¶ Intro / Opening
Bloomberg Audio Studios, Podcasts, Radio News.
Hello and welcome to another episode of The Odd Lots Podcast. I'm Tracy Alloway.
And I'm Joe Wisenthal.
Joe, I've been reflecting on this year. It's been a busy year.
Yeah, go on.
In fact, we're recording this. We're on yet another trip. We're in Huntington Beach for this year's future Proof conference, which is always a fun time an event I always enjoy, but we happen on the road a lot. Yeah, and I feel like the entire year is starting to feel very surreal for me. It feels just very different to prior years for many different reasons. But I was also thinking one of those reasons is because it seems harder
and harder to do portfolio construction nowadays. And I know that sounds really weird, given that markets are still at record highs and everything seems to be going reasonably well, even though we had that terrible jobs number. But if I think back to the big leg down that we saw this year, it seemed really scary because basically everything sold off at once.
Right.
You know what I really like. I like how you started this with this philosophical thing like we're out on the road and.
All this, and then I was like, how do I protect my.
Portfolio and reflecting and then the surreality of the times and now we bring it around to portfolio construction. But no, that's true, and there's two a couple of things going on. So one is the sort of like cross asset class moves. The other thing is and is very related to that. I mean it's the flip side of this, which is
correlation breakdown. And then there was still this other element that I think there is a play where at least, like I would say, there's two more things, which is that one within us assets, the winners are still the winners, right,
¶ Challenges of Portfolio Construction
especially a lot of these big tech names, so you haven't gotten the sort of secular and people.
Have been talking about overvaluations for forever.
And then the fact that you know you're not getting paid much to take on volatility risk or volatility measures are still very low. So there's a lot of difficult, unintuitive things going on.
And I don't even know what a tail risk hedge actually looks like at this point, because I would have thought like, well, obviously maybe you diversify into long duration bonds or something like that. But then in April when we had the big sell off long duration and not do that well either. So it kind of has me scratching my head about if you were worried about stuff both literally and figuratively perhaps blowing up at this point in time, what would you be doing, Like, what does
a tail risk hedge actually look like? Now?
You like buke gold that's already at record high. Yeah, yeah, it's confusing.
Yes, Okay. So on that note, I'm very happy to say we actually have the perfect guest to talk about tail risk insurance and just tail risks in general, someone who's been working on Wall Street for a really really long time and has a very storied career, lots of stories involving big names that you and I would definitely recognize. We're going to be speaking with. Veneer Bensali is, of course the founder of a long tail Alpha and again has worked at many many firms previously. We'll get into
all of that. Veneer, thank you so much for coming on.
All thoughts, thank you for having me.
So I should just go ahead and ask you to give a sort of five minutes summary of your career because it is kind of amazing. But the important thing is you didn't start out as a trader, You started out as a mathematician.
Yep. I started out as a theoretical physicist. I was finishing my PhD at Harvard, and this is nineteen ninety one. The recession had just hit. I didn't know what a recession was. I wanted to be a professor, but my job evaporated because I was going to go work at the super colliders. The Superconducting SuperCollider got canceled by Congress. Nineteen nineties. I had a post dot lineup in France and one I think it was in Texas and Austin, and I got a call out of Wall Street, out
of Goldman. They were looking for quants like me to work on options trading or options model building rather, I should say. So I went and interviewed, mostly because of the free trip in New York. I went there, got interviewed by an elderly gentleman who was taking notes saying, doesn't know any finance. For disclosure, I knew no finance. I had no interest in it. It was Fisher Black
¶ From Physics to Wall Street Trading
who was in Really Oh wow, I decided Black Scholes fame. Little did I know when I turned that job down from Goldman. I took another job at City Bank, trading derivatives, because in my mind was a sabbatical. I was going to do this for about six months to a year and then go back to physics. Well, little did I know that my whole life would become basically, very deeply connected with ation trading. So that's what I've been doing. And we'll talk a lot more about dail risk getting in a second.
Wait, I got to ask why did you decide to turn down Goldman? And given the Fisher Black himself was doing the interview, and you chose to go to City at that.
Time, Well, one was a research job at Goldman, and the job at City was actually trading drivens. And since trading was so far away from what I knew, and this was really supposed to be a vacation for me for about a year, like found like a good thing to do, for a fun thing to do.
Rather, did you ever feel like always so curious about stories from the early days of physicists going to Wall Street. Was there a period where you felt like it was a bit beneath I mean, you call it kind of a vacation job. Did it feel intellectually beneath you for a while, and then did it eventually become sort of genuinely intellectually satisfying in the way that maybe you had anticipated an academic career to become so interesting.
Though the modeling certainly at those days seemed a little too naive. So for instance, I'll give you an example very first trade that we did, large trade. I was a city bank at the time, and it was an interest rate gap on yen. Interest rates linked to the dollar yen, so it was basically a two factor option called hybrid option. And it turned out that at a physicist,
I was very easy. It was very easy for me, and I was very able to write a Monte Carlo to write this knockout gap, but for the finance people it was kind of tough. So the math was very easy. But I also learned that trading is not just math. Trading is a lot of behavioral stuff and so on, and that I just obviously had to learn. And I have some great stories of stuff that I did really badly back in nineteen ninety ninety four.
Tell us the story I did badly well, So nineteen ninety.
Four, if you remember, in a nineteen ninety three the fed ad eased and rates were quite low, and everybody was long the front end of the yeld curve and buying year dollar features contracts.
Wait, didn't it talent around here go bankrupt?
Yes, yes, yes, we'll get to that exactly. So February of nineteen ninety four, the Fed raised race by twenty five and then very surprisingly April eighteenth of that year, they did an inter meeting increase. And at that time bond market has always sold off quite a bit, and I just did what human beings you do, which is that on mean reversion. So I tried to buy the bond market, and tried to buy the bond market again and again and again until I realized that there's something
called trend following and exit. And I think the bond market sold off a good fifteen twenty points and finally
¶ Early Days: Quant Models and Market Lessons
I recouped all that. It was a brutal few months of literally getting my face ripped off.
So one other thing, I'm curious the sort of early days of quants, But what exactly was the pitch to scientists, whether they're you know, mathematicians or physics guys. When these big banks or big trading firms are trying to recruit back then, because you know, like quant was in the I know we had nineteen eighty seven by them, but it was still relatively in the early days. So I'm really curious, like what they told you about what you would be doing.
So from the modeling side is pretty straightforward, right, the blactual equation and stochastic calculus. Stochastic finance is basically what's called the eight equation or the diffusion equation in physics, and that's something that every physicist learns when they're in early graduate school. It's like solving a partial differential equation. So the math is exactly identical the math of finance.
And maybe that's the problem actually in retrospect now that having done this for thirty years and thirty plus years and survived, maybe that's the problem because the beauty can
somehow hide the frictions underneath it. From the trading side, when I first started crating, I think it was very simply being mathematically sharp and quick and being able to answer quizzes just made interviewers feel like they were getting smart people on the desk that they could train right the blank canvas, so speak.
So once people on these desks got armed with PhD physicists and understanding of like Brownian motion and stuff like that. Did that change how the actual markets traded from your perspective, like sort of pre and posts that, did assets conform
¶ Feedback Loops: Models, Markets, and Liquidity
more to as models anticipated because of the model effect on them? Like what was your observation of actual existing market behavior pre and post the physics revolution?
Oh? Absolutely, And this is a very important question because if you fast forward to twenty eighteen, the Big XIV debacle and the bottomagedin and a lot of things that happen now and actually fundamentally, what we do now, what I do now is related to this fact that there's a very night feedback loop between models and markets and models. So give you a very simple example, Right, you have an option that you've sold to somebody, and you have to manage the risk. Of course, when you sell the option,
you're getting a multimary premium. That's why you sell it. You're getting an insurance premium, so to speak. But then to manage the position, you have to delta hedge. But delta hedging means that you have to buy and sell the underlying asset and some higher order greeks as well, Gamma vega data that you've all read about. But delta hedging requires people to be able to buy and sell
so that they are the seller. The market maker is locally flat of course, so the market maker, that's what you do, and that's how you earn your keep, earn your visa, so to speak. The problem is that there's an idealization in mathematics or mathematical finance that you can do this at an unlimited size, and size doesn't matter, but it matters. Liquidity is actually not there. The basic assumption of black shoals is that you can continuously trade
with almost zero transactions costs. Well, that's just not true in real markets. As a matter of fact, in the last maybe two years even you've seen liquidity in the EMNI futures contracts, which are possibly the I would take the zero to order hedging instrument for the equity markets go down relative to the high levels, frequently go down to maybe one twentieth or one fiftieth office level. So people just can't get out. So what happens is that
people sell options, then they start delta hedging. Delta hatging results in the options market reacting to the delta, then results in new hedges coming in. So this feedback loop gets tighter and tighter and tighter until something breaks. And when something breaks and the box shut down, which is today's environment, you actually have no liquidity and that's when you get these crashes like Liberation Day on April second.
Vall Mageddon was definitely one of the more weirder events in markets because everyone could see what was going to happen when the VIX curve actually inverted, Like you could see that all these products were going to go absolutely belly up and no one, no one seemed to react to it until it was like much, much too late. That reminds me so one of the reasons that we are interviewing you here in Huntington Beach is because you
used to work at Pimco with Bill Gross. In the last time we spoke to Bill Gross, I think was actually at Huntington Beach two years ago, and one of the things we spoke to him about was volatility selling, and Bill kind of became the poster child for a little bit of volatility selling, at least in the bond market in the sort of like Guesse. It would have been twenty fifteen around then, mid sort of twenty tens area.
I'm really curious who's selling fall now and how has it changed over the course of your career.
Yeah, so a great little site point there. So Bill and I've been great friends. As a matter of fact, I went to pimcoll because I heard Bill speak at a talk when he was advertising in book back in two thousand and Bill's an amazing genius, great investor, and
one of the best compliments I got. Recently, I was communicating with him and he said, I have your paper at the top of my reading list and I said, wish paper, Bill, And he said, this paper that I wrote with Larry Harris on the volatility selling ecosystem that basically you grew up before twenty eighteen. So yes, So
¶ The Evolution of Volatility Selling
Bill actually in a sense invented the sole idea of selling volatility in fixed income, especially through buying mortgages or explicit selling of straddles and strangles and what we realized. And again I was head of analytics at pimcos, so over the last or over fifteen years or so I was there, I got to see and help him manage
the quantitative risks of those portfolios. We ended up educating a lot of our clients at that time about volatility selling, harvesting, wall premiums and so on, which did end up adding quite a bit of as Bill calls its structural alpha to the Pimco portfolios and twenty thirty forty basis points every year. What happened is that everybody got educated and it became part of the academic lore and everybody realized it.
There was a lot of crowding, and it's a little bit like selling insurance, right, so when you find that one insurance policy selling works, then you say, why don't become multi line insurance provider, so you start telling insurance
policy and everything. And so what has happened now over my career it have gone from institutional selling, where first of it was hedge funds, then it was large sophisticated mutual funds like Pinco, who could actually still fit it inside of the mutual fund complex because selling naked options
is not really allowed unless you cash back it. And then over time it has now gone to all the do it yourselfers, so all the wealth offices and family offices and large endowments, and this whole area which is now called alternative risk premiums, is based on this idea that you can go and sell volatility in various forums explicit forms or implicit forms to generate income. So everybody's doing it.
Yeah, that's the answer. Everyone. Even more people are doing it. So when we see alternative risk premia, it's basically a vall selling overlay. Is that it?
Yeah, I mean you can make it more or less sophisticated. I mean it's a little bit naive to say it's only wall selling, but wall selling is a very important component of it. And there were some great papers by people from AKR who took every asset class, so equities, bonds, credit, foreign exchange, and then also sliced stray down in various types of strategy, style and quality and momentum and so on.
They made like a sixteen by sixteen matrix, and then they recreated this what I'd consider to be more sophisticated sounding ball selling, But it really is ball selling. And what people do, just to be very clear, is it's not just ball selling. They also layer on other things like trend following on top of it to create a counterbalance to the ball selling, because trend following is naturally a ball liking or ball long ball type of strategy.
Going back to I hadn't realized that about the declining or the collapsing liquid within the many futures. But is there some sort of I don't know, law of thermodynamics or something. I don't know if that's the term or that's the analogy in market where such that when some instrument becomes the hedging instrument of choice, the more popular that gets, the less capacity there is for liquidity in that instrument. Is that sort of what's going on?
Yeah, So in this case, the even futures contract are basically a speculation vehicle. They're a cash equitization vehicle, so they serve a lot of different purposes. But I think the biggest thing that's going on here is that, starting maybe about ten years ago and somewhat surreptitiously, the market morphed from human market makers. So when I started trading, it was human market makers. I still remember when I was, you know, in the nineteen nineties, Tommy Baldwin on the
pit of the CBOT floor chicagoboard to trade floor. You know, you would do a trade and Tommy Baldwin, and he was legendary obviously, he would lift his hand up and the market would stop and turn and go the other way humans could do that.
Yeah, but what.
Happened surrepticiously or very strangely over the last fifteen or ten years maybe, is that the human beings have sort of left this market making area and ninety plus percent is being made by bots. And what bots know very well self survival is extremely important to them is as soon as they see a liquidity tidal wave coming so nami coming at them, they just get out of the way.
Liquidity just becomes very episodic and muhammadalarians to call it latent ill liquidity, which is just the fixture of the markets today. It looks liquid and when you don't need it, it's there, but if you need it, it's not there.
So how do you actually deal with that as a trader?
Yeah, so as a trainer. So this comes back to the role of options fundamentally, right, So what do options in the world of quantitative finance. You can take an option, you can replicate it by doing delta hedging and so on, basically looking at the partial derivatives of an option pricing equation, or you can say I'll just buy the option. An option is a contractual agreement between you and the option provider.
So if there's ill liquidity, and if you believe this is a fixture of the environment that we're going to live in, then there is no other way than to actually have a contractual agreement with somebody where you're delegating the illiquidity is to them, so you are buying it when the premium is cheaper. But trying to delta heget yourself is like literally trying to put an elephant to the eye of a needle. It's just people just cannot
work out. I mean, I just can't. I just can't imagine the market collectively trying to get to that needle. These days, there is just nothing there.
Let's talk about April for a second, and maybe that period like between April second and April ninth, because there was a market event, for sure, and it was also a real economic event with many things going on that weren't just lines on a chart, et cetera. And we know it sort of happened there with the tariffs and then the reversal of some of the tariffs and what so forth. Since then, we've seen some of these correlation breakdowns that some of our previous guests have talked about.
From your perspect active, you know, whether it's April second and three, April ninth, or April second through Now, what happened then such that maybe some maybe is it a new regime? What changed in that month?
Yeah, So I think one of the thing that is going on is we are slowly undergoing a regime shift.
¶ The Rise of Bots and Latent Illiquidity
And I'd like to always paint this picture, and I'll come to your question right after I give you this big macro picture. From the sixties to the eighties. Sixties to the mid eighties, you had this period of rising inflation, rising volatility, non credible central banks, and stuff was kind of breaking and people were behind the curve. Then you had the vulker increase of interest rates starting in the nineteen eighties and until the maybe late twenties twenty twenty
call it twenty twenty one, COVID was an accelerant. You got negative yels and falling volatility, credible central banks and so on. And I think we've actually turned the corner again. So starting in twenty twenty twenty one, I think we are probably going to look more like the sixties to eighty than nineteen eighty seven to twenty twenty. Now, having
put that backdrop, you know, in front of US. I think the issue really comes back to, yes, there is a regime shift, both in terms of people's response function and how quickly things happen. So one data point that I can realize since I started trading is in the past, when crises would happen, even including the GFC, which I lived through and did fairly well, it used to take months, maybe weeks for things to correct, and you had time
to plan and time to execute. Then Vollmageddon maybe took a few days twenty twenty COVID it maybe happened in a few days to few hours, and then starting this year, it feels like things are actually happening on an hourly
to maybe minute basis. For instance, in April, when the big crash happened and the correction happened, all the action, including some of our trading, happened in the pre pre market, so the markets had not even opened up, and if you needed to do something, you had to do it during the night session because that's where all the action was.
So I think that's one fixture of what's going on right now, is that stuff is happening much faster, and it does feel like the balance that's tilted in the favor of more automated trading rather than human driven trading.
Let me ask a philosophical question about tail risk protection, which is, whenever there's a blow up, we suddenly get all these stories about tail risk funds that have done phenomenally well out of last month's chaos or whatever it might be, and then no one talks about them for like the next three years.
You don't know how they're bleeding dry during those other months, right.
That's right, until we got another blow up, and then the cycle repeats itself in your mind, What is the purpose of tail risk protection?
Yeah, this is very simple, and I've been trying to do this. This is actually one of my missions since I started our firm, is not just managing the risk, but also trying to educate people and what the purposes. This purpose is very similar to insurance, and not everybody needs it. If you don't live in California earthquake prone zone or in Florida hurricane and prones on, you don't
¶ Rapid Market Shifts and Regime Change
need the insurance. But if you're going to run a large equity heavy portfolio, and by the way equities have demonstrated over the last hundred years and maybe going forward, are the one way to create long term wealth because people go to work. The first thing I learned when I was a city bank from my boss told me was just look at log GDP versus log SMP. The charts are aligned. Basically, if people work, the market goes up. So what that means is that you need to be
invested in the stock market. And the more you invest in the stock market, the more likely it is that you're going to make higher compounded returns over time. But also you will suffer big drawdowns. And one of the biggest problems with people's behavioral function is that when the markets collapse, they forget their plans and they liquidate. So what tail risk fundamentally does. It's not a fund that you should look at isolation and say is this fund
a good performer or not? Just like you would not go back home and say, well, what was the total return on my home insurance policy? Right? It's just negative percent? Right every single year? So would you quit buying insurance? You won't, because home insurance or car insurance is not
an investment. It is the cost of doing business. So that's the context in which one should think about dail risk catching is it allows you to first protect yourself from yourself in that events, and then secondly, when the markets are down, the value of those hedges going up allows you to buy assets on the cheap, which results in compounded growth.
Why hasn't Wall Street created an instrument where you could sell away your liquidity to protecting from yourself automatically. I'm going to invest in this fund and I cannot sell until the year twenty sixty.
Isn't that called lockups?
But to those funds that actually exist, could I buy that? And then there's two things that intuitively seem that A. You protect yourself from yourself. B You diversify automatically by the fact that you're across time. And then see presumably that would be more stable for securities, lending and collect the little instrument? Has Wall Street created a fund that one can't get out of?
I think, like Chrissie just mentioned, hedge funds like to have lock ups, and.
I should just be able to buy an e TF that I can't sell.
Yeah, I think that if you can get over the regulators. I think that we are living in a world where mark to market daily and av et cetera. For ETFs and port transparency is required but I do think. I mean, one one very sophisticated institutional investor who was a client of ours actually said I would bay you more if
¶ Tail Risk Protection as Essential Insurance
you sold me a product that actually had a longer lock.
Because this is a question I have about portfolios and diversification in general, and it goes back to the point that you made about how stocks have done very well and the expectation is that as long as the economy growers, stocks will continue to do well for a while. Sixty forty was a craze, right, and this is a good portfolio over your treasury is and your stocks balance out.
But why should like, what is the case for diversification, Let's say, sitting aside the behavioral fact that people sell it the lows, what is the case for diversification when there is this asset class that does so well over time?
Yeah, so this is great. Though, if you could guarantee that this asset class would keep growing always, then you woul one hundred percent be on stuff. Now, what bonds traditionally used to do was they provided you with income that when the stock market wasn't doing well, at least you wouldn't go completely broke because you would have some yield.
But I think it got taken to an extreme right, I mean to the greatest example, and I wrote a whole book on this topic is is the European Central Bank followed the Japanese Central Bank and then they start buying it negative yields. Yeah, and they convinced all the indexers to keep buying bonds with them, right, I mean think about this. You were buying bonds, meaning you were lending somebody money and you were paying them interest. And
at that point, diversification is an insult. I mean, you don't want to buy a negatively yielding bond along with stocks because it does nothing for you. And we're living the consequences of it today because the bond market over the last five or seven or ten years even has had absolutely dismal zero turns.
Joe, do you think people who want positive yielding bonds are entitled still?
That was your tradition. Yeah, I still think that. I still don't. Anyone is entitled to yield. No, I don't. If you want to take the risk, go get it. But the sort of moral demands that the government must provide you yield for what for not spending and doing anything? Give me a break.
Joe spent a good year making fun of yielding.
That's great, go out collect your yield. I'm happy for you, But don't pretend that it's some sort of moral insult that the government isn't providing you risk for yield. That is my only that is my only stamp.
That's I would argue, the US government's most important role. Anyway, Let's go back for a second. So it's not just the insurance idea you touched on this, but it's also the idea that, like, you can get a massive windfall when there's a market crash, and then you can use that money to actually go on a buying spree at a time when markets are cheap and everyone else is you know, short on cash and they can't do the same.
How do you actually deploy that into practice, and how do you scale, for instance, and expected windfall against that type of assets that you could potentially buy.
Yeah, I think this is where the principles thinking becomes really important. So you have to look at every portfolio is different, right. So one of the other mistakes I think people make is they think you can just pick up a finance one on one book and say every portfolio is identical. It's all risk neutral, and everybody is
exactly the same. It's just not the case. Public fund that has a forty percent or fifty percent funded ratio is very different than a ninety percent or a bank that's one hundred and twenty percent fully funded, right, so everybody has different needs. The first thing that you do is you look at the underlying portfolio's posture. How much loss can you take, look at the systemic risk shocks
that they can actually withstand. So you run a shock, you run a full distribution analysis and figure out what is the outcome under which they will be under so much distress or so much duress that they might end up having to liquidate assets. And there are actually quite a few like that right now, where if the stock market went down twenty percent and privates went down about twenty percent, in order to raise liquidity for distribution, they would have to actually sell seed corn, right. So it's
really really bad. So that's an existential risk that you want to quantify. So the first thing that you do is you figure out what that risk is a full distribution of outcomes, and then you look at the instrument set that's out there in the marketplace. Starting from the most reliable and surprisingly enough, like Joe mentioned already, the cheapest one, which is equity option volatility. You can buy those put options, but people who are not willing to
¶ Diversification, Yields, and Custom Hedges
be a lot of continuous premium, you can do more sophisticated tricks where you can buy indirect heages, for instance, credit to false opts. Today, the CDX index, if you don't see the charts, it's actually tighter than it was
pre the GFC. It's the tightest has ever been because people are buying it for cosmetic yield reasons, so there are a lot of derivative instrumental Cosmetic yield simply means that the total yield, if you look at the yield of a corporate bond today, it is basically treasury yield
plus some spreads. So the treasure yields are at quite four and a half four percent, but the spreads are actually very tight, only fifty basis points to see the X, So you're getting a five percent six percent yield, which in the context of where we were three years ago, it looks.
Like it's cosmetic.
It looks good, it looks good, but actually you are taking that risk. Okay, keep going that it's a cosmetic yield. You're decorated yield, So to me, the yield is not justified by the risks that I underlied. So there's various instruments that you can use and create a portfolio of these types of hedges.
Is tailor risk hedging like insurance from as from a structure of how people buy it? Is it like insurance where people sort of reload every year in a sort of okay start of the new year. What is the tail risk I want to put on et cetera, or something that renews and they have to keep paying a fee or is it just sort of something that can be set it and forget it a permanent allocation. That's sort of the tail risk heage. Like talk to us about the business of selling a tail risk cage.
Yeah, definitely. So it goes up to the highest level where this becomes part of where you guys started portfolio construction. It's an acid allocation decision. It's not a trade. So the context has to be that if the agents are aligned up meaning boards and trustees and so on, they think of this decision as protecting the portfolio or making a more robust portfolio. As part of the DNA and the tail risk becomes part of the how you re balance your portfolio over the long term. Okay, so that's
how you set up the strategic portfolio. But then to your point, every year, yes, you have to renew this policy. You re have to have to recommit premiums. Now you can prefund for the next five years if you wanted to. But because options decay, in order to have this reliable heade, you sort of have to buy new options.
What would be the worst kind of tail risk hedging in your view? Is it, you know, too expensive or does it not actually work when there is a big market crash?
Like?
What is the ultimate sin of a tail risk strategy?
Ultimate sin absolutely is the one where promises to work but doesn't work. Right, So a lot of people try to reduce your costs by creating synthetic strategies.
Right.
I already mentioned futures markets aren't very deep when you need them. But there's a lot of strategies which actually use a future's replication strategy like the nineteen eighty seven crash also purported to do. And those strategies typically don't work.
And so there's many that promise and they look like they are cheaper and they don't cost any bleed, but they also do not deliver, which, again going back to April second, the only thing that worked during that April second to April eighth period was reliable hedging using index options. Not that duration didn't work. Tr and following didn't work a lot of other ult eupremium strategies didn't work. So
that is the cardinal's sin. You just do not have the luxury to go to the constituency of clients whoever's bought it and said, you know, we're to be too smart and oops, it didn't work.
Yeah, as you mentioned that, to even talk about buying a tail risk, heade, you have to sort of understand is what is the existential risk for the fund? And different funds have different flavors of existential risk depending on how funded they are, And so obviously an entity that's one hundred and twenty percent funded is going to have very different risk scenarios than one that's forty percent funded.
But you said something interesting, which is that and I've been thinking about this a lot in a different context, which is how levered is the financial system or the real economy to an ongoing rise in the stock market. How important is that? And at what point does even a sideways stock market, let alone to decline, become risky for something that could break. And you know, we used to think credit is the thing that breaks, but I
wonder if it's in the stock area thing. Now where you really get the problem with the equity values don't go up? Tell us more about what you said about what happens to various types of economically important players. If the stock market one day stops going up for sustained period of time.
I think you have a big problem.
Right.
So not only is the stock the whole system for one ks and public pensions, they're all levered up to the stock market because that's the only way you can get to your seven and a half or eight percent actual yield. So if the stock market doesn't keep going up and keep delivering those kind of returns, it's very hard to get to that point. Maybe if inflation rises, at least again cosmetically, maybe the long bond gets up to seven percent or eight percent and everybody can just
lock it in and immunize and you're there. But in real terms, you're not going to have the income that you need thirty years from now to retire.
I'm fine.
I have a Zurperer mortgage. Yeah, so I have a mortgage that's locked in from that one keep week period of time.
Yeah, exactly. So the system is very levered. And then corporate credit clearly is very very concentrated. We all read about pains and so on, but corporate credit, based on the Mertin model again that connects equities to corporate credit spreads,
is also levered to the stock market. So if the stock market suddenly had a big sell off, corporate credits wide Now, which is the real problem, right, because if corporate credit widens out and the cost of borrowing goes up for all the corporations, maybe not the Fang stocks, but the four hundred and ninety three other stocks, then
how does the system produce? Because our whole system is based on borrowing and I don't think very many companies in the US can function if your cost of operating your business was ten percent a year.
Okay, Well, on that note, we would be remiss to have a tail risk person here and not ask what's the big risk that you see on the horizon in let's just say the short to medium term.
So I think for me, The biggest risk right now is what people have been talking about is, you know, the so called and I call it so called the FED independent paradigm shift, because I don't believe the FED was ever really fully independent. But now it's coming to the foe that the fiscal and monetary authority they're actually one.
¶ Pitfalls of Tail Risk Strategies
So what happens in the aftermath if the FED actually becomes part of the central government the fiscal authorities. I think at that point all bets are off because that's the one anchor that everybody, whether realistically or not, has held onto. But if interest rates can change just based on the need to finance something, that totally upside down the financial system. So to me, that's the single biggest risk right now.
So would that materialize into an inflationary risk for instance, and then would you be focused on what you can do to offset that?
Yeah, inflationary risk and I think one of the best option traits. Again this is not a direct option. So going back to what you were asking before, you don't always just have to pay premium. The yield curve steepener where you buy the short end of the yield curve and you sell the long end of the yield curve Today you can do it through using swaps and all
that for essentially zero net carry. So here's an option very similar to shorting the negatively liding bond market in Europe a few years ago, where if you put a youth curve steepener on either in a hyper inflationary maybe not hyper but a lot high inflationary scenario, or in an aggressive FED cut, the yield curve steepens. So yes, so that environment is the environment in which the curve
steeper could work. And yes, my zero to order prior forecast would be that if we lose explicit independence of
¶ Systemic Risk of Stagnant Equities
the FED, the yield curve actually steepens a lot more.
Something I'm interested in. So, you know, you're talking about the recent eras and the sixties and eighties and things may have gotten a little on glued, and then the Vulgar era and then the post COVID era, and now this question about whether what's left of FED independence is at risk. You know, you're a physicist, and are a
lot of people in your space are mathematicians. Is there a limit to how much you can sort of math it out, so to speak, Because a lot of these questions are external to mathematics, and so how do you think about the limits of quantitative analysis when we're dealing with things like will the political system allow the Federal Reserve to remain independent?
Yeah, I think a lot of it is actually non quantitative. And what I've learned, even though I come from a quantitative background, is not the math itself, but it's the sequence of logical arguments that you can make to get to a conclusion. Right. So, for instance, we knew even before fancy mathematics was discovered, you know, Lagrongins and so on, that gravity exists. Gravity's existence has been known before maybe
math was invented, but gravity has been there. And so I think there's some central laws of finance which will still continue to exist regardless of the mathematical modeling of them.
And you know, the Bill Grows When I used to work with him, he used to say, some things we can take for granted I'm paraphrasing it, but the steepness of the youth curb, the fact that the youth curve needs to be upward sloped for the financial system to function, because people lend money in order to get something in return. Those are not mathematical devices. Those are really just the way the capitalist system works. So I think you can
take the quantitative modeling to its own limit. But there are certain things that have happened in our system where we are a point now where gravity so to speak of the financial markets are going to have to take over.
But presumably also if you can't predict the politics, because it's very difficult, especially nowadays, if you can't predict the politics, then maybe right sizing your positions becomes more important, and so the maths actually becomes one way of dealing with the very uncertainty, non mathematical element of what's going on.
Yeah, exactly. And I think to take that point one step further, so correlation has been the greatest gift since the nineteen mid eighties to twenty twenty. Right, so you got stocks and bonds to say sixty forty. Stocks went up, bonds went up, and they were diversifying, which is what a beautiful place to be in, right, sounds nice? Ye, So that was a freebe And again this goes back to financial gravity, so to speak, that state of affairs
that free lunch should not exist. So I think we might be entering a phase where stocks and bonds maybe are actually not diversifying, and you have to look at other things gold, of course, as you mentioned, maybe bitcoin, who knows. But I think the fact that reliable insurance or portfolio protection is so available today using the options market would be the place where I would look.
When you look at the long end of the yield curve today in the US, is there an element in which these concerns about the loss of FED independence are being priced in right now? If suddenly you could snap your finger and know for a fact that the federalill operate it as it has been for the last twenty years for the next twenty years, would there be a change?
¶ Loss of Fed Independence: The Major Risk
Is there some margin that's concerned there?
You know what?
I don't know if the FED is going to be a committed inflation fighter as well as it has been in the past. Therefore I'm demanding extra yield today.
No, not yet, I don't think so. Maybe a slight amount of premium has gone up. But one of the most striking features of the system is that if you look at the treasury yields, look at the thirty year bond to day is four seventy, but you look at the thirty year interest rate swap, it's straighting at believe it or not, three eighty nine, right, so it's almost
eighty five basis points under the US Treasury. Now you ask why would somebody take the swap market at a lower yield, And I've been eating swaps its inception back in the nineteen nineties. Swap spreads are negative eighty five and that goes back to the receiving of interest rate swaps to hedge liabilities by a lot of large institutions. So they have certainly not priced in inflationary effects into the swap market. But at some point this has to also equilibrate, So in my view, it has not been
priced in. Maybe it's too early to price in, because maybe the FED does not lose its independence and you know, rises its phoenix from the ashes. But I'm a little bit pessimistic about it.
Just going back to your storied career on Wall Street for a second, how good were you at playing Liar's Poker?
I was actually pretty good, I think. I mean I learned it after I joined Salomon Brothers as a good group of people, and I think the first year maybe I lost a bit, but I think in the third year that I was there, I won it. And I was actually, I think the one who took the biggest part. And I also my boss gave.
Me his.
Eighteen foot fishing boat. He was buying a new one as part of the settlement in.
Lieu of cash. He was like, here to take my.
Cash plus the boat again.
Wow, So yeah, it's a really big pot.
That was a big pot. Yeah, at that point you used to spend after the trading day was over. Every day we would print out randomized liars poker sheets, usually
¶ Limits of Quants and Financial Gravity
about twenty four or thirty of them, and we'd play about thirty thirty rounds every day.
Wait, liar's poker sheets. I thought you played with actual cash.
Yeah, so actual cash. Yet you play with dollar bills. Yeah, but you know, if you're playing twenty four rounds, they're not enough.
Dollar bills drawing around. I never thought of that.
Yeah, so you randomize based on how the dollar bill numbers are generated.
Is there going to be a future in finance for a young physics student or a math nerd in high school today? You know people worry about this with AI and so forth, But a young person who's quantitatively minded, do you feel confident that there will be a role for them? And finance in the future.
Absolutely. I think finance has existed from the very very beginning because it's based on the two fundamental emotions, right, greer and fear. Right, So as long as there's greed and fear and they're smart people around. And again going back to math and physics, it's not so much that the DOUN kit itself is teaching you anything special. It's just that teaches you think in a discipline logical fashion.
And I think with tools like what we're seeing with AI and so on, encoding becoming completely democratized, I think the ability to ask important questions rigorously becomes even more important. I think it's going to be even better than it's been.
Vanir, that was absolutely fantastic. Thank you so much for spending time with us at Huntington Beach at the future Proof conference and that was great.
Yeah, thank you so much. That was fantastic.
Thanks for having me, Joe.
That was really fun. We should have a near back and just do like stories from Wall Street in the nineteen nineties episode, we just do that.
I love the stories. We could do a lot more on the story. And I'm also interested in basically, you know, the philosophy of portfolio construction. I mean, obviously there's the math of portfolio construction. But I do have a certain dissatisfaction with many conversations about portfolio construction, including this, what
sense well diverse? If I have stocks have almost always gone up his every insurance I mean, I guess another question that I could have asked is, has every insurance contract on the stock market essentially so far been a waste in human history? Because the stock market is at all time high, I have questions about that.
But the counterpoint to that is, and I've come to realize this as I get older in my life and in my portfolio, is there is something nice about like waking up during a cell off and going like, oh shoot, my four oh one K has been absolutely decimated today. But if I look at, you know, some other position, some other tail risk hedge that I have, like that's actually up a little bit, and it's offset some of
¶ Fed Independence and Yield Curve Pricing
the pain. And if I actually had to cash out of my portfolio on that day because of whatever I had to make a mortgage payment or whatever, then I would have some extra cash to spare, and you could get an extra return by having that extra cash available to you to then go into the market and buy stuff on the cheap.
I think that we really should have an odd lot's ETF that just advertises its illiquidity, that you can't sell this if you need cash now, this is not the instrument for you. If you are putting your money in this, don't expect to see it again for thirty years. But the plus side is it will keep you from making baddi rational decisions on a day when everything is read.
I mean there's a value in that. There's a value in that, and there's also a value in being able to sleep at night a little easier because you have different positions. But anyway, shall we leave it there.
Let's leave it there, all right.
This has been another episode of the Authoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway and.
I'm Jill wisent Though. You can follow me at the Stalwart. Follow our guest Vanier bon Sally He's at long Tail Alpha. Follow our producers Kerman Rodriguez at Kerman armand Dashel Bennett at Dashbot and kel Brooks at Keil Brooks. For more odd Lots content to go to bloomber dot com, slash od Lots. We have a daily newsletter and all of our episodes. You can chat about these topics twenty four to seven in our discord discord dot gg slash od Lots.
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