby because, of course, you’re good friends with Toby, and Toby and I back in the day when Artemis had nothing, no institutional clients, you know, Toby and I would be in a beachfront apartment, and, you know, we would go out on a Friday night after the markets closed and just wax philosophical about volatility markets after happy hour. So this brings me back to some good memories back in Los Angeles. But volatility as an instrument of truth, you know, I think vol as a concept is just widely misunderstood. It’s not fear, it’s not the VIX index, it’s not some statistic or standard deviation. Vol is no different in markets than it is to life. It is just the difference in the world as we imagine it to be and the world that actually exists. So the more you deny truth, the more truth will find you through volatility. And this is true in markets or in life. Volatility is the instrument that makes us face truth. Vol time, oh, this is interesting too. Okay. So, you have to think, Chris, two glasses of wine in, begin to think about volatility in terms of… No, volatility, as it’s measured statistically in markets, is always measured based on linear time. But what if we look at market prices and things other than time?
Let me give an example of this. You know like at the end of Armageddon, where Bruce Willis is like imagining his…you know, he’s about to blow up the nuclear bomb, to blow up the asteroid, and then he sees his life flash before him. He sees his daughter and his wife and all the happy times. He’s experiencing not linear time, he’s experiencing his life in event time. And I imagine if any of us remember our lives, we remember our lives event time, not linear time. So the average Monday or Tuesday where we don’t do anything interesting we completely forget about, but that day something really amazing just happens or the day that we get married or the day you have a child for the first time, those are very important memories, and time will slow down. Well, in the same vein, we used to look at time and markets in units other than linear time. Let’s imagine if we measured market prices, not in linear time, but we measured in terms of volume time. So one day would be every time we trade 1000 shares.
Well, we can also measure time in terms of volatility. So, instead of looking at the passage of time, you’d look at what is the price of the market given 1% moves in either direction, was to be called variance time. And if you measure, we measure market prices based on these other elements of time, you get very, very different perceptual awareness of price series that provides some really interesting information.
Meb: Yeah, I was thinking about it, and it either is a somewhat similar related concept which we talked a little bit about with Tom Dorsey when he came on the podcast about. It’s old school, just a price-based pure charts, the old school point and figure charts, which actually don’t take time into account at all. It’s simply the concept of an investment based on price moves relative to their actual moves, instead of time being a component. With the theory being that there’s many periods of years where a stock or an investment may go nowhere, there’s other periods where it moves a lot. All right, winding down to our final two questions. Otherwise, we’ll keep you all day. And I’m guessing half the people listening to this are probably gonna, soon as we get done, go back and listen to it again, because there’s so many awesome nuggets in here. So first question we ask everyone going back in your career, is there any one most memorable trade or investment that you can think of? It could be good, it could be bad, it could be in between, that comes to mind if you were to say if you…all the trades you’ve made what’s been the most memorable?
Chris: It’s a little hard to say trade, because a lot of what I do is designed…is similar to you. I don’t know think about it in terms of trade as much as systems, but I think systematically holding volatility after Lehman went bankrupt. So when most people were exiting their vol positions, I was actually pressing my vol positions after Lehman went bankrupt.
Meb: What was the thinking there? Because I think most people probably would have been like, “Oh my god, this is great. I’m making money. I’m gonna take my winners,” which is a natural reaction for a lot of people. What was the thinking at the time where like, you know what, this has got more room to run?
Chris: One of the thinking could be that you’re paid to own vol at that point in time. So on a risk-adjusted perspective, there was actually kind of a positive carry, it’s owning long vol at that period of time. That’s one aspect. The other aspect is the common knowledge was to sell vol once it went past 30, but anyone looking at the leverage conditions and the framework there could actually see, and going back and studying the history of volatility, going back to the Great Depression, you could see, you know, the Great Depression volatility retouched 86 times. So there was an understanding that vol could go much, much higher than what the market or what most people imagined it to do. Particularly given a highly levered unstable financial system. I think the combination of the macro understanding and the understanding, it was a combination of two things. The idea that first of all, you’re just…you’re paid to own insurance. So that makes it intriguing. And the second aspect of just understanding that there’s a state of the world that wasn’t being priced in, that was actually much more probabilistic than most people imagined, yeah, I think was sort of a life-changing trade.
Meb: This is actually a good example on long vol in general, because one of the challenges that most people shoot themselves in the foot with long vol strategies, and even owning a stock systematically could be seen a portfolio of these as actually pretty similar concept, which is people love taking the small gains. And often when you have a long vol strategy at some of these really massive multi-bagger gains that end up determining the success of the portfolio. Obviously, we think about that in the trend falling space where we have tons and tons of little whipsaw small losses, but really it’s some of these really long trades that end up determining the success of the whole system.
Chris: To your point on this, most retail investors in particular, but even some professional investors have very unrealistic expectations of what long vol is supposed to be. It’s very similar back to the George Lucas thing, you know. Lucas was not expecting “Star Wars” to be a moderate success. You don’t buy the merchandising and its sequel rights, expecting something to be a moderate success, you buy those rights, that optionality because you’re expecting something nonlinear and something powerful to pick up. So you shouldn’t own Artemis for, you know, a 5% move in either direction. You want to own Artemis for the 50% move in either direction. On Bloomberg today there’s an article kind of ripping on one of our competitors, and to defend one of my competitors, the asymmetry and the nonlinearity of returns doesn’t come into play, you know, if the market is dropping, you know, 5% to 7% and then rebounding. That’s not why you should be in long vol, that’s not convexity. And I think there’s a lot of misunderstanding as to that. You know, people would sit back and say, “Oh, this is a high volatility year.” No, actually vol has been a little below average.
So I think people just have very different perceptions on what vol and what convexity is. And I think when one’s looking at adding a long vol, yet long vol being momentum, or long vol being owning optionality like we do or long volatility even being a type of global macro trade, one is, have an understanding as to how far markets actually need to move for that convexity to even kick in.
Meb: I love it. Last question, which is a riff on this, and I mentioned this is an impossible question for me. And I think it’s actually a fairly terrible interview question, but I’d like to hear what you think. Last time I asked this I said the universe scolded to me and I got food poisoning. But given your background, and I know you’re a bit of a film buff, and also Toby mentioned, I didn’t know this, graphic novel buff, do you have any favorites in either category of the past five years? It could also be something that people may not have seen. And this is coming from an uncle who is supposed to be taking his nieces and nephews to “Wreck It Ralph” this week. But anything that comes to mind as you’re like, “Oh my God, this was just the best novel or film over the past five years?”
Chris: Well, you know, films been a little disappointing over the last five years. I gotta say that. I’m a little disappointed with all the movies. [inaudible 00:59:11] been. But you know, going back to the graphic novel thing. I’m a fan of different graphic novels, and this isn’t exactly an original idea. But a lot of times people will go back and they would say, you know, “Was there anything that influenced you back in 2008?” It must have been the same celebs, you know, “The Black Swan,” and in fairness I loved that it’s a fantastic book, and it did have an influence on me. But the book that has the biggest influence on me was Alan Moore’s “The Watchmen.” And I think that was a graphic novel where you had various characters, each with their own point of view that was all real, depending on the character, and you could buy into any of those points of views. And there was a non-linearity to reality and how the perception of reality was siphoned through different views. And I think that book was incredibly important for me in my understanding of markets.
Meb: That’s a good one. I actually just bought two. I try to read like many people outside of finance to keep the juices flowing and had recently googled top graphic novels in 2018 in order to couple. One was called “Vision” and another was “X-Men Grand Design.” Haven’t read either yet. But I’m curious to see how they end up, but love that medium. It goes back to…you know, Stan Lee just passing. It goes back to me, back in the day when my parents in a normal blue-collar family where they said, “Meb, the only thing we won’t skimp on is if you ever wanna buy a book, we’ll buy you a book.” And I interpreted that to me in comic books too. And so fast forward about a week or two later, I subscribed to about 20 different comic books and started getting them in the mail about every day, and they said, “Well played, Meb.” So I was laughing because I ended up buying a few of those recently and we’ll see how they go, but “Watchmen” is a great one. I read that years ago.
Chris: Just amazing. It’s funny, because my parents had a very similar philosophy, and I think it’s fantastic philosophy. And we’ve instilled that in our company, at Artemis. If you’re an employee of Artemis, you’d only ask permission to buy book is somebody…you have to share it with everyone. That’s to be added to our library, but you’ll need to ask permission to buy a book.
Meb: Book allowance, I like it.
Chris: Yeah, it’s self-learning constantly.
Meb: Chris, this has been a blast. Thanks so much for taking the time. Where do people follow you, your writings, they wanna invest? What’s all the good places? What’s the home base? What’s the best place to find you?
Chris: Just come to our website www.artemiscm.com or just google Artemis Capital Management and volatility. I’m sure you can find us, but www.artemiscm.com is where you can find all the good stuff and we’ll post some of our papers up there and pro for accredited investors.
Meb: If you google it you’ll find lots of images
Chris: Just find a lot of stuff as well.
Meb: Lots of images of snakes eating themselves. We’ll post all these show links and links to your website and everything else on the mebfaber.com/podcast. Chris, thanks so much for taking the time today. Really appreciate it.
Chris: Great. Thanks, Meb, it’s been a ton of fun, and we’ll catch up next time I’m in LA or next time you’re in Austin.
Meb: Awesome. Listeners, you can find more in the show notes, we’ll post them again, mebfaber.com/podcast. Shoot us an email to let us know, criticisms, feedback, everything feedback in the mebfabershow.com. You can subscribe to the show on iTunes, Overcast, Stitcher, Breaker, any place fine podcasts are sold. Thanks for listening, friends, and good investing.
