The Market's Big Bet on Low Volatility

season right about now. It always warms my heart and that's when you start getting analyst notes from sell side shops talking about what the forecasts are for all asset classes, uh, stocks and bonds and currencies. I truly think it's really like the most heartwarming time of year for right, Okay, Um,

don't you absolutely the most wonderful time of the year. Indeed. Uh, But there's there's a little bit of a difference this year, I feel, and probably it's because December is coming off the back of November and October, which, as we've discussed on the All Thoughts Podcast before, have been pretty painful months for a lot of investors. Yeah, that's true, and of course people always update their forecasts basically to some extent,

extrapolating on what happened in the recent past. So I think the fact that we got this sort of October November intense about of volatility has caused people to say, oh, suddenly, we see all these new risks on the horizon, Whereas if you had asked them at the end of September, they would have been much more sanguine about what the future had in store. Yeah, everyone's sort of rushing to

retool their risk forecast for next year. But there's one person who has been consistent in forecasting a very similar set of risks for many years now, and that person is going to be our guest on the show today. That's great. I'm looking forward to this because a it'll be nice to get an alternative viewpoint from the always sort of, you know, somewhat rosy outlook of the mainstream

investing class. But it's also interesting to talk to people who are contrarians, because while it's true that you know, it can pay to have a different view, in the meantime when markets aren't blowing up, it can be a costly view. So how you reconcile that is always very interesting. Yeah, absolutely, And I have to say I've been a fan of this particular person's work for a very, very long time. So I'm quite happy that we're going to have him on the show and that we'll get to put these

questions to him. So, without further ado, our guest for this episode is Chris Cole over Artemis Capital Management. Chris is the founder and c IO of Artemis Capital and he's been writing about the markets and specifically volatility for many, many years now. Chris, welcome to the show. Thank you for a pleasure to be here. So Chris, maybe just to get started, you can give us a little bit about your background and how you got to Artemis and what exactly it does, because it's a little bit unusual,

I feel sure. Well, I think the mission of Artemis is to really create opportunity out of chaos. Normally, when there's volatility in the marketplace, that's a bad thing, big equity draw downs, it impacts people's portfolio in a negative way. Our job is to turn that volatility into something that's positive. And the history of the firm actually comes out of

an old school hedge fund story. I used to I was trading my own proprietary capital throughout the period of two thousand seven to two thousand ten, and really turned two thousand eight into something that was quite profitable and try to develop strategies that paid off in the event that there was a tremendous amount of volatility, but it didn't bleed uncontrollably or lose a tremendous amount of capital. Uh if the market continue to do well. And that

that was how Artemis was founded. It was founded out of a bedroom um and you know today we have institutional clients all over the world. So is the goal of Artemis to be or even the goal of their sort of framework, to be profitable over the long term, or is it as some other funds are positioned, to essentially allow people to take more risks during the good times while ensuring that when the bad times hit unexpectedly

that they don't suffer a massive negative shock. Basically, the answer is both actually depends how you want to use the uh. You know where a hammer, you can use this whatever we like to. I think we have clients to look at it in both ways. But the goal at the end of the day is is that throughout the business cycle we want to deliver returns that show excess alpha that are on par with what you'd expect

from an alpha generating hedge fund. But The difference is that we want to create most of our returns when the overall market is suffering the most and when there's the most volatility. So instead of where most the classic hedge fund structure of the classic portfolio has these long periods when there's a bolt market and people are doing really, really well. But that's when we're just trying to stay static and not not really make or lose a lot

of money. Um. But when we end up having that twenty brought down draw down a market crash, that's when we want to really shine and do do particularly well. And uh So, to that effect, you can you can think of us as a hedge, but we we like to look at ourselves as a hedge that pays you to own it through the business stuffle. Right, So you mentioned creating value out of chaos, and I'm trying to

think how to phrase this question. But why did chaos or volatility become your thing or your area of expertise or focus a long time ago? Uh Now, I train myself with the c s A, I PAS the CFA program.

I worked at Merrill Lynch in my early days, and I, like most people, began starting out and value investing and I looked at all these different strategies like like value and momentum and all these different financial products, and I really kind of looked at them the way that an alien would looking look at different looking at different return streams, whether you're talking about credit or value investing. These are

mean reversion strategies. And then there are strategies like global macro and c t A s that make money off of prend or divergencies, divergences and change. So I came to this conclusion that really there were only two at A classes in actuality, long and short volatility. There's people that say is volatility asset classes, saying volatility is the only ethic class because in a crisis, people have all

of these these different strategies in their portfolio. But in a crisis, these strategies end up looking a lot like a short volatility strategy, a strategy that is that ends up doing particularly bad during draw downs, and all of these different diversification ends up being correlated with one another, and then you end up having a strategy that is

particularly fragile to change. So institutional investors, individual investors in essence, kid themselves into believing that they have all these different asset classes when n actuality, they're just crowding into strategies that are that are fragile to change in the market, and that the true diversification is actually finding strategies that are long volatility or strategies that that make money from change, and that when you look at the world in this lens,

there there are really there's really only one asset class, and volatility is the only real asset class in a sense of replicating returns chris In theory, this idea of having assets or having diversification that could pay off in both long, heightened and reduced volatility is the premise behind a lot of sort of do it yourself at home portfolios, like buying a lot of stocks and buying a lot of bonds, buying treasuries that you know, maybe pay off a little bit a little bit extra money during the

good times button bad times bit up and are a safe haven asset class when we get a surgeon volatility. This arguably has worked well for the last few decades. Do you think there's a reason that that won't work in the future, and that the assets that seem to have thrived in the past during heightened volatility won't do

so in the future. You know, it's a wonderful topic to bring up because for the greater part of thirty years, people have looked at the stock bond anti correlation and have said, you know, why do I need to be invested in something like long volatility or something that that is exposed to change when I can just be invested in fixed income because I know that bonds will go up when stocks go down, and that has been true

for my entire life. But if we take a longer history and look out one one hundred twenty years, and I presented this evidence as far back, it's become a popular thing to talk about now. But if you look at some of Artemiss research dating back to two thousand fifteen. Two fourteen, we talked about this at length, stocks and bonds have actually spent more time correlated with them one another,

and they've spent anti correlated. There's been multiple periods in history where stocks and bonds have dropped together for two to three years at a time. This includes the early nine hundreds, periods like in the fifties, and periods like in the late seventies. So if I go to an average financial advisor, out on the street and I say, what, you know, I have a hundred thousand dollars. What should

I do with my money? That person is likely to say, well, you put it in sixty stock bond split and then the bonds will protect you when you're stocks too badly. And if I have a little bit more money, I can go to a very expensive financial advisor and they'll say, you know what, we want you to lever the bonds against the stocks because that's better on a market with risk reward framework efficient frontier. That's something called risk perry. But if you look at these portfolios, they performed very

very well over the last thirty years. But if we look out over a hundred years, there are multiple free year periods where these portfolios would have had massive drawdowns, massive drawdowns in some instances for risk parity, even even career ending drawdowns. So this assumption that stocks and bonds will always be anti correlated is a very very dangerous assumption. And I think all one has to do to prove

this is look look across history. Now, if yields were all the way up at you know, ten, as they were in the late seventies, you could sit back and say, well, there's room for bonds to perform uh in the event stocks drop. But if we think about what it would take for treasury bonds to perform as well as they did during the last recession, we'd have to have treasury yields go all the way down to negative two. I'm not saying that that's not possible, but I'm just saying

that's highly improbable. And if you're this is the baseline assumption from which trillions of dollars of asset allocation decisions are made upon this, this assumption on the stock bond at a correlation. So this this makes alternative forms of defense like volatility, like smart global mackerel very very important

at this particular juncture in the cycle. I think it's very important that people understand that the stock bond, the assumption that bonds can be a form of defense for you, is particularly dangerous at this stage of the market cycle, when most yields are at their zero bound. Right. So the argument here is that when most people talk about being short volatility, there's an assumption that they're explicitly short volatility by for instance, you know, buying VIX related exchange

traded products or something like that. But you're saying that there are big parts of the market that are implicitly short vall through an assumption of existing relationships like the correlation between bonds and stocks. Are there other things that you think are implicitly short vall in the market. Absolutely.

One of my papers I talked a little bit about the short ball trade as being like an oboros or the classic image of a snake devouring its own tail um And this is this is how I like to visualize modern markets today, this financial outcomy driving markets higher and volatility lower. The global short vall trade now represents an estimated to trillion dollars in financial engineering strategies. And these strategies that I deem as short volatility simultaneous exert

influence and are influenced by volatility. This includes what I would deem about sixty billion dollars of explicit short fall exposure and another one point four trillion dollars worth of implicit So what do I mean by the difference between explicit and implicit short fall? Well s, Explicit short fall

tends to be the weak hands at the table. These are These are traitors or their institutions that are actually shorting volatively This is where you're actually going out and shorting a vixed future, where you're actually going out and you're rolling. Are you doing a by right overwrite program. You're actually shorting your shorting calls or your shorting puts to earn extra income UM. It involves actually selling a

derivative UM. I think most people are aware of this, but this is actually the smallest component of the short alter rate. The much much bigger component of the short all trade, the trillion dollar plus component of it, is what I call implicit short fall. When you are when you are sorting an option, you are taking on the assumption of stability, and that assumption of stability expresses itself through various risk profiles that can be expressed in uh

these esoteric Greek terms that we use. But long story short, you're taking the assumption of that volatility and markets will be stable. You're taking the assumption that there's not going to be any jump risk. This is something we've option traders are called gamma. You're taking the assumption that there's not going to be rising interest rates UM, and you're taking assumption that there will be stable cross asset correlations. These implicit short fall strategies replicate the payoff of a

portfolio of short options by creating these similar exposures. So these would include strategies like ball targeting funds, which are a short gamma in the market, their short volatility and their short gamma. These would include strategies like risk parity which are implicitly short gamma and short correlation. So even though these strategies may not be directly selling volatility, they are implicitly replicating the exposure of a portfolio of short options.

And you know what, one of the greatest examples of an implicit short ball trade in history was actually was the portfolio insurance debacle of portfolio insurance was implicitly um short some of these exposures of a short option portfolio, even though it was never actually shorting a put or

a call option. Um So, I think many of these strategies, ranging from the the financial engineering of share by backs, to certain risk premious strategies, to certain ball targeting strategies, to certain risk parity strategies, which are comprising a very large portion of the institutional flows in equity markets today, are replicating the payoffs of a short straddle. And this presents a layer of embedded and very hidden risk that

people aren't fully taking into consideration. Chris, I don't want to get too philosophical here, but whenever I think about this, I start my mind starts to drift beyond mere financial markets, and I always think about like, isn't life and living in a society implicitly short volatility? I take a job, there's no guarantee that that job will last. But as long as sort of things more or less function as they are, I keep my job, I buy a house. There's no guarantee that there's not going to be some

freak fire or war in the area. But if there is, then of course that's completely potentially destroyed. Like isn't aren't we all always going to be as long as we're functioning members of society sort of all implicitly short volatility? Well, you know, Joe, it's it's funny you mentioned this, and I could ask this question a lot because I actually wear a watch that counts time backwards to my to my death, So so that gets some perspective on the

issue the world. I guess that's right. I look at myself as a call option, you know, and I by there's an element of of time exposure. That's ticking off. We are a short time and that's that's a form of short fall. There are ways in our lives that we make ourselves and I fragile and in less exposed to the whims change. You know, certainly, if by by a process of self education and by learning, learning, um and reading and continually educating yourself, you are making a

long volatility trade. By meditating and taking care of your health, you're making a long volatility trade. By having lots of meaningful connections in your life and knowing a lot of individuals um that that can provide good contexts and good healthy relationships. These are these are ways to be long volatility. But almost certainly most of what we do in life has an element of of of short vall exposure, and the biggest one of course being time that is the

only true currency and the most fragile one. So is the implication here that overall people should think about the role of financial markets and investing sort of differently than they do, because I think like basically people see, they go about their lives and they make money from their jobs, and then to some extent, the role of investing in the market is to augment that and to turn their savings into even more and to make even more money

than they would just get from labor income. It sounds like the implication is that, for you, since most of our lives are going about being short vall that to some extent, we should really rethink what the purpose of investing money is and that it should be more like a general lifeheage. I absolutely think that one of the ways to look at savings is to to make yourself

and I fragile to turbulence, to give yourself options. So you know, it's amazing that the US is probably one of the only cultures in the world where we assume growth. I think my friend Jared Dillian has made this point really well, that it's it's always assumed that the stock market should always be going up, it's always assumed that

earnings per share should always be going up. Now, that's been a fantastic assumption to bet on over the last fifty years, um and maybe a wonderful assumption to been on the next fifty years. But it's actually important to understand it's it's it's quite unusual in the history of most most nations. Most people don't have that philosophy. So the concept of being able to provide a sense of savings is not necessarily to to lever up your lifestyle, but it should be too to give you an ability

to to be your highest self. The money and saving should be a form of of antifragility. Um Cash itself provides optionality, So I want to be an in the money call option. That's how I'm going to start thinking

of myself. So I want to get back to that short volatility idea, because of course, in February we had this volumit getting occurrence where we saw a lot of explicitly short voll strategies like VIX related exchange traded notes and products blow up, and there was a theory that when they blew up, they basically had to hedge, and so they started pushing up the VIX index itself, and that kind of caused investors to get even more nervous, and then the VIX would go up even more and

the exchange traded notes would have to hedge even more. So you have this feedback loop that ended up making the whole thing really really painful for a lot of people. I think you mentioned one point for trillion dollars for your implicit shortfall strategies. So I'm wondering, could we get a sort of self reflexive feedback loop in implicit shortfall strategies And if we did, how bad would that be for the overall market? Well, if we look at the

cause of this main problem. So today trillions of dollars in central bank stimulus share by back systematic strategies are based on market volatility as a key decision metork for leverage. So what we think we know about volatility is pretty much all wrong. Uh you know the MARKO it's modern portfolio theory conceives volatility as some external measurement of the

intrinsic risk and asset. And this is a highly flawed concept, even though it's wildly taught in MBA and financial engineering programs, because it views volatility as an exogenous measurement of risk. So this is extended sort of like the way a sports commentator sees strikeouts and shots on goal. It's sort of a statistic measuring past outcomes of a game to keep score, but that somehow exists externally from the game. But the problem is that volatility isn't just keeping score.

It's a player on the field now massively affecting the outcome of the game itself in real time at a level that's never been seen before. The last time we we saw something like this was leading into and back then the short volatility dynamic of portfolio insurance. What's really only about two percent of the market today. Today, these

short volatility strategies comprise upboards of ten of the overall market. Now, that doesn't mean that we're likely to have another type of crash in a day, but it does make the probability of some event like that much much greater. These short volatility strategies are like a barrel of nitro glycerin sitting in your offices. Now I can walk over to your offices in Bloomberg and I can sit back and say, hey, guys, you know Joe Tracy, what's what's in that barrel? And

be like, Oh, it's, uh, just some nitroglycerin. Be like, isn't that highly explosive? Could it blow up several city blocks? Oh no, it's it's not a big deal. It's been there for for years. It's been in factually, we've been adding to the stockpile of it for years. The banks pay off a healthy yield to store it here, and I'm like, my god, this is scary, this could this could blow up. And then you just say, well, haven't blown up for years on end, and you know what,

it may never blow up. Risk does not necessariate outcome. But if you have a fire that starts somewhere else, and that fire gets larger and larger and larger, it may touch that barrel of nitricglysra in and what starts out as a as a regular fire could explode outwards into something that blows up several city blocks. That's what happened in where we had a routine market correction. Market was down, and then that caused the barrel of nitric glycerim known as portfolio in, starts to blow up and

drop the market. One day, we could see something very similar. It's a fundamental credit crunch. Liquidity and leverage crunch intercedes with these short volatility strategies the way that they're currently composed in the market. Chris, I just want to point out that your theoretical story about us having nitroglycer and barrels in the office is not as ridiculous as it sounds. Because I used to sit next to Tracy and she literally had a mini barrel of oil sitting on her

desk for a long time. So are sort of like internal risk management practices with dangerous substances in the office. Is not quite as outlandish as maybe you thought. I want to ask one last question I think is right key, and it touches on something you said in the very beginning. You know, it's very easy to come up with sort of naive long volatility strategy strategies. You could uh, you know, buy puts that pay off in the event of a massive draw down, or you could just go along the vix.

But we know that these are really costly strategies and keeping it very simple like that doesn't really pay off. You could really lose a lot of money fast. So you talked about how the goal at to this is not just to provide a classical hedge, but do you actually make money over the whole cycle. So can you talk a little bit about how you go about sort of identifying long volatility strategies that don't kill you during the weight during the low volatility periods. Sure, it's it's hard.

It's really hard to do, and I think that's why why Actually, you know what we spend we have. We've spent all day and all night thinking about this. So I think it takes it takes a specialist to be a little crazy, a little cookie, to focused on this day in and day day out, because you know, it's it's one of those strategies where you don't see the

payoffs every day. But there's a couple of different routes that you can use to execute this, and and some of the tricks that we use UM we look for opportunities when we're paid to own connexity, So we're analyzed markets every single day using computer algorithms. And when you know, if I sit back and said, you know, Joe, would you would you like to buy some car insurance? You'd

be like, and I don't really need car insurance. And I'll be like, well, what if I pay you ten dollars to own car insurance but you only get it for free days? Would you then want to own car insurance if I pay you to own it? Be're like, yeah, yeah, sure. Well sometimes in markets you're able to to buy portfolio insurance very inexpensively or get paid to carry it, but you have to be very quick and nimble and UM

agile to find those opportunities. The other opportunities is you know we we if I look at it and you're trying to figure out when a forest fire might break out, you know, you you don't look at the spark that lights the forest fire. You look at a myriad of

underlying conditions. So we're looking at when numerous or use a tremendous amount of data and we crunch a lot of that data to understand when is it opportune to buy that portfolio insurance and when can we get in um into positions where the probabilities are higher, even if when we're carrying a negative lead, but it's worth it too based on the probability set, and it requires crunching a tremendous amount of data. So these are some of the techniques that will use in order to find ways

to carry that exposure efficiently. And it's not an easy thing to do. It takes a lot of time and expertise and focus and a lot of data and a lot of quantitative efforts to be able to manage that process. All right, Chris, I'm afraid we're going to have to leave it there, but thank you so much for coming on. That was really great, Yeah, thank you. It's been been

a pleasure. I really appreciate it. So, Joe, I love that conversation, and I'm going to start thinking of myself as a call up and hopefully in the money call call option. I really like it too. I think that the you know, we've seen a lot of in the post crisis period, the emergence of a lot of popular like perma bearer types. You say, oh, everything is going to blow up eventually because the fed and run for

the hills. And I feel like Chris had a slightly more interesting perspective, and in particular his idea of well, we're sort of uh, you know, implicitly short volatility all over the place, and so the idea of seeing investing as a reason to at least sort of get flat volatility or more long volatility, the way he framed it,

I think made a lot of sense. Yeah, And I think his point is that those volatility strategies, the low vall strategies, tend to feed on themselves, and they tend to sort of naturally cause the market to double down on those positions. And so basically, maybe before the era of low interest rates and central banks and lots and lots of path some funds. You used to have markets and investors that were sort of self limiting. Once things got out of whack, eventually there'd be a correction and

things would get evened out for a little bit. And I feel like what Chris is implying is that that doesn't happen that much anymore. Stuff just stays sort of imbalanced for much longer than it used to, and that means that when it does finally correct, the correction is more painful than it used to be. Yeah, it does feel like maybe as investors overall are sort of sleep walking into some big risks that they're not thinking of because they think they have them all taken care of.

So they buy an index fund. So they're thinking, Okay, I'm going to diversify away idiosyncratic risk of investing in jewel stocks, and I'm going to buy a bunch of bonds, so I'm going to diversify away macro risk because I

have some bonds. And then it's like, all right, I bought this, said it, forget it by a little bit every month, and then look at my portfolio when I retire, Like, maybe it's not quite so simple, and maybe it's impossible to just sort of people just sort of naively think that they've taken care of what they need to do to be good risk managers. Right, Okay, Well should be interesting, that,

shouldn't it. Yeah, No, absolutely, And you know, the one thing I'll say though in the meantime is that we have had these blow ups, but they so far it's worth noting that the market gets by them. Like we had the exchange traded products blow up earlier this year, and we talked about it, but we didn't, you know, and then it's sort of flushed out of the system

and it was okay. So I think the jury is still out on whether the system is still you know, sort of so filled with nitroglycerin that the big one will come and there'll be this massive unwind. But maybe we'll find out more in the next year or two. Hopefully nothing and we'll have Chris. He could come back and do a victory left the night choke lyscer in metaphor is a little bit unnerving, there are right, ye, a bit to us to home. This has been another

episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and I'm Joe wisn'tal. You could follow me on Twitter at the Stalwart, and you should follow our producer on Twitter. He's to for foreheads and he's at foreheads T, as well as the Bloomberg head of podcast, Francesco Levie at Francesco Today. Thank you for listening.