Episode #226: Vineer Bhansali, LongTail Alpha, “The Bigger Question To Me Is Not Whether Tail Risk Hedging Is Good Or Bad, But Whether It Is Good Or Bad For Your Current Portfolio Posture”
Guest: Vineer Bhansali is Founder and CIO of LongTail Alpha. He has over two decades of experience in both developing many of the tail risk management frameworks in use by the industry today, and in managing portfolios and funds for clients at PIMCO for over 15 years. He has authored a number of books, and regularly publishes his thinking and research.
Date Recorded: 5/21/2020
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Summary: In episode 226 we welcome our guest, Vineer Bhansali, CIO of LongTail Alpha. In today’s episode, we’re talking current markets and tail risk hedging.
We get into what has been going on in markets, and talk about asymmetric portfolio construction. We discuss recent market liquidity, and how it is the worst Vineer has seen in his career.
We cover tail risk hedging, and walk through some examples of how to implement, and how different techniques fare in various environments.
All this and more in episode 226 with Vineer Bhansali.
Links from the Episode:
- 0:40 – Sponsor: YCharts
- 1:24 –Intro
- 2:28 – Welcome to our guest, Vineer Bhansali
- 2:43 – The Meb Faber Show – Episode #82: Vineer Bhansali, “The Market is Severely Underpricing the Probability of a Sharp, Catastrophic Loss to the Downside”
- 5:10 – How the world has changed since Meb and Vineer’s last conversation
- 12:45 – The Three Sides of Risk (Housel)
- 14:11 – How the last few months of the market have been for Vineer
- 15:24 – Broken Markets: Notes From The Trenches of Market Turbulence (Bhansali)
- 16:17 – Narrative Economics: How Stories Go Viral and Drive Major Economic Events (Shiller)
- 18:40 – Implementing LongTail Alpha’s strategies
- 26:10 – Sponsor: YCharts
- 26:52 – Tail risk in 2020
- 33:05 – The reduction of liquidity earlier this year
- 40:30 – Equity market recovery
- 43:39 – Currencies
- 48:52 – Trading Sardines: The Case of Currency Hedged Negative Yielding Bonds (Bhansali)
- 53:30 – Discussions he’s had with his clients and investors
- 58:12 – Best way to follow Vineer: Forbes Column, books on Amazon, longtailalpha.com
Transcript of Episode 226:
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: Hey, podcast listeners. Another great show for you today. As you noticed, I’m podcasting from the deck of the Millennium Falcon, which quick bit of trivia is what the SpaceX recent launch rocket is named after. We welcome back today, our guest, the founder and CIO of LongTail Alpha. He’s got over two decades of experience in both developing many of the tail risk management frameworks used by the industry today and in managing portfolios and funds for clients at PIMCO for over 15 years. He’s authored in a number of books and regularly publishes thinking and research.
In today’s episode, we’re hopping into the boxing ring with the other big heavyweights and we’re talking current markets and tail risk hedging. We get into what’s been going on in markets and talk about asymmetric portfolio construction. We discuss recent market liquidity and how it is the worst our guest has seen in his career. We cover tail risk hedging and walk through some examples of how to implement and how different techniques fare in various environments. Please enjoy this episode with LongTail Alpha CIO, Vineer Bhansali. Vineer, welcome to the show.
Vineer: How are you?
Meb: Doing good. If you’re following this on YouTube, you can see my background’s a Millennium Falcon because today is the NASA SpaceX launch, so in honor of that. I should actually say, Vineer, welcome back to the show because last time you were here, it was late 2017, if I have my math right. And you offered to take me on a ride in a helicopter, which I’m still waiting on.
Vineer: Yeah. I just did that three or four days ago. I took some family members and I took a good friend of mine and then a few weeks ago, we did social distancing, flying, exploring California poppies. So, yeah, we’ll do it soon.
Meb: We drove up there. It’s absolutely gorgeous, the big orange fields. And so, you’re part of my quarantine world-ending transportation plan as if when the world goes full zombie, you’re gonna be taking us to Catalina or Channel Islands or something to hide. Before we started chatting, you were mentioning, you know, you’re in Newport, your offices, Fashion Island. Give us the update on your qualitative indicator of how the world’s reopening.
Vineer: Yeah. So very interestingly, you know, obviously there’s a lot of quantitative indicators that, you know, people watch, the top of oil tanks to see what consumption is like, and they’ve got satellites and they’ve got, you know, people acting like real estate agents. Everybody has got their own intelligence. And I have what I call our same-store indicator, which is I just look out my window from my office in beautiful Newport Beach and I see a big parking lot between my office and the ocean. And we just count the number of cars and see how crowded at any given point of day. It’s not a very good indicator. It’s a very coarse indicator, but on a scale of 0 to 10, right around Christmas, it was maybe a 10 or 11, people were driving around and couldn’t find a spot.
In February, March, it probably dropped down into one. I think there was a time in March, maybe I only saw 2 cars and the parking lot can take probably 300 cars. So that was definitely as close to zero as it gets. And right now, and I look out, I would say, quantitatively, I’ll call it between a six and a seven. And we try to do it at the same time at lunchtime at 1:00, which is close to market close because that’s when people step outside and so on. So I would think at least right now, it looks like people are, you know, feeling more optimistic about the economy and about markets and consumption and all that.
Meb: Yeah. As I was saying, I have a daily dog walk and it’s gone in two weeks pretty quickly from like 80% masks to…They just reopened the beaches and it feels like almost like spring break in Florida or something, for better or worse. All right. So last time we chatted, end of 2017, we titled the episode…which listeners, if you wanna go back and listen to it, it’s a great one, episode 82 is titled “The Market is Severely Under-Pricing the Probability of a Sharp, Catastrophic Loss to the Downside.” Well, what’s happened in the two years since we chatted? The world been pretty normal? What’s going on? What do you know?
Vineer: Yeah. So clearly, in 2017, we were way too early because the market actually rallied in 2017 and 2018. But what I think happened is because the crash didn’t happen in 2017, 2018, it actually emboldened people in a way that potentially resulted in a much more significant crash than even what I had anticipated in 2017. So to kind of summarize perhaps 70 or 80 years worth of financial history, which Meb and I have spoken about in the past, you know, into the next, maybe 3 minutes, what has happened is that if you go back to the ’30s and ’40s, especially after the 1930s depression era, I think policymakers realized that one way to keep the economy going was to create a lot of production because production keeps people employed, and it’s a good thing and production, gross domestic product, GDP, etc., that has been the benchmark for how rich or how productive a country is.
Now, the trouble with that after, you know, many decades is that if you’re going to produce a lot in our economy and indeed the whole global economy is a production economy, you have to create consumers to consume that production. And in the initial stages, perhaps, of the last century, that consumption was natural because, you know, people were moving from villages to the cities, etc., etc., so the consumption was very natural. But after a while, as production kept ramping up, there wasn’t enough consumption. So the way consumption was generated was by the invention of credit markets, as we all know.
So now we fast forward, and I don’t wanna give a whole history of economies and financial markets over the last couple of 100 years. But the point is that we certainly found a lot of excess creation of credit and now fast forwarding again to 2017, 2018, and 2019, a lot of this extra money or credit that has been created is looking for return because at some point, you know, everybody’s got enough shoes, and t-shirts, and cars and all the other consumables that they can consume, so people wanna invest the money, but there’s a lot of extra money sloshing around. So a whole ecosystem of short volatility strategies developed looking for return and looking for yield.
So Larry Harrison and I wrote a paper in 2017. As a matter of fact, perhaps on the same time that, Meb, you and I had this conversation. And what we identified was that there is a very significant number of strategies that are harvesting or generating return from selling options, whether they’re explicit options or implicit options. And that’s the way or was a way to generate yield when there was very little yield to be had because of excess of credit in the system.
Now, when we did our computation, when I did the calculation at that point in time, the VIX was probably hovering in the low teens and it made a new low of below 10. My calculations showed that if there was a shock to the system, an endogenous shock to the system, the system would get so destabilized because of rational reasons, everybody trying to delta hedge and balance their risk, which I think most of your audience is pretty familiar with options and options delta heading and so on. So if one person or one large entity decided to delta hedge for obviously very good and rational reasons, they could trigger a cascade, which would require everybody else to delta hedge. So you combine the dynamic of delta hedging with the other side of it, which is that the market makers today are all electronic and these market makers can very quickly turn off the ability to provide liquidity in the system.
So what happened in 2017 was that the first rung or the first element, the buildup of the short volatility or short gamma complex got incredibly large. And we got a little shock in 2018, you know, the XIV debacle, which in the paper we identified as probably the pyramid or the tip of the pyramid, that didn’t do anything. And people got very confident that maybe that was it and there was really no disease lurking below the surface. And then you got to December 2018, collapse in the markets, which also recovered very quickly because Powell and the Fed went from a tightening bias to an easing bias. So they essentially pivoted and the shock and awe of going from tightening to easing created the belief in people that the Fed was going to provide liquidity under the system. So the markets rebounded very sharply.
And as you know, 2019 was a massive year to be long the markets, not short the markets. And like I always like to say, the postman rings twice or thrice before you got to take delivery of that letter. And the letter came obviously this year and the short volatility complex had gotten even bigger because people were emboldened because they didn’t get destroyed in ’18 and ’19. And this time around, the avalanche couldn’t be stopped.
Now, just to kind of summarize this whole thing, back in January of this year, I did my retrospective for our clients and I did not know about COVID, obviously. I knew about it but I didn’t think it was gonna be a big issue. And I was out snowboarding out in Mammoth. So it was a beautiful day, sunny, fresh powder on the ground. I was in the backcountry. I’m skinning in the backcountry on my board and I’m going up this hill and just loving it and suddenly I go, “Oh, my gosh, this is how I’m gonna get buried under a big avalanche.” Things look really good, fresh, fresh powder and sunshine. And suddenly something’s gonna give because there’s somebody else out there who’s doing exactly the same thing and not being careful and can trigger this avalanche.
So I got out of there and long story short, I kind of dug into how to protect yourself from avalanches, basically an avalanche physics and avalanche safety book. And I basically reflected on that in my piece and I did not anticipate what would happen, but I did know that the markets were incredibly unstable because of aforementioned calculation. So 2017, we were too early. 2018, the seeds of the debacle were sown. 2019, they got amplified, and 2020, obviously it all came home to roost, and that’s what we’re seeing. So sorry about that longwinded explanation, but now I have caught you up with what’s happened over the last three years.
Meb: No. It’s perfect. You know, Mammoth was actually going to be my quarantine hideout. We had just come back from Jackson Hole. There was a great investing conference at the end of February. I was actually sick, but then we were gonna go to Mammoth and that’s right when they closed all the mountains. But I don’t know if you saw it, but a friend, Morgan Housel, actually had a pretty great piece on tail risk and avalanches too. Do you see this recently?
Vineer: No. I haven’t. But I’d love to see if. If you could link me or send it to me.
Meb: Yeah. We’ll put it in the show notes, listeners. And it’s a pretty sombre piece, but Morgan, obviously one of our favourite writers, but he was living in Tahoe in the early 2000s, which is interesting because I would have been there at the same time, although I think he was finishing high school. And so, I definitely would have shared a chairlift with him, but he was racing and had been skiing backcountry at Tahoe, at Squaw, and skied a run with his two friends. He said there was kind of a slough, not avalanche, but like, you know, boot-high sort of slough. And then he went into town, they went out back for another one. Sad story, but ended up being an avalanche and taking the lives of both of his friends. But the papers spent a lot of time talking about, you know, these tail risks sort of events and the little decisions and little times that people make to think about them. So do you go full airbag backpack? Because that’s what I have now. Not for inbounds.
Vineer: Yeah. So I had the home equipment. And so, when I came back, I got in touch with this avalanche expert who is essentially the guru and his book, I think it’s called something like “How to Survive in Avalanche Terrain” or something like that. It’s like must reading. So I couldn’t take my eyes off it. And, you know, the first thing that resonated with me, and I did email it with him, he said, “First thing is, don’t go alone because if you’re buried, you have just a few minutes to get dug out and if you think you can flail your arms and do other stuff,” and there’s a lot of parallels with financial markets, “and you can kind of dig yourself out, you are absolutely fooling yourself because the mass of that snow top of you is so big that you’re just not gonna be able to dig yourself out.”
So, yes, first don’t go alone. Secondly, humans cause most of the severe avalanches or some sort of disturbance. And thirdly, if you do have to go yourself, I mean, God forbid, you know, have all the beacons and the airbags like you were just mentioning. So what I did was I did it for a few days and then I started to actually…Fortunately, in Mammoth, they opened up some of the slopes to actually backcountry now. So you can actually go at the resort if you’re by yourself and you can take some of the routes so you’re always in touch with somebody else and you can look around and, you know, see one of the people taking care of the lift if you get into serious trouble. So I just started doing that because I got a little worried about it.
Meb: All right. Well, let’s move back to markets. So January transpires, February, all-time highs in the stock market, and then things started to get a little different and you actually had, in one of your pieces, a quote, which was in the midst of it, but I thought it was interesting because I’d love to hear you expand on this thought. You said, you know, “The current financial crisis is the fifth one I’ve experienced. It’s not very different from the other four,” which I think would surprise a lot of the listeners. “As usual, markets went from being completely complacent to completely panicked in a matter of days.” Maybe walk us through kind of the last few months and how you thought about it, how you experienced it. I saw you were doing some 20-hour days at a time as many of us were, but what was it like?
Vineer: You know, the cycle, they’re very hard to forecast and whether it’s euphoria or panic, they’re very hard to forecast with any pinpoint accuracy on what will trigger something and how it’ll unfold, but it repeats in somewhat predictable milestones, so to speak. I read another book actually over Christmas break, which I referred to in one of my pieces was Bob Schiller’s book where he drew one of his new books called…I think it’s called “Narrative Economics,” where he drew the parallels between virals or epidemics in markets and the epidemic of fear. And I thought it was very cute because he actually shares this very classic model called the SIR model in the appendix of that book. So what it basically shows is, you know, this peak in epidemics that slowly then flattens out like we’re experiencing. You know, when I read that book in January, I thought this was super cute, but I had no idea that COVID would be right around the corner.
So the same piece that I was referring to before, I said, you know, effectively, what you just said, is once the avalanche starts, the fear will spread and market narratives will change and they will change like an epidemic, and I referred to Bob’s book. Turned out that, you know, we were closer to the truth than we would have liked to be and once the disease started, it’s the fear that started to amplify. So whether it was COVID or something else, the cycle started to play in exactly the form that it has played.
Again, going back to my last four crises, 1990 to ’94, then ’98 to 2000, then 2008 to 2010 and then you could have many crises that happened. You know, we can count a couple more in the middle, including perhaps to 2015, 2013, you know, bond market issues. But generally speaking, the cycles are the same. Everybody starts to lean a certain way, starts to believe one thing. And the odds, if you are a probability-based person, the odds get so tilted that it becomes very easy to make bets, so to speak, where even if you are wrong, you can make very, very significant asymmetric returns.
So our approach is not to try to forecast outcomes. Our approach is to say, if everybody’s believing one thing and the market is reflecting that belief, if that conditional probability is found out to be inaccurate, how bad can things get? And I’ll give you a couple of examples when you come back to it in today’s market, like in a forward-looking sense where I do believe people should be looking at stuff, which is just enormously mispriced in the context of how markets and economies work.
Meb: Yeah. Let’s hear it. Let’s hear how you think about some of these ideas and strategies. I know we can’t talk about any particular funds or performance, but listeners, you can certainly look up how Vineer has done this year and it’s been pretty mind-blowing. So talk to us a little bit about some of the strategies, how you think about implementation, any rookie mistakes. And then you mentioned some potential opportunities still in 2020, because it’s been a crazy rollercoaster. I mean, looking back to all-time highs to bear market lows, this was one of the fastest we’ve ever seen. then we’ve ramped right back up. Here we are in late May and given all the carnage that’s happened in a lot of the traditional economy, I’ll hand the baton to you. Talk to us.
Vineer: Yeah. So what’s important, I think, is to realize, and perhaps this comes from experience and maybe it comes from reading a lot, but these cycles and, you know, we’re probably just, you know, little microorganisms existing in this very short period here, but, you know, if you go back and look at the history of financial markets and speculation and leverage over the last 3000 years, these things play out in very, very similar ways. And every era presents to you new sets of facts that if you step back and, you know, maybe boil it down to some simple factors and look at it and say, “Well, I’ve actually either experienced that and I’ve read about it in the past and perhaps it’ll work out in XYZ fashion.” So that’s your hypothesis. And then you can obviously collect facts and test it.
So in today’s markets…and I’ll come back in a second to what helped us this year in terms of our strategies and so on, in equities and credit and so on. But in today’s markets, one of the commonalities, so to speak, or one of the assumptions…I mean, let’s go back to this fact that people start believing one thing and when that belief gets shattered or changes very sharply, markets go from one equilibrium to another equilibrium very, very rapidly, right? So in today’s markets, if you look at what’s going on, and I’ll just go back to what you just said, so markets went from being down 30% or 40% to essentially unchanged and now they’re probably gonna make new highs, right? And that’s happened partly because people are too pessimistic, people bailed out too early, there’s a lot of liquidation. Liquidity, by the way, that we saw in the markets in March and April was the worst I’ve seen in 30 years of doing this as a practitioner.
So what that did, it got very predictably like what had happened over the last maybe 60 or 70 years, it got attention of the Federal Reserve, of the ECB and many other policymakers. So they’ve plotted the system, as everybody knows, where then a massive, enormous amount of liquidity, call it $10 trillion that has never happened in our history. And that money, even if you take a haircut and say, “Let’s take 10%, or 20%, or 30% of that liquidity and allocate it to risky assets, whether they’re ETFs or stocks or something like that,” that’s a very significant change in the flow of that asset class. So 10% or call it $1 trillion comes into the equity markets in a compressed period of 2 to 3 weeks, and people are obviously going to front-run it, creators are going to front-run it, you are going to get exactly the kind of performance in the equity markets like you have seen before. Now, that sets the seeds for the next set of corrections. But what you have to realize is that this is an evolving story that has been going on again, you know, for the last, maybe 10 or 15 decades, right?
So every time a bubble gets blown up and it bursts, what you find is a more pristine, larger balance sheet gets drawn into it. What is happening now is that the largest balance sheet in the world, which is the central governments of the United States, China, Europe, and Japan have gotten pulled into this because they are now taking ownership stakes in what used to be considered private markets. So what does that do? What does that tell us that is gonna happen next? So what has happened is in order to facilitate this move into assets, they have to have to cut rates to zero. And I’ve written a fair amount of negative interest rates. And I think there’s a chance that the U.S. might also go negative. It might not happen with this Fed, but the Federal Reserve is an appointment and maybe one of the future presidents will have a Federal Reserve that will actually go negative.
When there’s a lot of excess supply of capital and rates go negative, it is essentially a way to transfer wealth from savers to people who are consuming or debtors or whatever it might be. And the question here is what does that do now to risks that have gone underground, right? Risks like inflation. So inflation obviously is not on anybody’s radar screen. And I don’t think inflation is going to come back in a big way. But if globally governments start to confiscate money away from savers, what’s going to happen is that those savers are going to try to find refuge in other places where that money can’t be confiscated. So maybe it’s digital currencies, maybe it’s gold, which has gone up a lot. Maybe it’s real estate, stuff that is real. And if enough people start buying stuff that is real, that you need to survive on, it will ultimately result in price pressures in certain places.
So one of the cheapest things that one can do today in terms of, you know, buying protection, one of the cheapest things is protection against not inflation, in particular, but what we call, you know, essentially financial depression, where your currency is debased and your savings are debased. So looking out 5, 10, 15 years from now, we know that the whole financial system is going to have trillions, if not quadrillions of debt and that quadrillions of debt has to somehow get paid off. And there’s only three ways to pay off that debt. You either default on it, you debase it somehow, or, you know, maybe you inflate it away or you do something else which maybe nobody’s invented.
I think that’s where we’re headed. I think the big risk to the world is that anything that is in terms of financial prices is probably not a good store of wealth. So in terms of what I’m looking out to do is we’re completing our strategy set for our investors and our clients to now protect against, you know, stuff that will be victim of financial oppression. In that environment…and I’ll stop at that. In that environment, stocks don’t do very well, bonds don’t do very well, but real stuff does really well because people move away from financial assets into real assets.
Meb: Yeah. Would tips fall under that banner at all?
Vineer: So the risk is that tips are an obligation of the treasury, right? And I call it the Fed but it’s the obligation of the government. And because it’s a bond, it is only as good as the full faith and credit and also the currency of it. So there’s a competing pattern. Tips are indexed to inflation, but at the same time, how they get paid is an, you know, index to the U.S. dollar. So I kind of come out in the middle. I’m not quite convinced right now that the tips are the best place to take or put protective risk. I think there’s many, many other ways of doing that.
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Meb: And so, as we think about sort of the topic du jour, maybe talk to us a little bit about how you think about kind of tail risk in 2020. There’s been a couple of big heavyweights who have decided to weigh in on Twitter endlessly and not in such a friendly way and so, I figured you and I both think a lot about tail risk, so maybe we could have a bit more of a collegial discussion. What’s your thoughts on tail risk? Because as 2020 has played out, are there optimal ways to implement it? Are there anything changed in the last couple of years? Just any general broad perspective.
Vineer: Yeah. That’s an excellent question. And yeah, you’re right. You know, every generation sees its competitors who challenge the dogma, and then the public obviously gets his head spinning because they don’t know what’s right and what’s not. So I try to simplify it. And the way I think about it, and I think, Meb, this is your approach as well. So I think of everything in a portfolio context and I think of everything not as a product or a thing that you buy or sell, but as a solution on what it does for your portfolio. So that kind of takes you away from absolutes. So the couple of fact that we all know or the fact of the matter is that if you believe in probability distributions of whether it’s normal distributions or fat-tail distribution or whatever it is, sooner or later, you’re going to visit the tails of the distribution.
The tails of the distribution can be, you know, pin, in the case of a normal distribution or fat-tailed in the case of a complex distribution, that as a physicist I’m very familiar with. But, you know, instead of getting into the arcana of, you know, what those distributions look like, the fact of the matter is that for distribution to exist, sooner or later, you’re going to visit both the left tail and the right tail. That’s just a given. So the bigger question to me is not whether tail risk hedging is good or bad, but whether it is good or bad for your current portfolio posture. If you have a lot of equities and you have a lot of risk and you are out there on the risk frontier, then running a portfolio without some sort of risk mitigation strategy is just dangerous. If you elaborate too much, maybe not having too much cash or other protective strategies is dangerous.
Now, having said that, I think it’s also very easy to start competing and kind of go across like this without having a common language and start arguing about things. So when people talk about tail risk hedging, I think some people think of tail risk hedging as just option space. You go and buy options in the market. And other people talk of tail risk hedging as using diversifiers versus treasuries, or cash, or electronic money, or dynamic rehedging, whatever it might be. So the way I look at it is not to take an absolute and say tail risk hedging with options is the only way of doing it. I’d say, what are all the diversifying strategies and when do they work? So there’s essentially four or five levers out there in the current market conditions where you can have tail risk hedging, and all of them have to be on at all times, but the allocation to them can change based on pricing, right?
So list all five of them. So at the very, very left end of the fat-tail distribution is cash and maybe gold if you’re, you know, worried about debasement and inflation and all that, maybe short term treasuries. If you come closer to the distribution where, you know, you’re not worried about counterparty defaults and somebody confiscating your money, then you can have options, tail risk hedging options. If you come one step further in from it closer to the center of the distribution, you’ve got trend following, which is basically an anti-mean diversion strategy by construction, which both you and I have quite a bit of experience with. And then if you come further, you know, inside towards the center part of the distribution, you’ve got things like rebalancing and volatility targeting and so on. And I can take this whole thing and mirror-image on the right side. So you got things like call option then you can have trend following on the right side, you can have things do better and right tail events and so on. So you can basically fill out your distribution with a mixture of strategies that do well for different market environments.
So stepping back, now, the question, so what is going to do well in my view in 2020 out of these four or five levers, tail risk hedging with options was a no-brainer. It was one of the easiest things you could do last year because of the volatility dynamics and the fact that somebody was willing to sell implied volatility very, very cheaply in order to juice up their yield. In March, you should have not been buying tail hedges using options. You should have been either buying stock because of the incredible risk premium or you should’ve been doing other things like trend-following or you should have been doing perhaps buying long-duration treasuries.
Today what has happened again is markets have rallied because of the liquidity. Go back to the picture of the distribution, markets have rallied, VIX has gone from 80 down to call it the mid-20s and tail risk hedging with options is becoming attractive again because options basically, whether they’re short-dated or long-dated, are functionally related to the level of the VIX with a lot of nuances. Buying cash in that framework or by treasury in that framework are probably not a great hedge here because if you buy a 2-year treasury, which right now has got less than 20 basis point, which was about 2% just a few months ago, in order for the 2-year treasury to actually protect you against a meltdown in the equity markets, the yield curve has to go very significantly negative.
So the Fed has to cut rates to -100, which had happened in Germany and I think at some point it could happen in the U.S., but it’s just not very good risk-reward credit, especially if you believe inflation is gonna come back. Using dynamic techniques like futures-based delta hedging for tail hedging would have been a disastrous thing to do in February and March because you had no liquidity. The liquidity in February and March was roughly, call it one-twentieth at best to maybe one-hundredth of average peak liquidity.
Meb: Can we pause real quick on that? Because I think the listeners would be curious. One, I think most would be surprised to hear that because you would think as the volatility goes crazy, I feel like a lot of people would think the liquidity would improve, but you’re saying is just almost nothing there. What was behind it? Why do you think it was that way?
Vineer: Now, I’m gonna take you for a little, maybe two-minute diversion into what I call the atomic building blocks of current financial markets. So in today’s financial markets where option pricing, whether it’s implicit or explicit is part of every asset class, whether it high yield or corporate credit, or even treasury is gonna be thought of as options or equities, of course, and then equity options, the common denominator is an underlying assumption that you can delta hedge or you can manage your risk using one or two instruments that exist out there. The two most popular instruments that exist out there that are in every model for every option trader in the world, and I’ve been doing this for about 40 years almost now, are the E-mini futures contracts. Those are the S&P mini futures contracts and the 10-year, TY futures contracts. So those are the atomic building blocks because everybody assumes with good reason that if you ever had to delta hedge your position, you will have infinite liquidity in the E-mini futures contracts and almost infinite liquidity in the 10-year futures contracts.
Now, what you’ve found, and as I mentioned before, is that over the last maybe decade or so, those markets…And by the way, there’s an article on Bloomberg today about this. But over those 10 years or so, these markets have become completely automated. And perhaps 95% to 98% of the trading is being done by algos and only 2% or 3% is being done by humans who get picked off every time they enter and cross the bid-offer spread. Okay. So let’s rewind on what happened. When you don’t need the liquidity, meaning if you don’t need to delta hedge an option position, there is an immense amount of liquidity in the system because the bots are humming, they’re scalping, bid and offer, bid and offer I don’t know how many millions of times a day and collecting that one-tenth or one-twentieth of a basis point on each trade magnified by a billion times, that’s real money.
When stuff happens and they see a supply coming, whether it’s in the E-mini contract or the 10-year futures contract, which is what happened in February and March of this year, and also in January of 2018 and December of 2018, the bots completely turn off. So now what you’ve got is residual liquidity that is basically being provided by the market makers who are human. And there’s very few of them. I think there was a point where I was counting myself as probably one of four people who were actually actively…we turned our bots off. We were actually trading E-minis by hand, so to speak. So in that environment, and I have charts, which I’m happy to share with you, Meb. In March, the futures contract liquidity went from roughly $80 million to $90 million top of book, and you can see that in the future stack if you have real-time data, to less than $2 million top of stack.
So what that tells you is that if you had to delta hedge using an ago, an option position…So let’s go back one more second. So let’s say the cash market closed yesterday at 4:15 or 4:00 and you had an option position. Overnight, there was some tweet or something like that, the futures markets are limit down. So they open tomorrow morning, limit down or close to limit down, which happened seven or eight times back in March. Now, what has happened when the market’s limit down, it stays down about 5%. If you recalculate your delta of the option positions that you left with in yesterday’s close, your delta has gone up from…quality of starting delta was -0.20. Now that new delta has probably gone up to -0.25 or maybe even -0.23.
So you’ve got 30% or 40% more risk that you are on hedge. Your first reaction, assuming that you are a market maker or assuming you are an, you know, active creator, if you’re not gonna think your mandate is to be delta flat, you’re gonna go into your futures trading screen and you’re gonna basically hit the bed. And you’re not the only one because everybody else with that strategy is going to do exactly the same thing. So what the market makers, the electronic market makers see is a wave of sell orders coming. And they know that they can scalp when the markets don’t need that liquidity. But if you were going to get 10 billion of E-mini futures for sale for delta hedging reasons, it would be absolutely stupid for you to actually say, “Yeah. I’ll take a few right now.” You just back off. You just say, “I am not in the game right now.”
So that’s what we saw in March. And that is singlehandedly, in my observation, 30 years of doing this in real-time in the screens, the worst liquidity I have seen ever. So, Meb, you and I were talking about staying up for 20 hours for about maybe 45 days straight. I love my sleep. I like to sleep, but I was trading with other guys that I knew these were humans who were only going to show me the liquidity if they knew they could actually get out of it. That’s why the market was moving 7%, 8%, 9% every single day. But that’s kind of a deep dive into the rabbit hole of a market microstructure.
Meb: Yeah. Well, I mean, I think a lot of the listeners could think back, it feels like, you know, 10 years ago, only a month or two ago of these markets behaving like that. But it felt like almost every night or Sunday night, everyone was watching futures and like you said, limit up, down, in between.
Vineer: It wasn’t equity. What was absolutely shocking to a lot of people was that the treasury market was moving 25 basis points because the treasury futures market was moving unbelievable amounts during that time. And I think what happened personally, and I’ll stop for a second here, is that the Fed is not concerned so much about the markets misbehaving because they misbehave a lot. They were concerned about this carnage of liquidity where no asset class was safe. I don’t know if you remember, there were a couple of days where stocks were down, bonds were down, gold was down, oil was down, everything was down because you just couldn’t sell anything to get your cash back.
Meb: Yeah. I mean, 2020 has seen a lot of interesting days. Oil futures going negative was certainly an interesting one to watch. There’s two parts of 2020 that I think are a little surprising. One is the increased interest of retail investors. And I don’t know if it’s just because of the volatility or what, and then, of course, the government’s involvement, particularly through being involved in ETFs now, which is so strange to me, but it’s something that we’ve seen for a while and in Japan. I don’t know if you have any other general thoughts about kind of the way that this year is developing or anything that we haven’t talked about thus far that’s particularly interesting or odd to you.
Vineer: Yeah. So what’s the artist thing, and I think a lot of people are talking about it now, is that the fact that the equity markets have essentially recovered. Bond markets are obviously flat-lining, U.S. bond markets, because we’ve got essentially an infinite bid from the U.S. Central Bank. Okay. So equity markets have recovered because there’s this massive amount of monetary and fiscal liquidity. At the same time, the economy, as we all know, is doing very badly. It’s the worst GDP statistic that we have seen since the Great Depression. So you got, you know, that wedge, you got the equity market essentially making all-time highs and the economy kind of making all-time lows, call it that. And the misery…there’s something called the misery index. The misery index is still low, but if the misery index starts to go up, which is essentially the sum of unemployment and inflation, if that condition happens, we are going to have very significant political problems.
So that, to me, the biggest thing to watch right now is the following. Equity markets make a new record high and suddenly we have a return or a repeat of 2008, 2009, 2010 where people were picketing Wall Street. This time around, people might actually start picketing some other government organizations because you’ve got the stock market up to all-time highs. The rich just got richer, you know, in the eyes of a lot of people, but at the same time, there is significant unemployment. So what does the Fed or any monetary authority do at that point in time? They cannot keep interest rates low and they cannot say we are generating more liquidity to, you know, make the financial markets healthy because at this point in time the economy is not responding. So I do believe that creates an incredible amount of risk because a lot of central banks are going to have to start backtracking on this extremely easy policy. And if you do believe that the current rally in the market is primarily low-rate, low-liquidity, easy money-driven, that could set us up for a very significant correction and the credibility of the government comes into question. So that’s the first thing I’m watching.
The second thing I’m watching are negative yields in Europe, which are a ticking time bomb. In my view, the fact that you are depositing money and you have to pay an interest rate is a time bomb that’s going to implode sooner or later as soon as economic doctrine begins to change. But from a point of view of investors, if you’re getting paid to actually “short the bond market,” when the spectre of inflation is potentially rising and all central banks are trying to raise inflation, that’s possibly the best positioning you can do at this point in time is not by negatively yielding bonds and, in particular, if there’s a way to actually take the other side of it. So you should be a borrower at negative yields and take that money and do other intelligent things. So those are probably the things I’m looking. And I think, as always, how these things unwind and reequilibrate is going to be very interesting.
Meb: What do you think as far as another big market, any general thoughts on how this plays out with currencies? You know, the U.S. dollar has been really the only game in town for a while. It was interesting because the dollar used to be almost like a high-carry currency, which is weird. It’s like the U.S. dollar and a bunch of emerging markets. Well, the dollar has come down as far as the yields in the U.S. Any general thoughts on FX?
Vineer: Yeah. So my biggest attention or biggest focus right on FX has been less on the FX cross-currency markets by themselves, but on what we call the hedge returns. Right? So let me just explain that for your listeners just for a few seconds. So because of the globalization of the markets and the tight integration between bond markets and currency markets, when a big saver, let’s take one example, the Japanese GPIF, which is the largest pension fund in the world. When they buy assets, they look around the world and they say, “Where can we get most yield?” Because think about it, in Japan, they’re printing infinite amount of money. So they’ve got a lot of cash coming from that money-printing…Japan has been the leader of money printing. Now, this money printing is not going to stop anytime soon, right? Because the debt to GDP there is very, very large and even despite very high debt to GDP, the yen is not depreciating, whereas one would have expected from classical economics.
So what the Japanese, for instance, I’m just taking an example here, have is a well that they can go to, print a bunch of yen, go to a foreign country and say, “Okay, where can I get some sort of positive yield on this?” And I don’t need to get any return on it. All I need to do is get my principal back because if I buy enough zero-coupon bonds globally, staggered, let’s say, you know, one-year, two-year, three-year, all the way out to infinity, when my zero-coupon bonds come due, whether it’s from the United States or from Germany or whatever, that’s like an interest payment because I’m getting that from money that I’ve just printed. So when they look at it, they’re looking at it from the point of view of how can we take a bond somewhere, hedge it using the cross-currency, swap or cross currency forward rate and convert that yield into moderately positive yield.
Now, how does this connect to the foreign currency markets? If you know how currency arbitrage works is that forward currency and spot currency are related through the differential in interest rates, something called the basis swap, which is a technicality. But the point of the matter is that if somebody in Japan, let’s say, buys negatively-yielding German boons, let’s say -50 basis points and hedges it using a euro-yen forward currency, they can convert…if the short interest rate differential between the euro and the yen is positive, they can convert a negatively yielding bond into a positively-yielding bond. Okay. So why is that important? It’s important because what you have done is you’ve taken something that’s negatively yielding. There’s a lot of duration, but by doing a currency hedge which rolls every three months or every month, you have converted this into a positively-yielding asset. Okay? But now you can see what the problem is. The problem is that you are running both a carry trade on the yield curve and you’re also running a carry trade on the cross-currency differential.
So now I can answer your question. If you followed along with me, Meb, is that if at some point U.S. yields provide a higher either unhedged or hedged return for this exemplary Japanese investor, in this example, relative to negatively-yielding bonds, they might decide that they don’t need to hedge and they might just move from one country or one continent and mass to another continent. So in this world that I have painted for you, inflation doesn’t matter, policy doesn’t matter, the only thing that matters is whether or not they can get carry, right? Because everybody’s hungry for carry. It’s a very, very delicate balance because as soon as the carry flips, money can go from one country to another country in literally trillions of dollars.
So to summarize this whole thing, I do believe currency volatility is extremely cheap and at some point, it’s going to explode up. People have lost too much money trying to bet on it. I don’t know when it’s going to happen, but coming back to our estimate of portfolio construction, if there is one asset class today where the asymmetry is enormous, if you have staying power, it would be the FX markets.
Meb: The famous widow makers with Japan, one of these days. I was smiling as you were talking about moving in mass to carry because I was thinking of Argentina who then will also decide that you’re not allowed to have your money out and put in some controls. But yeah, with the big ones…I think people, we talked about this a little last time, struggle with the concepts you mentioned of negative-yielding sovereigns, and then also with FX. But you’ve written a lot about that, so we’ll add some of your papers to the show notes so people can dive in more on that topic. Anything else got your brain abuzz here in almost end of Q2, 2020, anything that you’re excited about or that you’re working on or interested on?
Vineer: Yeah. So one other thing I’ll mention just in passing, which again comes back to, you know, what I call the long history of financialization and asset class. And, of course, you know, oil was an unbelievable example of it because in this day and age, the fact that all futures can go negative simply because there was no storage and there was no way to take delivery, then we tried to figure out, engineer it, but we couldn’t figure out a way to take delivery just shows you how broken the market is. But instead of going into commodities, you know, what I do wanna mention is, you know, something that’s maybe much closer to your listeners’ portfolios, which is ETFs, right? And what we saw in March and April was an unbelievable liquidity crisis in ETFs where many ETFs like the big, you know, corporate ETFs and a lot of closed-end funds were trading at discounts NAV to the pricing discount that was five times the annual yield, right? That doesn’t make any sense. You buy the CTF for a yield of 3%, but you could have bought it at a price basis for a 15% discount and basically made all that discount back in 4 days if the market rebounded. But it was, again, another side of this liquidity crisis. People just did not have cash.
So in my way of thinking, if you believe and you bet that the Federal Reserve and ECB and Japan’s liquidity solutions are be-all and end-all and you trust them, by all means, that episode is over and you should think about accumulating the assets that they’re buying. But if you believe that there’s any risk, as I do, that their credibility in terms of printing money forever as Ed Yardeni called it, “QE forever” comes into question, then my view would be that you probably wanna have excess liquidity at this stage in your portfolios because you’ll always get a second chance at accumulating cheap assets. So that’s where I’m kind of at. We’re pretty balanced in our portfolios. We’re not taking any crazy risks, but we are accumulating positions where we believe there is significant asymmetry.
Meb: Yeah. The liquidity topic is one that investors just…I feel like they have to keep learning it every few years. And it’s not just individuals or advisors or brokers, it’s institutions too. And, you know, we learned it pretty clearly in the financial crisis where all the endowments and so many pensions got into trouble with mismatches on liquidity and then, sure enough, you get into more scenarios like this year. And some of the…you mentioned ETF, some of the even more extreme dislocations, which happen every once in a while, you know, in closed-end funds, some of those, we’re seeing discounts in that asset value of 30%, 40%, 50%, which, you know, happens, but not that often. But yeah, the liquidity issue is one that seems like people got to beat it into their head every few years to keep learning the same lesson.
Vineer: Exactly. And, you know, it’s what we call latent illiquidity. You get paid for that liquidity that is gonna right under the top layer, subterranean liquidity. And, you know, that, again, we could talk about it all day long because that has significant parallels to avalanches where we started this whole thing. You know, the thing that you could easily fool yourself is that nice fluffy snow on top. But underneath there is that slab, that ice slab that’s going to break and slip. And it’s incredible how quickly that can happen and how quickly people’s beliefs change. So I think one of the biggest risks to the marketplace today is an excess amount of belief that the central banks have an infinite ability to provide liquidity to the system.
Meb: Before we let you go, what was sort of the…You know, you have a lot of LPs, institutions, as well as, I assume, family office individuals. What sort of has been the discussions this year, what’s been kind of the mindset? Is there any generalizations you can make? Were people pretty calm, were they freaking out? Was it something that…I don’t know. Like how was your interactions? Because I feel like on my side it was kind of a bagel. I feel like people would happen so fast. So many of the people we talk to just kind of just, you know, went full ostrich, but what was kind of your world like?
Vineer: Yeah. So I classify it in three categories, three types of communications. I’ll list them for you. I take every person or investor that we speak with, we speak with a lot, I mean, you know, 2000 investors who are interested in tail risk hedging, you know, over the last few years, but…So there’s three classification, three classes. So the first one…and some will just reflect the cleaner battle that’s going on between two giants of the field right now. So there’s…the first school is look, you know, we don’t believe in hedging and deltas management period, these events happen and we’ll just suck it up, you know, and deal with it. Okay. That’s the first class. And I just got to tell them that you can think of risk management coming in different flavours when you buy treasury to zero, you’re also giving up opportunity costs. So it’s all the cost of an option and the [inaudible 00:54:24.984] to pay off. But that’s fine. If it doesn’t work for you, it doesn’t work for you. Fantastic.
The second class is people who want to do some sort of tail risk hedging, but they want to wait for the right time. So they want to time it. And that’s a little bit to me like saying, “Look, I usually drive on icy roads without my seatbelt on, but when I know that I’m going to have a wreck and I start slipping, I’m going to very calmly put my seatbelt on and I’ll be cool. So I believe in deltas hedging, but right now is not the time. And I’ll let you know when the right time.” Those people, you just kind of have to interact with them and tell them kind of where in the cycle you are and, you know, relative pricing and so on. The fact that expensive hedging costs don’t necessarily mean that you have to buy plain minimal hedges. You can do a lot of other things in terms of structures and so on to cheapen it up. And when hedges are expensive, you can still reduce the cost by actively managing it and secondly, you have better things to do with your core portfolio because equity risk premia are much higher and risky assets are cheaper. So when you combine that long portfolio with these slightly more expensive hedges, better done, you end up in a better long-term outcome. So that’s the second class of conversations.
And then the third class of conversations are people who just have crossed these two bridges and they believe that the world requires self-insuring. And what that means is you take all the levers you’ve given, like we talked about before and you use them optimally. And those are our favourite conversations because we talk the same language. And fortunately, what I have done, tried to do at least over the last 20-something-odd years is build that educational framework within which I can have that high-level communication, not in terms of buy option hedges, but the framework. And those are beautiful, deep relationships, and those are the folks that have stayed with us and funded new strategies and looking to give us and have given us a lot of flexibility in recommending stuff for them.
You know, in this market, the financial markets, I’ll call it equity markets globally are $50 trillion, you don’t need too many of the third category of the people. You need maybe 3% or 5%. That’s still a significant number of trillions of dollars and bottom line…and I’ll stop at this. The bottom line is that those people have repeatedly made the right decisions, and they have repeatedly outperformed, and they have repeatedly shown that their long-term performance because the framework is better. So for us, it’s very simple. We don’t try to market it very aggressively. We don’t try to convert category one people to two or three. We just give them the facts. And usually, the third category of people self-select.
Meb: Yeah. Well, I think if anything then Q1 of 2020 has been a reminder, despite the fact if you close your eyes and woke up in May that not a lot has gone on as far as equities net, that, you know, the path can be really painful and if you don’t have the ability to survive or the wherewithal just to get from A to B, then it becomes a big problem. And I think a lot of people in our world too, asset managers and financial advisors, felt the very real pain of being overexposed of one particular risk in general, which has always typically been U.S. stocks. You know, as you mentioned, some of those indices were cut in half. But the sun is shining it looks like in Southern California again, and the rest of the world. Vineer, any last thoughts? Where do people find you if they want to read your writings, see what you’re up to, where do they go?
Vineer: Yeah. So I do a piece on “Forbes.” I try to write at least once every month. And if you go to forbes.com for the blog and put my last name in, you’ll see about 30 or 40 of those, I have about 30 or 35 published papers on various technical aspects of portfolio construction, fixed income hedging, etc. I also have four books on the topic if anybody’s interested, I think on Amazon. And the last one is they can get in touch with me through you, Meb, or just go to our website, longtailalpha.com, and just click on the info link and send me emails. Typically, if the questions are about views and markets, etc., I love nothing more to engage with people because as you can probably imagine, both for you, Meb, and I, you know, financial markets are an ongoing thing of curiosity and education and learning and teaching. That’s what we do and that’s why we’re in it for multiple decades.
Meb: I love it. Thanks. Listeners, by the way, don’t contact me. Contact Vineer directly and pester him with your thousands of requests. He asked for it, so he deserves it. When are you going to get on the slopes next? Are you going to try to go Southern Hemisphere this summer or wait out until next year?
Vineer: Yeah. Recently, we have gone to Chile once in the summertime, but I think at this point in time, you know, I also run and do like ultra-long races. Everything is cancelled. So I’m actually not planning very much. Maybe take a little break with the family and then I hope by November, December slopes are open and we can get back up there. If not, I’ll be out there in the mountains doing something because we all got to get out.
Meb: That was one of my favourite pieces of advice you had. In one of your pieces, you were talking about what to do and you…listeners, despite how complicated, a lot of the topics Vineer talks about, a lot of the conclusions tend to be pretty sensible and practical. And you were talking about liquidity and everything else, but you also said, you know, just enjoy and spend some quality time with your family, learn to play Minecraft, which I’ve never played. My son’s only 3, so he’s not quite there yet, but I was laughing at that one. Do you do any of the ultra races?
Vineer: Yeah. So I was signed up for four this year. So my schedule, usually it starts with a 50k then a 50 mile then 100k and 100 mile. And I’ve done that for the last, gosh, 12 years now, running.
Meb: What’s the one in Colorado, Leadville?
Vineer: So you nailed me. You found my Achilles heel, right? So, yeah, so I’ve done Western States six times, finished five, got a silver buckle there, that’s the Boston Marathon of ultra running up in Tahoe. I’ve done Ultra Trail du Mont-Blanc, which is around Mont-Blanc, finished that. I’ve done an Angel’s Crest, which is just North of us in L.A. twice. And yes, last year I did Leadville and I computed everything wrong. I did basically…it’s an out and back race and this will probably be another conversation, but I calculated everything wrong in terms of my pacing and what an out in the back race means because I’m usually doing point to point races or big loops and out and back changes your whole strategy because you’re crossing people on narrow passes and all that. So, unfortunately, I got demoralized and I decided to throw in the towel, which is only the second time in 50 races that I’ve ever done. But I was signed up to go back this year and redeem myself and just heard about two weeks ago that Leadville was cancelled, unfortunately, but when it’s up and running again, as it will be, hopefully next year, I hope to be back.
Meb: Well, I wish I had known. I think it was last summer. Maybe it’s two summers ago. I can’t remember, but I was there, West Grand, the Alpha Architect crew was there and same sort of attrition rate. Not a lot of finishers, but I just went for moral support. I went and came and drank a few beers and shook my head and smiled that I wasn’t doing the race. So maybe one of these days.
Vineer: The positive part was…and you probably saw, the positive part was that on the way back from the midpoint, I found…I was actually also running it completely solo, meaning…because I’ve done it so many times, I thought I could actually do it without any spacers and support. So I was coming back to the hill and fortunately, I found somebody whose runner hadn’t come there. So he decided to pace me. And so he and I ended up spending about five, six hours on the, you know, tough terrain and became very good friends. But at the same time, basically made a brand new friend in the mountains, but it probably saved me because my flashlight ran out in the middle of the night and fortunately, he had one and we were at 11,000 feet…I was at 11,000 feet with no working flashlight. So the alternative reality could have been, I’m still roaming out there in the mountain somewhere one year later. So fortunately, I made it down safely.
Meb: See, that’s the biggest summary from the tail risk discussion is don’t be an a-hole, make friends because you never know when your flashlight will run out. And there’s a lot of analogies there and someone’s there to help you. Vineer, this has been a lot of fun. Thanks for joining us today. We’ll do it again, hopefully, not two years away next time.
Vineer: Absolutely. Thank you very much, Meb. It’s always great to catch up with you. You’re fantastic. I’ve learned from some of the other podcasts that you’ve done and good luck to all of us with COVID in the markets.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us firstname.lastname@example.org. We love to read the reviews. Please review us on iTunes and subscribe the show anywhere good podcasts are found. My current favourite is Breaker. Thanks for listening, friends, and good investing.