JASON BUCK: Welcome to Ahead of the Curve. I'm Jason Buck from Mutiny Fund. And today, it's my pleasure to sit down with
Chris Cole from Artemis Capital and talk about all things long volatility. Looks like it's a beautiful day there and
Austin, Chris. How is it treating you? CHRIS COLE: Oh, it's beautiful but a little
hot. So this time of year in Austin, Texas can
be a little trying. But sunny is always good. JASON BUCK: Great. I was going to start with an easy question. But it actually might be a very difficult
question to answer. You have popularized the idea of long volatility. I think that your white papers and everything
have brought the idea into the zeitgeist of what long volatility is and why people should
have it in their portfolios. But just the simple ideas, what do you think
long volatility is? How do you define long volatility? What kind of philosophy do you think long
volatility entails? CHRIS COLE: Volatility in markets-- being
long volatility in markets is one thing. Being long volatility in life follows that. And they're very similar. It simply means making change work to your
benefit. And usually, that involves paying maybe some
sort of small upfront cost to transform any type of extreme change in whatever direction
to work in your favor. Obviously, in markets, when you're long volatility,
you're long in option. And you could profit from extreme movement
to the right or the left tail. And you usually pay something in order to
have that exposure, and the profit is non-linear. In life, when you're long volatility, you
pay some upfront cost that could be maybe meditating 20 minutes a day. It could be working out. It could be putting yourself out there to
make new relationships. And that makes you benefit from change and
be able to handle the changes of life and to transform those to be a positive rather
than a negative to you. JASON BUCK: Fantastic. So we've been exploring the idea of why add
long volatility to your portfolio. And I love a good metaphor. So I love when you talk about Dennis Rodman. So you and I, coincidentally, happened to
grow up in Michigan around the exact same time. So we got to experience in our formative years
the original bad boy, Detroit Pistons Dennis Rodman. But I think across the globe, due to this
new documentary The Last Dance, people have gotten more exposure to Dennis Rodman. So talk to me how you think about Dennis Rodman
as long volatility. CHRIS COLE: Well, I love this metaphor. Most people, obviously, Dennis Rodman is a
colorful personality. But he's also a member of five championship
teams. And there was a tremendous piece of work that
was done, statistical analysis, that actually came out and said that Dennis Robbins was
one of the 20 best players to ever play the game of basketball. And that analysis was backed by a substantial
amount of advanced statistics. Well, Rodman is the lowest-scoring inductee
in the basketball hall of fame. The high scoring he ever did in a season was
11 points. He was not a threat to score as you know. Really, outside of dunking the basketball,
he was not really a threat to score outside of five feet. But despite that fact, something really bizarre
happened when Rodman was on the floor. When you put Rodman on the floor, the offensive
efficiency of his teams went through the roof. His wins over replacement value were among
the highest in NBA history. You could put Rodman on a mediocre offensive
team. And it would turn that mediocre offensive
team into a rare, very good offensive team. If you put him on a team with Michael Jordan
and Scottie Pippen, two of the best players to ever play the game of basketball, all of
a sudden a really good team becomes the all-time best team ever. Why is that? What did Rodman bring to the table? Well, Rodman couldn't-- PETER COOPER: Sorry
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it. CHRIS COLE: all of a sudden a really good
team becomes the all-time best team ever. Why is that? What did Rodman bring to the table? Well, Rodman couldn't score the basketball. But he was good at one thing and really good
at that one thing, which was rebounding the basketball. When somebody missed a shot, he would go grab
the rebound. He averaged close to 18-20 rebounds a game
at his prime. Well, this gets very interesting because,
at the end of the day when you look at that, if you're grabbing 10 offensive rebounds a
game, that converts into who an extra 10 shots at a 50% efficiency. You're getting a good extra 10 points a game. So you give Michael Jordan an opportunity
to have a second or third shot. And Michael Jordan's not going to miss that. Scottie Pippen's not going to miss that. So Rodman, when you put him on these teams,
increased the offensive efficiency of his teams. And he turned-- he transformed teams into
great teams. And he was unique in this fact. But people don't consider Rodman this great
player because, first of all, a team of Dennis Rodmans is not going to work. You need to pair Rodman with other scores. And people overlooked these other defensive
contributions that Rodman did because he didn't score much. Dennis Rodman is a lot like long volatility
in the portfolio. Long volatility is an asset class that tends
to be anti-correlated, and it tends to do best when there's a lack of liquidity, when
stocks are crashing, when bonds are malfunctioning, when there's terrible credit drawdowns. And long volatility, when the rest of the
world is sucking liquidity out of the system, long volatility is giving you liquidity. When you need that extra shot in the fourth
quarter, long volatility is rebounding the basketball and giving you a chance to take
a second and third shot at these other asset classes like stocks, bonds, real estate, credit. So very similar Rodman, if you put long volatility
in an institutional portfolio, it greatly amplifies the other asset classes. And this is not an opinion. I published a paper earlier this year. It came out in January. I looked at 100 years of testing in various
portfolio strategies and determined that a portfolio that had what I called the dragon
portfolio, has substantial positive exposure to left- and right-wing tail volatility, putting
the long vol in that portfolio at a clip at a shocking percentage of about 20% is a major
constituent of that portfolio. And that portfolio has beaten almost every
other portfolio that you can imagine from 60-40 stock bonds, to risk-parity portfolios. And I wrote that in January. And sure enough, that portfolio this year
is substantially beating all other peers, both during the period of the March drawdown
and also the recovery. JASON BUCK: Fantastic. Not to belabor the point too much, but if
you were to have that Rodman in your portfolio and let's just say, hypothetically, you could
have negative points in basketball, would you be willing to take negative 5 points on
Rodman, knowing that that line item or a stat sheet would do you negative 5 points but plus
10 offensive rebounds? So you'd look at that lineup, and you'd be,
why would I carry this player? He's terrible. He loses me 5 points a game, right? And then, you combine him with the other four
athletes, when-- especially Jordan and Pippen. Would you be willing to spend negative 5 points
on Rodman for that plus 5 points, I mean plus 10 points expected value of the portfolio
of players? CHRIS COLE: Absolutely, mathematically. JASON BUCK: Yeah. CHRIS COLE: Mathematically, absolutely, of
course. JASON BUCK: Exactly. CHRIS COLE: If Rodman's giving you 20 rebounds
and that many extra chances a game, statistically, you're gonna be better off with him on the
score, even though he's costing you points. And this is the problem with the thinking
of coaches at the time. They undervalued Rodman. Rodman was traded to the Bulls. They gave him away. I mean, part of that was behavioral issues. JASON BUCK: Yeah. CHRIS COLE: But his previous team gave him
away. Well, the dynamic there is that someone says,
well, we can put a power forward in his place that averages 10, 15 points a game, but it's
not as valuable as-- a mediocre 10 or 15 points a game is not as valuable as an exceptional
20 rebounds a game. It was much more unusual. Rodman's ability to rebound was six standard
deviation outlier compared to other players in the rebounding space. Well, to this extent, people underestimate
defense. They underestimate non-correlation or anticorrelation. And they underestimate liquidity, the value
of liquidity, and investments that give you liquidity versus investments that take away
liquidity. Institutions love to go find a manager with
a very good-looking trailing Sharpe ratio that is anti-fragile to change, and they underestimate
the impact of volatility and the need for volatility. And this is why long volatility remains the
small niche, when it actually should be a dominant part of the institutional portfolio. And once again, this is not an opinion. You can go back and look at some of the research,
allegory the hawk and serpent. Over the years, I've read many research papers
over the years, and these arguments are presented using math over, and over, and over again. And there's just no other way to look at it. JASON BUCK: And it just so happened serendipitously
that there's five players on the basketball court, and it just so happens your Dragon
Portfolio has five categories of assets. Can you describe the other five and then discuss
which ones are short vol, and which ones are long vol, and why that combination? CHRIS COLE: Absolutely. So if you look at the console of the Dragon
Portfolio, there's five different asset classes. And the first two are pretty basic. That could be stocks and bonds-- standard. You could substitute real estate or private
equity in there. I would say stocks would be equity-linked
investments, a business cycle-linked investments. The other asset classes would include long
volatility, which plays off of both left and right tail. That's an investment strategy that profits
in secular change. Another investment would be gold. That is a right tail investment that profits
from periods of secular change. And the last one would be trend-following
commodities, which also profit from periods of secular change. Asset classes like bonds and credit stocks
tend to do pretty well during periods of secular stability. And that would really be the last 40 years
of-- since the 1970s till today. The other investments do very well during
periods of secular change. This includes periods of intense deflation,
or periods of intense stagflation, or, in the worst case, hyperinflation. So people tend to think about left tail is
the markets crashing. We see that in the Great Depression, what
we experienced in March, what we experienced in 2008. Obviously, people think about volatility in
that context. That's one element to that. But people don't understand that there's also
this right tail, where you can have incredible volatility with rising asset prices. We've seen a little bit of that recently,
while we saw that in the late '90s. We saw that with the stagflation in the 1970s. And you also see it in areas like the hyper-inflationary
eras of the 1920s with Germany, where you have tremendous spot and vol up behavior. We saw a little bit of that in China in 2015
as well. Volatility can do well in that environment. Obviously, gold is something where, in a right
tail environment where you have fiat devaluation, gold, in many ways, is like an option. It has convex nonlinear payouts during periods
where there is devaluation of fiat. And gold does very, very well during those
periods where you either have a right tail risk giving fiat devaluation, or you have
governments looking to devalue fiat in conjunction to combat the deflationary environment. The last is, obviously, commodity trend, which
are very similar to gold and very similar to volatility performed in the 1930s and also
the 1970s. Commodity trend does very, very well during
periods of stagflation. So the '70s were the home run period for commodity
trend. If you take all of these asset classes together,
overall, you get a portfolio that has performed for over 100 years consistently through every
regime cycle. So you're able to consistently make money
with between 1/3 to 1/5 the drawdowns experienced with other investment strategies, and you're
able to hold these. Not all of these asset classes will do well
at any point in time. Long volatility has done very, very well this
year, but if you looked at its trailing Sharpe ratio over the last five years, it was not
a very popular investment. Commodity trend hasn't done very well, and
it doesn't recently, but it did exceptionally well during the stagflation of the '70s. If we had a stagflation come back to the United
States, you'd want to be in something like commodity trend. The point is that these investment strategies,
like long volatility, they're not really intended for a rainy day. They're intended for a rainy decade. So the idea, at the end of the day, is that
you have to hold a balance of all of these different asset classes, and some of them
actively managed, in order to get the benefit of that composite portfolio. JASON BUCK: There's obviously a credible amount
of epistemic humility, too, with holding those assets for longer periods when you don't know,
you know, around the next bend what kind of environment we're going to be in. But when I look at it a lot of times, I'd
like to think about it as mean-reverting trades like stocks and bonds are convergent trades. And then you have divergent trades in long
volatility, and in commodity trend. And then gold, like you said, it can be a
fiat debasement or some sort of convexity there. What I find fascinating is that people have
gotten anchored to this idea of 60-40 portfolios, right? So they have 60% stocks and 40% bonds, and
they think their stocks are their offense and their bonds are their defense. But when we talk about the Dragon Portfolio
of almost equal weights, more or less, across all of those buckets, is that only 40% is
held in these mean-reverting or convergent trades, while 60% is held in divergent or
asymmetric trades. And that rebalance over time compounds wealth
better. I like to think about it because of the huge
left tail of those stock and bond or convergence strategies, and then the small left tail,
but the right skew, of those divergent trades. How do you think about that combination at
the portfolio level? CHRIS COLE: Yeah, I think about the same. I think about the same concept. One of the terms I've used historically is
just to say that there are really only two asset classes. JASON BUCK: Right. CHRIS COLE: Long and short vol. And that's just another way of describing
what you eloquently said in the idea that you have assets that are based on the assumption
of mean reversion and that are correlated to the business cycle, that assume stability
and assume mean reversion. And those aren't bad. Those aren't bad assets. Real estate assumes some level of mean reversion. You're buying the dips. Stocks assume some-- value investing assumes
mean reversion. There's nothing wrong. There's smart ways to play those. But nonetheless, you are going to take big
drawdowns in those asset classes during periods of secular declines, during changes in the
business cycle. And then, there's long volatility investments
that actually profit from change and non-linearly profit from change and that are non-correlated. And those tend to have elements of non-linearity
to them and tend to actually profit from trend as well. So a lot of people talk about volatility. They only think about volatility in terms
of the movement of the stock market. But when you're owning volatility, you own
something called gamma, which is the trend in the underlying asset. In many ways, the more the option moves in
your favor, the more exposure you have to the underlying asset. That's gamma. In many ways, you're not only benefiting from
the vol exposure, but you're also benefiting from this trend exposure in the underlying
asset, which is something that becomes very, very valuable when there is not the mean reversion. People come running, stocks drop 20%, real
estate drops 20%, and all of a sudden, people come in expecting it to be in revert, but
it keeps going down-- negative 50%, negative 80%. That's where volatility becomes, volatility
investment becomes nonlinear. And commodity trend has that gamma effect
as well. So these are ways that you can capture this
momentum effect and to profit from change. And they tend to be non-correlated with investments
that assume the re-assumption of stability. And that's so important to building a balanced
portfolio. Going back to the idea of a Rodman analogy
or a football analogy, just because you're on a scoring streak doesn't mean you pull
your defensive rebounder out of the game. Just because in soccer, when you're on a scoring
streak, you don't pull your goalie out of the quality box. But yet, institutional investors, desperate
for yield, will continuously chase excess returns that are correlated, when in actuality,
the value of that non-correlation and convexity to these other investments is worth more in
the composite. That's a lesson that people learn have learned--
it seems like learned the hard way over, and over, and over again. But you brought up bonds, and this is very
interesting. In '08-- and look, if you've been a Real Vision
listener, I'm sure a lot of people have listened to Real Vision. You've heard me talk about this for years,
going back to the original Real Vision interview with Grant, how bonds are convex instruments
when there is yield-- when there is an ability to cut yield down to 0-- but they lose that
defensive non-correlation benefit and their convexity benefit with yields at the 0 bound. And we've seen this. The 60-40 stock-bond portfolio struggled to
control drawdowns during the Great Depression, and they reduced interest rates to close to
0. And once you reach that zero bound, the defensive
properties of bonds, high-quality bonds, become neutered. And this is why you need to look to alternatives
in order to supply some defensive properties. And with the 10- year Treasury hovering around
50 bits, I mean, this is where we're at. JASON BUCK: Right. And when we were thinking about Rodman, I
was thinking about some other, you know, sports analogies or metaphors before. And I was thinking about even what we call
soccer, or European football, is if you look at Team Liverpool, you know, they recently
signed Virgil Van Dijk, who's an amazing defender. And they have an amazing goalkeeper in Alisson. But the point of hiring both of those players
was that so their front three could go out on their allout heavy metal attack. CHRIS COLE: Yes. JASON BUCK: So it's about the combination,
getting the combination right. I don't know if you remember, when we were
kids, there was a Nintendo game called Ice Hockey. It was the first game. But you had to pick between small little fast
guys, and medium guys, and the big, fat guys. The fat guys were slow, but they can knock
the small guys down. But you needed the right combo in your portfolio
to have a winning team. CHRIS COLE: The balance. JASON BUCK: Exactly. And so what you were just hinting at, with
bonds being that uncorrelated trade-- and a lot of people tend to think about uncorrelation. But what we like about long volatility and
tail risk is the structural negative correlation of when you're buying options and et cetera. So part of portfolio construction has this
cornerstone of Sharpe ratio. And maybe if you get a little more advance,
maybe you use a Sortino ratio based on downside volatility. But when you're thinking about long volatility
and tail risk, you can't really put those in a Sharpe or a Sortino ratio, especially
because you have a punctuated equilibrium with these. So if we don't have a good mathematical, Gaussian
metric for long volatility and tail risk, how do you think about putting those in your
portfolio? And how do you think about positioning them
or position sizing? CHRIS COLE: Well, there is a massive failure
of institutional portfolio management in only looking at the efficient frontier in terms
of returns in vol. This is-- risk-return, we think in terms of
these variables. But we don't include a key variable, which
is liquidity. When you are in these other asset classes
that rely on the assumption of stability, you're actually, in many ways, short liquidity. And when you're positively exposed to change
through something like long vol, you are long liquidity. What do I mean by that? What I mean is that a dollar at the bottom
of a market crash, when valuations have come back to Earth, and when stocks are cheap or
when real estate is cheap-- is worth more than a dollar at the top of the market cycle. Wouldn't we all like to have more money at
the Devil's bottom in 2008, or in March of this last year? So people tend to think or imagine that investors
are selling things because they're panicking. That's oftentimes-- while true-- overblown. What is occurring is liquidity squeeze. People are being blown out of their levered
basis trade positions. This is something we saw in March. People are being blown out of their short
volatility positions. They're facing margin calls. They're facing draws on their private equity. So the rest of the mean-reverting investment
strategies that rely on stability suck liquidity. They lack liquidity. They're short liquidity. And something like a long vol strategy gives
you liquidity. It gives you the liquidity when liquidity
and a dollar is worth more. It's giving you that. These other strategies take it away. So it's amazing to me that many institutions
will throw money in illiquid investments like real estate, private equity, that actually
suck liquidity out. And then we'll say, well, they have a higher
Sharpe or Sortino ratio than something like long volatility. Well, these are investments that are correlated
to the business cycle, the rest of one's portfolio, and require liquidity when the dollar value
is the greatest. But that is not built into the way that risk
is evaluated. There's no metric. I've been trying to think of one, actually,
and work on one, but there's no metric that values the liquidity benefit from a strategy
that's giving you money when money is dear and that's helping you avoid a margin call. So if we go back to the sports analogy. If your team is down three points in the fourth
quarter, what is the value of a second and third shot to basket? It's massive. It's the difference between being thrown out
of the playoffs and losing the game, and having a chance at survival, or winning the championship. So you need players that can score, and you
need players that can get that rebound and give you a second chance when your first shot
or second shot misses. And for investors that had long volatility
in their portfolio this last March, I think the average long vol fund was up 30%. You can stay invested in that, or you could
take that profit, and reinvest it, and rebalance it in your equity exposure. For investors that had 20% or 30% of their
portfolio in long vol, March was no big deal. On a day-to-day basis, hardly noticed a problem. JASON BUCK: Before we dig into that a little
bit more, when you say day-to-day basis, I want you to expand on that. Because I think another thing that investors
typically look at is their monthly returns, or they look at month-to-month over multiple
year time horizons. Where if you look at long volatility daily,
especially if you're able to hold it and house your short volatility and your long volatility
assets, speak to a little bit about looking at a daily timescale versus actually looking
at a monthly time scale. For example, we touched, maybe, negative 35
intra-month on the S&P in March, but at the end of the month, negative 12.4. So talk to me about daily versus monthly. CHRIS COLE: Yeah this is something that I
think is incredibly important. It's typical to evaluate funds on a month-to-month
basis. There's nothing wrong with that. But in many ways, that's like saying, OK,
I'm going to go-- I'm going to be driving to go visit my family in Michigan. Well, I could go through-- I could go to California,
go to Colorado, and then drive to Michigan, or I could drive straight up from Texas to
Michigan. There's a lot there's a lot of different ways
you can get from Austin, Texas to Michigan. So I think in the same vein, monthly returns
don't give you a good picture as to the performance of any strategy, but especially convex strategies
and non-correlated strategies. In some instances, you may see situations
where managers might go up 60% and then give back 20%. This is not uncommon with these convex elements. So in this sense, by looking at daily returns
for a long vol manager, you get a much more nuanced understanding as to, number one, the
power of the convexity, and number two, how well that anti-correlation is working with
the rest of your investments. And it also helps you understand whether or
not someone is actually following a strategy. Because you have some people that could--
for example, a manager-- I've seen this before where someone says, well, they weren't a long
vol manager, but they were a relative value manager. They were like, well, look, every single time
we had a market sell-off, we performed. Well, that's because they were selling skew
and selling optionality. So they were actually playing a mean reversion
trade for most of the sell offs, until that finally broke on them and hurt them. So I think it's very important to understand
the nuance and look at daily returns. And that provides an element that's much more
clear as to the effectiveness of what the manager is doing. There is no silver bullet. You wouldn't hire just one equity manager. You wouldn't hire just one bond manager. Long vol is no different. There are all types of very strong reputable
long vol players the two very different things, and they profit differently depending on how
a crisis evolves. So a mosaic approach among a bunch of different
vol managers is something that some of our best clients often do. And as a result of that, I'm actually friends
with many of the other vol managers in the space. I don't really consider them competitors. And there are times where I'll listen to somebody
and say, well, if you're interested in that type of volatility, you should you should
talk to this other group. So for example, there might be managers that
do better in exogenous shocks than endogenous shocks. There are managers that might do better if
vol stays elevated for six months versus jumps up over one month and comes back down. There are a lot of different styles of long
vol, and if someone wants protection across the wide range, the best thing to do is to
pursue a mosaic approach, as you would with other strategies, or to find some kind of
aggregator, like me, for example. JASON BUCK: I was saying, are you speaking
a love letter to me right now? CHRIS COLE: Yeah, well, I'm a believer of
it. Because not everyone has the ability to go
put $200,000 in this long vol fund, another $200,000 in this long vol fund, it's just
much more responsible to have it aggregated if someone doesn't have the capital to be
able to spread and get the exposure across multiple managers. JASON BUCK: When we're talking about daily,
looking at long vol and short vol assets on a daily basis, what we're really talking about
is psychologically being able to sleep at night, to know that you have this convexity
when markets sell off that's structurally negatively correlated, because you don't want
to sell at an inopportune time. You want to be able to sleep at night. We're talking about, we don't have a good
metric for it? We don't either. But what I really like is my partner, Taylor
Pearson, has coined this term, an entrepreneurial put option. Because you and I think about this much more
holistically. If I own a house, if I own a business, I own
a car, a lot of these things are implicitly short vol or implicitly long GDP. So I need to hedge out those risks. So if I'm an entrepreneur, and I have some
long volatility exposure on the books, and a crisis happens-- a liquidity event, especially--
then I've got this convex cash position that now allows me to either maintain payroll for
an extended period of time, maybe invest in CapEx, or maybe buy out my competitors. Because now I'm the only person in town holding
this cash, that now cash, as you alluded to, has a much different value. But part of this sleep-at-night that I really
like is that I think you referenced the multiple times you've been on Real Vision. And I think if people go back and watch that,
they would say Chris Cole, the long volatility guy. i.e., or therefore, he's a permabear. Now, I know you, and I know you're not a permabear. You're just a realist, right? A permabear would be a pessimist, but a realist
would say, look, bad things happen. I want to hold short vol and long vol. So if I have exposure to long volatility,
I can actually hold more of that short volatility, that implicit short volatility, that beta
risk. So therefore, it's almost like you're switching
kind of an optimist. It's like I'm allowing you to hold more equity
in bond risk if you put more long volatility on the books, and then you can sleep at night
and compound wealth better over the long term. So it's an interesting, I think, playoff in
that sense. A quick side question is, I think the question
would be, why buy right tail? So if I hold stock and bonds or short volatility
assets on the books and hold that risk, if I'm talking about long volatility, most people
think of the left tail. But why buy right tail? CHRIS COLE: I'll answer that in one moment. I want to go back, and just to your point
on it, about the idea of being a permabear, I think it is misguided to think about it
that way. Because I think our mission is to help investors
take risk responsibly, to give investors the freedom to take risks responsibly. So I don't see myself as being-- put on an
end of the world hat. The media likes to really-- the media really
likes to push that idea. JASON BUCK: Maybe if you win wouldn't have
called your paper "Volatility--" CHRIS COLE: [INAUDIBLE] JASON BUCK: If you hadn't called
your paper "Volatility and the End of the World," maybe they wouldn't put that hat on
you. [LAUGHS] CHRIS COLE: Yeah, it sells papers. I look at it this way. I see myself as like a Special Forces team,
and my team is to help people get out of liquidity predicaments. When they're in trouble with the rest of their
portfolio, we want to come in come in and help. We don't cheer for the world to end, any more
than a rescue team or firefighters cheer for fires and for misfortune to happen. But we prepare every day, and try to think
about every different scenario, and design systematic strategies that are intended to
profit from these various regime states of the world. And I think that's the difference. It'd be like saying Dennis Rodman hates high
scores, or hate scoring, or all people who score. It's not the case at all. It's just his focus is on something different--
to help the aggregate. I would never recommend somebody put all their
money in a long vol fund. They should put their long vol fund to balance
out the rest of their investments. And if they had done that this year, March
would not have been a problem. They just-- no sweat. It's just an opportunity for them. To go back to the right tail concept, I think
most people are very focused on left tail, and understandably. But there is a different form of secular decline--
and I've talked a lot about this-- where there is no way to destroy volatility. It can only be transmuted in time and form. And in my paper, "The Allegory of the Hawk
and the Serpent," I describe the two forms of volatility transformation. One is, what I say, the left tail of the hawk,
which represents this type of deflationary collapse. But then there's the right tail of the hawk,
which represents the reflationary movement and where fiat is devalued. So this would involve periods like the 1970s,
where Nixon de-pegs us from the gold standard and there's a massive devaluation of money. It would resemble periods like 1919 to 1923
in Germany, where there's a hyperinflation, where vol, equity vol started at 20% and then
topped out at over 2,000% because nominal prices were exploding so much. In each of these cases, whether it's stagflation,
hyperinflation, or any type of fiat devaluation or helicopter money type of scenario, stocks
go up, but they don't-- they don't keep pace on a real adjusted basis. The 1970s, on a real adjusted basis, was a
depression for stocks. But in actuality, you had about a 30% drawdown,
but they were a depression for stocks. But if you were invested in right tail gold--
let's look at gold. Gold right now, vol is around 15. From a greater point of several years, it's
been as low as 9, 10 vol. Gold volatility in the 1970s went all the
way up to 80%. So you might be invested in equities, but
if inflation is running at 10% to 15% a year, your savings are being eroded. Obviously, real assets are doing well, but
if you're owning right tail volatility, particularly in the right asset classes, be kt gold or
stocks, that can provide excess return, particularly if layered on top of equities to help make
up for that loss in real adjusted income. So volatility is something that plays on both
tails and I think is very, very important. We don't know-- we are going to devalue. The world is going to devalue one way or the
other. I'm not smart enough to know which way it
is. But there's only two routes. You default on the debt, or you default on
fiat. And this is going to be the reality that we
encompass over the next decade. If a bull manager focuses on only one tail,
they may miss the devaluation of fiat scenario. And I think that's something that's very,
very important to look at and consider when evaluating long vol, but it also explains
the role of gold. Things like Bitcoin, I believe, I have a small
exposure to Bitcoin in my personal portfolio, which act like options. They have an option convexity component, particularly
on the right tail of the return distribution. And commodity trend, which profits from trends
in commodity price movements, creates an optionality through the dynamic rebalancing of linear
futures positions. So you don't need to tackle right tail vol
with only one bullet. It's the multitude of these different alternative
asset classes that can be quite important. JASON BUCK: And also, with right tail volatility,
I think you've written well about 1999, where we can-- most people think that volatility
rises when you have a sell-off in markets. You can have volatility rise as equity are
rising, as we saw in '99. It's about the volatility of those movements
that can rise volatility as we have a melt-up. And part of that melt-up I like to think about
is like, why do you want to monetize that right tail? It's kind of like maybe if you have your house
in-- you know, the houses in your neighborhood are skyrocketing in value. Everybody says, great, that's fantastic. Except for then, when you go to sell your
house and monetize it, now you have to leave your neighborhood because everything else
has risen with it. CHRIS COLE: That's right. JASON BUCK: So talk to me-- yeah, how you
view right tail if we have rising equity prices or meltup in equities, as well as volatility
rising, which we haven't seen in a while. CHRIS COLE: Well, it's fascinating, because
what we have seen in the last three months is truly unprecedented. We had one of the fastest sell-offs since
the Great Depression. The Fed has-- and both monetary and fiscal
policy, over $7 trillion of stimulus being pumped in, $10 trillion globally. And that has filled the system with liquidity. And we have gone from a 2008 1932 meltdown
to a to a 1999-style melt-up. In three months, what we've seen are substantial
structural changes. One of the things that I think is incredible
is that if you look at mean reversion as measured quantitatively through something called auto-correlations,
the one-year mean reversion of the S&P 500 and the Dow Jones Industrial average is at
all time highs. We have never seen more mean-revertive market
driven by this melt-up in history-- never. It's unprecedented. In fact, it blows away any other measurement
of mean reversion. And so now we're in a market-- we've gone
from this deflationary collapse to a market that resembles the worst speculative melt-ups
in history. And in my world as a vol practitioner, that
really means three things. You have spot-up and volup. So you have these environments where both
were the movement of the underlying becomes correlated with vol. Most people think about the VIX going down
with the market going up, and the VIX went higher with the market going down. But the VIX is agnostic to price direction. It only cares about the movement of the underlying. So when you start to see these daily 1%, daily
2% moves higher in the S&P, this drives this dynamic of higher vol, spot op, and vol op. And we've seen that in-- we've seen that in
China in 2015. We saw it in Japan at the onset of Abenomics
and the blowout of many of those Uridashi structured notes. We've seen it in 1999 with the dotcom bubble. It's been prevalent in almost every major
speculative bubble. From an option standpoint, the other thing
that is particularly prevalent is substantial right-tail skew in options prices. And this is pronounced in the most popular
names. The FANG stocks are perfect examples A this. And many of these popular stocks-- be it Tesla,
be it Apple-- are trading over 90th percentile of measuring call implied volatility versus
at the money volatility. It's what I call a right-tail skew. What that means is that you have a lot of
speculative investors putting a ton of-- making a lot of speculative leveraged bets on the
right tail distribution. We saw a lot of that in 1999. There were entire con men who sold programs
to investors on how to bet on right tail options during that period of time, and we're seeing
that now again. The names are different. The retail investor access is different. It's not Yahoo message boards anymore; it's
Twitter. And it's not E-Trade; it's Robinhood. It's not a bunch of boomers, but it's a bunch
of millennials. But it's the same pattern generation after
generation, and it echoes the framework in the vol market as well. So I think these are very, very interesting
phenomenons and that are hallmarks of right-tail euphoria. JASON BUCK: I think about there's a lot of
this like prohibitive nomenclature we have in the option space, and certain words can
mean many things. So I think about-- when you're talking about
right-tail skew and the over-buying of calls, I always also wonder at the same time, it's
like, when trades become inherently right-skew in the over-buying of calls, and then you
put that trade on, are you now on a left-skew P&L, meaning that you're predominantly going
to only see risk go to the downside? Or how do you think about that? CHRIS COLE: Well, I think that's-- what's
interesting about that is that, you know, right-tail skew, it means that people-- at
least, in many ways, it's better than putting a levered bet on the underlying , because
at least you have a known loss profile. But what with that is indicative of, to me,
is that you have a lot of new investors coming into a market using options to access leverage
who are not even looking at the implied volatility, and there they're making these-- they're using
options not in a sophisticated way, but in a way that's really speculative, to gain access
to leverage in a way that they can't gain through other-- because they don't have the
capital. And they're doing it in a way that is not
necessarily informed. And that's very telling, and it's something
that you see time and time again. I look at that right-tail scheme, and I see
something that is-- yeah, you can graph the name. The names and the situations change, but the
numbers look the same as they did in the '90s. Another thing that's really interesting is
the leadership of the FANG, or what I call "FANG mafia," include Microsoft. And it's fascinating to decompose the variants
of these stocks. So not-- since the last three years, these
stocks have comprised over 50% of the returns in the S&P, but it's very interesting to look
at how-- what is the decomposition of the variance, or the volatility? What's their volatility contribution? And one of things that we're seeing is that
during periods of excessive gains in markets, there's outsized contributions to these stocks
to the volatility of the market. And all of that is right-tail [INAUDIBLE]. But they're dropping and not buffering the
S&P during periods of weakness. So these are all signs of speculative tops
and-- or, potentially, something that continue if the government just decides to continue
handing out free money in all its forms and just monetize the Federal-- if we go full
MMT, and we go ahead and just make the Fed's balance sheet legal tender, and we just decide
to go full-on fiat devaluation, you would see this phenomenon continue. I'm not smart enough to know whether we go
left tail or right tail, because ultimately, that's a sociopolitical decision. But I think we'll know by this November. JASON BUCK: By November? CHRIS COLE: Yeah. JASON BUCK: So just going back to touch on
the retail traders, obviously, you need to pay attention where all those flows are coming
from and everything. But I think it's-- there's nothing as certain
in life that the old are going to disparage the young, right? And I think about how dumb, maybe, I was as
a youth, right? And we came up, probably, betting on the first
dotcom bubble, right? And we all thought we were geniuses. So I actually look at the retail traders as
like, I think it's great. You lose money on calls on FANG [INAUDIBLE]
stocks or whatever. But through losing that money, a lot of them
are going to dive deeper and go, oh, there's these other dimensions of implied volatility--
skew, time horizons. And it's an impetus to learn. So I have a much more, I think, positive outlook
on that, because I remember how dumb I was in my-- not that I'm any smarter now. But these things happen perpetually, like
you're saying, over time. You brought up an interesting point, I think
that, you think the default is going to happen, whether you believe left skew-- on the left
tail or the right tail. But you said something very interesting, I
think. You said, over the next decade, or, I'm not
smart enough to figure out if it's on the left tail or the right tail. Can you see a scenario where Goldilocks, straight
down the middle, the left or the right-- you that sharp deflationary default doesn't happen,
or that slow-motion default of inflation doesn't happen? Is there a Goldilocks scenario over the short-to-medium
term? And part of that is not knowing exactly where
it's going to come from? CHRIS COLE: What we'd call Goldilocks would
probably be the Japan scenario. JASON BUCK: OK. CHRIS COLE: Japan's been in 20 years of deflation. And if you invested at the top of the Nikkei,
you're still waiting, right, really, to make your money back. And it's been 20 years of deflation, but they've
managed to hold in there pretty well. Part of that is devaluation of-- the they've
gone a fiat devaluation route, which has helped trade to that effect. I'm going to go out, and I'm going to say
that anything's possible. I'm not going to put that past. But I'm going to go out, and I'm going to
say that I think it's wishful thinking. I really do. Because when you look at these level of fiscal
deficits, when you look at corporate debt to GDP, which is now close to over-- it's
over 50% now, I think. 20% of companies can't make their interest
payments, off of revenue, and we're just reliant on a continual rolling of debt. And what we've seen traditionally is that
there is this kind of unholy trinity between volatility, liquidity, and credit stress. It's an unholy trinity. And if you want to know where vol comes from,
it comes from the lack of liquidity and stress in credit markets. And what do we seem to continuously do is
just flood the system with liquidity. Flood the system with liquidity every single
time. But liquidity is not a cure for insolvency. And we're at a point now where it is divulging
into-- and this goes back to previous quotes. Because I think I talked in Real Vision, way
back in the original interview in Real Vision, saying that ultimately, the risk is that they
keep flooding the system with liquidity. The income disparity becomes so large that
it becomes a threat to our democracy. And I think I stated that in The New York
Times interview. And I stated that in my first interview with
Grant on Real Vision. And this is now coming true. We're beginning to see a tear in the social
fabric. And I think we have to make a choice whether
or not there's going to be some element of-- whether we're to go through with some element
of default, or whether there's going to be some sort of massive fiat devaluation. And the idea that that can manifest itself
without movement involved, I think, is-- over a decade. Certainly, maybe, over a year, or a couple
of months, you can suppress it. But over the next decade, when you have a
massive amount-- when the baby boomers are entering into full retirement, when you have
forced distributions of retirement savings. Before this crisis happened, if you looked
at the average pension system, they said it was 70% funded. But I didn't get a chance to release this
research. I had a whole paper that I never released
before the crisis hit. But I recalculated the pension systems using
expected returns of about 5 and 1/2% or 5%, which is what true returns are for their portfolios
over 100 years. And before the COVID crash, the average pension
system went from 70% funded on these new baseline churn levels to under 50% funded, with 1/3
of them under 30% funded. So you really have, already, pre-COVID, an
insolvent pension system. Your point is correct. I'm not worried about the kids. I can't believe I'm saying "kids," because
I'm getting old now. You and I cut our teeth in the dotcom bubble,
and probably made mistakes in this and that in the framework of it all. But the kids are going to be fine. I'm not worried about them. I'm worried about the retirees who are relying
on these massive pension systems for their retirements, and these pension systems are
completely geared towards long GDP investments with no anti-correlated defensive exposure. That's what I worry about. And I think the culture of these institutional
investors has not embraced the thinking required to survive through a major secular change. There is-- and I talk about this at length
in my "Hawk and Serpent" paper-- but how unusual the last 40 years were of asset price history,
how stable it's been. And that's been a combination of the fact
that rates have dropped from 15% all the way to 0%. It's been a fact that you've had a major class
of positive demographics, baby boomers, coming to entering their careers in the 1980s, entering
the savings. And then, on top of it, you have taxes drop
all the way down, massive drops in taxes since the '70s. So these have been huge, huge boons to all
asset markets. And now we're at rock bottom. And despite all that, you would think that
there would be excess savings, but we have historical deficits on every single level. The highest corporate borrowing, highest corporate
debt to GDP in American history, highest federal deficits-- I mean, it's staggering. So I don't think where we are, I would be
shocked if we can find a Goldilocks path for another 10 years. Maybe for another couple months, maybe another
10 months. But if we go-- I don't think we go back to
a 2017 environment. And if you look at the history of vol, and
if you study vol across history, across different countries, in deflationary periods of secular
change or inflationary periods of secular change, this idea that you have a period of
vol that gets over with in a month-- vol remains elevated, during periods of secular change,
between, at a minimum, three years up to 10 years. Vol of the equity markets would have realized
over 30 during the entire decade of the 1930s and had multiple re-testings of above 60. Look, if the Goldilocks scenario happens,
no big deal. That's why you have the equity. That's why you have your house. That's why you have a real estate and your
private equity. But we are woefully under-prepared as a country
with pensioners and retirement retirees for a scenario where the opposite occurs. And I would put the odds much greater. The good news is that individual investors--
family offices, small investors-- can be more nimble than these mega institutions in instituting
the right steps to insulate their portfolio. And that is the good news. JASON BUCK: And so we frequently hear this
question, have I missed the boat for the long volatility tail risk after what happened in
March? And as you referenced earlier, endogenous
and exogenous events. So a lot of us look at March as a liquidity
event, which is endogenously created. And then a lot of the things you're referencing
with pensions and everything else and with the overarching economy can be an exogenous
event that plays out over the next few years. Is there a scenario-- obviously, you don't
believe you miss that long volatility boat, because you're talking about volatility can
cluster at a higher level. And we've seen that for years on end. Is there a scenario where you would take long
volatility off your books, or is long volatility always going to be on your books because it
acts as a ballast to those other short volatility assets and it allows you to take more exposure
to them? CHRIS COLE: I absolutely think there is a
point in time where you take long volatility off your books-- absolutely. That's what it's there for. It gives you liquidity. So in that sense, you can be in a situation--
and we expect this of our investors-- where, during a period of asymmetric returns, someone
rebalance their portfolio at the end of the month and pulls down, takes some of that off
the table, and reallocate it to equities, or reallocates it to real estate, or reallocates
it to-- so that's, in that idea, I don't think you ever want to get the rebound and just
hold the ball until the clock runs out. So there is a need to rebalance that. JASON BUCK: I understand monetizing and rebalancing
it, but would you ever take your volatility exposure, long volatility exposure to 0? CHRIS COLE: Well, we are we are very opportunistic
the way that we trade vol. And there are different ways of trading vol. Some pure play tail risk players constantly
keep the exposure on, and that's more like an insurance policy. There's been a tremendous amount of media
on some of these tail risk players, but I think when you look behind the results and
actually adjust the returns based on notional rather than margin, these are-- these acts
as an insurance policy. When your house burns down and you get the
insurance, you don't say you made 100% of the value of your house. You paid out-- you got an insurance payout. But that's one form of vol trading. And we're not tail risk players. We're more opportunistic. And what we have sought to do, and what we
have done, is, over the last 10 years of our returns, make money and deliver anti-correlation
to investors. That's our objective. And so as a result of that, we do not always
have insurance on every moment. We're very opportunistic. We're looking to buy it when it's efficient. But I think from a portfolio standpoint, if
you're an investor looking to invest in vol and have a mosaic of different managers, it's
important to think of it like an asset class. Understand what your portfolio asset class,
what your allocation should be to that asset class, and maintain that allocation. Take profits when there are gains, but-- this
is what's important-- re-up exposure when you have gains in equities into the long vol. That's the other hard thing. So nobody-- look, you go back, and you look
at a period like 2017, we had some of the lowest vol in the history of equity markets. Who would have wanted to take gains in stocks
and put them in vol? That was not a popular time to do it. But that's right when the vol regime started
to shift. One of the most difficult things about these
strategies is that they don't always look good in the rear-view mirror. One needs to trust, and take a multi-decade
view, and understand that this is not for a rainy day. It's for a multi-decade. It's a core portfolio holding that should
be reallocated and rebalanced, both up and down, in accordance with the rest of your
investments to get the best result. And it's very difficult for people to do that,
because it's a drag. When markets are going to the moon and things
are working out great, It's a drag on the portfolio. And when the world is ending, you're so scared,
you don't want to get rid of it, right? You don't want to take your profits and reallocate. So the behavioral biases are massive. And that's why having a program that rebalances
appropriately is so important. But me, as an active manager, we are constantly
adjusting our exposures in various multi-asset class vols based on where we see the opportunity--
which is maybe different than what a top-down allocator should be looking at. JASON BUCK: And almost every complex thing
in life inherently has shitty trade-offs. And so we talked about the pros and the cons
of just pure tail risk, and some of the benefits, and then also some of the exposure as to on
the negative side. How do you respond to the trade-offs when
you're an active manager, that some people say you cannot time tail risk? CHRIS COLE: You can't time tail risk in the
sense that-- because you never know when there's going to be a-- you never know when there's
going to be a spark that causes a fire. But this is what I will say, and it goes back
to the concept of volatility. Vol is not just something that happens out
of the blue in a macro sense. We think that vol is entirely COVID, but really,
COVID is a spark that ignited a debt crisis and a liquidity crisis. This crisis was coming and will still play
out regardless of COVID. And we think that 2008 was caused by Lehman
Brothers going bankrupt. If it wasn't Lehman, it would be somebody
else. Because if you take vol-- and we've done this
in prior Real Vision interviews as well-- if you look at debt levels, volatility regimes,
periods, multi-year periods of elevated volatility follow the debt cycle. It goes back to the unholy trinity of liquidity,
volatility, and credit risk. So companies become incredibly over-levered. They're stealing from the future to bring
to the present. And that temporarily reduces volatility. And then, when there is a disruption in growth,
they can't pay back their debt. That results in margin calls and poor liquidity
in a non-virtuous cycle. And that elevates fault. So when you look at volatility regimes, they
follow credit cycles, and credit boom and bust cycles. And as a result of that-- and those credit
boom and bust cycles, in many ways, are something that you can look at and, to a certain extent,
have some success in seeing the underlying conditions. What has made-- I like to-- I've used this
analogy before. It's like a forest fire or an avalanche. There's no way to actually understand the
spark that causes the forest fire, but what you can do is you can look at the underlying
conditions that will cause the spark to become a fire-- when there's a lot of dry kindling
on the ground. When there are high winds. When there's potential for lightning. When there is a lot of oil and chaparral. All of these conditions, one of them alone
is not enough, but when you put them all together, the probability that a transformer blowing
up becomes a fire, or a lightning strike becomes a fire, or an errant camper who doesn't put
out their embers becomes a massive wildfire go up dramatically. So one of the ways to understand vol is to
look at these underlying conditions and to see what underlying conditions allow one to
time into volatility events and volatility movement. What's fascinating, though, is that this is
a new wrinkle in the equation. The Fed is doing the same thing. We have quantitative models that evaluate
many of these different factors globally across markets and have been particularly, I think,
effective in giving early warning signs as to when volatility will spike up. What becomes fascinating, though, is that
the Fed is looking at these same factors. And you can never gauge the extent of the
Fed's response and bazooka. And this is what is incredibly unusual, is
that we now have, in real time, a Federal Reserve that responds to these underlying
market, credit volatility, interbank lending stress periods and are preemptively moving. And this is a unique wrinkle across history. And it makes it a little bit more difficult
to understand how the end game plays out. It's the thing when you're not able to go
back and look at the Great Depression and say, because the response time is so much
quicker and proactive, comparative. This is the challenge, and it's not something
to complain about. It's something to be aware of, and it's part
of the unique challenge of managing vol today. JASON BUCK: So Chris, you and I can talk forever. We've spent hours and hours on the phone before. Thinking about the future-- and maybe this
is kind of a teaser because we might be running over to overtime here-- but how do you think
about, as we move into these different market environments, like you're saying, that dynamic
changes, whether it's a more proactive Fed. Now that we've had a liquidity shock, maybe
you need to move over there into the pan-asset class protection with options. What is on the horizon for you guys as far
as at Artemis Capital of what are you looking into? What asset classes? What kind of trades are you looking at as
we're sitting here in 2020? CHRIS COLE: Yeah, that's a great question. Artemis, the very beginning of Artemis came
down where I started trading VIX futures and VIX options. That was the basis and the founding of the
firm. But over the last couple of years, we have
really expanded out across multi-asset class and are looking at diversified vol and looking
at finding ways to signal volatility and find flags for volatility using global cross-asset
data. So we're scanning the globe, looking at different
features that might indicate the probability of volatility breakouts in different asset
classes, and then valuing the volatility in those asset classes using the traditional
volatility arbitrage techniques that are the crux and basis behind many managers, but actually
augmenting those with additional data that goes far beyond. So I see us going from what really was a VIX
specialist into a cross-asset momentum macro long vol shop, and doing it in a way that
is very capital-efficient for our investors. So an investor can use an SMA and actually,
in a very capital-efficient way, layer our exposure on top using listed options. That gives them the ability to have capital
efficiency and convexity at the same time with positive carry. JASON BUCK: Well, capital efficiency is my
favorite subject, so before we go on another rant, I guess we'll have to revisit this in
the near term. But Chris, just want to thank you again for
coming on Ahead of the Curve. I always really enjoy talking to you, and
it was a pleasure. CHRIS COLE: It's been a pleasure to be back
on Real Vision, as always. NICK CORREA: Thank you for watching this interview. This is just a taste of what we do at Real
Vision. To learn more about the complex world of finance,
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