Waching daily Feb 6 2018

Well, I'm here at apparently a haunted hotel in Austin, Texas--

That's right.

--with Chris Cole, the chief investment officer of Artemis Capital Management.

Chris, thanks for joining me today.

Thanks for having me.

I'm thrilled to have this conversation, because I've read a bunch of your stuff over the last

few years and it's re-- it's resonated with me like few other things I've read, so I'm

excited to get this chance to talk to you.

Perhaps if we can, just for the viewers that don't know who you are, we'll just run through

your background history a little bit and then get into some

interesting stuff about volatility.

Sure.

So I'm the chief investment officer of Artemis Capital Management.

I founded Artemis in a bedroom in Santa Monica after making

really large proprietary gains.

And essentially the money that funded Artemis was essentially

the money that was exponentially magnified from my personal account in the 2008 crisis.

So Artemis was started with my personal money and a little bit of money from my neighbor,

who's still an investor.

And we've expanded over the years, have begun to hire and move down to Austin to

continue the expansion process.

Artemis is a fund that focuses on long volatility trading.

Yeah.

So when you-- the money you're making in your bedroom, what were you doing at

that-- at that time?

You were in college?

It's not in college, actually.

So I did work as a derivatives structurer.

So I worked in derivative structuring on the banking side,

mainly in interest rate swaps and swaptions.

And at the time, I developed a trading model around VIX Futures and VIX Options-- that

that was a very new market.

But I saw that there were parallels between interest rate swaps

and the VIX market.

So I built these algorithmic trading models, and I had clearance to do it through the bank

because VIX was not a stock or a bond.

It was-- so they had no problem with it.

And I originally ran it systematically because I

was-- I was a full time-- I was working full time.

So it would rebalance these systematic trading

strategies and during the period of '07 to 2009,

in a very leveraged proprietary account really amplified a small amount of money

exponentially-- and that was the seed money for Artemis.

Got that audited, and then went out and-- and went out on my own.

Now when you're going into that world, selling a volatility strategy to people, was that

a good time to do it or a bad time to do it?

Because the guys who'd run volatility strategies had kind of peaked and were going down.

How did you find actually raising the money for that strategy at the time?

Yeah.

I think it was really-- I first began to-- coming out, I spent some time researching

and testing using proprietary funds.

So the period between, really, '09 and 2010 was really a

period of refining my ideas.

And then from there, really officially launched the institutional

product at the end of 2011.

I always said that this is-- there's an irony to this because I said if I had-- if I had

started the institutional product six months earlier,

I think it would have grown substantially more

because we would have had this tremendous performance during the period of the crisis

in 2011 in August.

If I had started the fund six months later, I think I'd be out of business because I don't

think investors would have been-- we went into a

period of low vol and very kind of flat returns between 2013 and 2015, and I don't think investors--

many investors would have been able to sort of stay with the program.

Well I mean, vol's something that we haven't had too many chances to talk with people

about, which is why I was so thrilled to get you here today, because it's something that

everyone's kind of aware of it, vaguely-- they kind of understand the concept of volatility

as a noun, maybe not as an investment strategy.

So talk a little bit about the strategies you

run, and then I want to get into some of the stuff that's going on in volatility world

because it kind of seems to be conflicted at the moment.

Sure.

I think there is a lot of misconceptions about vol as an asset class.

People tend to think that you either have to be one camp or the

other.

You were either this short vol guy that's just picking up pennies in front of a steamroller,

and eventually you looked like a genius for many, many years, and then you blow up,

and Nassim Taleb screams at you.

Or you're this long vol guy and you bleed, and you bleed, and bleed.

And then one once in a blue moon, you make a ton of money--

but that's not repeatable.

Artemis was really founded on this idea that there is a middle

ground where we are biased towards convexity, we're biased towards trying to create returns--

portfolio changing returns in a period like 2008 and a period like 1928 or '87-- but we're

trying to find a way to carry much more efficiently.

So the problem with a tail risk fund is if you're down 10% or 15% a year, you're down

50%.

By the time you hit the crisis, you make a 100%-- you're back to square one.

The idea being with a long vol fund is you use

relative value volatility arbitrage principles and

timing in order to have a return profile that's much more neutral even slight positive carry

during bull markets, while at the same time retaining that convexity exposure to do really,

really well during the worst period of markets.

So when you say that, is sounds so simple.

You go, yeah, that makes perfect sense.

It's a really tough thing to do, right?

To carry that-- to be-- to be able to bleed away and keep

that funded, it's a really tough thing to do.

It's a hard-- it's a hard thing to conceptualize, and it's a hard thing to kind of imagine within

the portfolio context.

But what's amazing is that sometimes, even though volatility might be

very low, when uncertainty is very, very high that can give you an ability to carry long

vol and tail risk positions in a way that's much

more effective.

And I think I've given this analogy-- there's a paper I wrote recently, I talk about Star

Wars convexity and this concept of what George

Lucas did in 1976 as an analogy for long vol trading.

In many instances, a first order effect in markets, and in life, is something that's

predictable.

For example, if VIX down at 12 you're not a genius for predicting that it will

go to 17.

Those effects are pre-built into markets.

They're pre-built in in things like vol term structure,

in vol skew.

Higher order effects represents movements that are very difficult to

conceptualize and are rare.

Human beings conceive linear effects very easily, but we

struggle to conceive higher order effects.

An example of a higher order effect is the 20%

drop in 1987, or the idea that vol rises 10 consecutive days-- these are higher order

effects.

In our-- in life, and generally, people spend most of their time maximizing their exposure

to linear movements and ignoring higher order

movements.

We, oftentimes, will seek to sell the first linear movement in order to finance

the cost of the higher order movement.

One example of this was in 1976.

So George Lucas did this with-- he was coming off of a

success with American Graffiti.

And at the time, he went to the studio and he wanted to make a movie that was a space

opera movie.

And Fox Studios said, OK, this is a little bit risky but we'll put up the moneyhe's

a hot, young director.

Lucas said his going rate for his salary at the time was-- he

could command up to about $1 million.

And he said, you know what, give me only $150,000.

I'll give you a discount on my writing directing fees, but instead I want the merchandising

sequel rights to his new movie, Star Wars.

At that time, the Fox Studio executives-- who had

been reeling from the failure of Dr. Dolittle in 1967-- they tried film marketing, they

tried marketing tie-ins, there was a huge write

down on toys from this movie.

And they thought, why in the world would this guy accept an

85% discount in his salary to own these higher order rights on a failed concept.

Obviously that, you know, $850,000 trade that Lucas did turned into about $45 billion

dollars and more.

But the point is that this is-- this-- Lucas was a brilliant volatility trader.

Right?

What he did is he took a first order movement that could be conceived, which is just-- he

had this first order carry benefit.

He forego some of the carry benefit to own higher

order movement.

So in that sense-- in terms of volatility, the way that that type of trade might be structured

is you might have some negative delta exposure

but you would have positive gamma, or positive dgamma dvol-- or positive dvega dvol--

these higher order derivatives-- or, excuse me, higher order sensitives where, in the

event markets move tremendously, you have a

non-linear payout.

But these are very hard for people to conceive.

They can only be fixated on the first order effect, not the second, third, fourth order

effect.

And this is just one way of explaining how a fund like Artemis has been able to actually

beat the average hedge fund, dating back to 2012, while actually having negative correlation

to the S&P, and explosive performance during periods of off markets.

So this is what's very interesting.

A couple things you said-- first of all about George Lucas

being a great vol trader because you wrote in the Volatility and the Allegory of the

Prisoner's Dilemma, which everybody watching this needs to find and read-- we'll a link

to it in the transcript-- it's an extraordinary

piece of work, and there were a couple of things

in there you said that, when talked about George Lucas, that you said in that piece

everybody's a volatility trader but only some people realize it.

And when I read that, the bells are going off in my head left and right because that's

exactly right-- we're all trading volatility.

We think we're buying stocks, we're buying currencies,

we're selling commodities-- we're all trading volatility.

How do you try and get people to understand this idea that what you're actually

trading is volatility?

You know, is this is so amazing because you sit back and the institutions have all these

asset class buckets-- it's long.

There's equity, hedge funds, credit-- let's just imagine that you

knew nothing about finance, and you're an alien that comes down from outer space.

You have no-- you have nothing but data.

You have nothing but data.

So you look at these data streams and these returns streams on how these different asset

classes behave, and the world segments into two asset classes-- asset classes that had

a short vol profile where they make steady returns

with solid sharpe ratios and then have arge drawdowns.

I mean, this would be an example of value investing.

Not that there isn't any wrong value investing, this is-- it's

a smart, short volatility return profile, but it's a form

of short vol, in that sense.

Credit is another example.

And then you have asset classes that are long volatility that

would be-- I mean, naturally, volatility trading is that.

But if you at systematic CTAs and contrarian global macro investors have that

profile.

The problem, at the end of the day, is that people artificially diversify their portfolio

when in actuality, oftentimes, they're just 99%

in short vol and fail to conceptualize the benefit of

convexity in the portfolio, or even what asset classes represent a resource to that element.

Yeah.

You know, I interviewed them a guy called Michael Green in New York.

Oh, Mike.

Do you know Michael?

Yeah, he's a good friend.

Brilliant, brilliant thinker.

I pay money to sit sit and hear the two of you guys talk because we spoke about this,

we spoke about--

Actually, ironically, we were supposed to be in a call after this.

Oh, there you go.

We should have just conferenced him in.

You're going to laugh, actually.

So I'm actually-- we're talking after this.

It's funny because, you know, Michael and I spoke about this idea that people are selling

vol and they don't even know they're doing it.

No, yeah.

And, you know, you look at what's happened to the VIX, you look at how it's just repeatedly

getting crushed, and crushed, and crushed, and crushed in an age where the volatility,

as people understand it, outside the financial

term hasn't been higher in living memory, certainly.

Post-world War II, we've never seen the kind of pulls at the geopolitical social

fabric that we're seeing now.

So trying to help people understand how that's happening, that this vol is continually getting

crushed-- because I know in the Prisoner's Dilemma you wrote about central banks'

preemptive strikes, which I think is just such an important concept for people to understand.

Dorothy Thompson once said that peace is not the absence of conflict, and I open up

Prisoner's Dilemma by actually referencing the book called Command and Control where

this idea of a prisoner's dilemma, where you have different competing forces where people

will be best cooperating but a force of tenuous competition creates an equilibrium.

An example of that is an arms race.

It creates a false peace, but underlying that false peace is tremendous volatility potential.

So Command and Control talks about an episode where there was a plane crash in North

Carolina, and this B-52 was carrying, I think, two nuclear weapons.

The only thing that prevented an explosion about 100 times the

power of Hiroshima going off in rural North Carolina was a very low tech failsafe.

Very, very low tech failsafe.

There were six failsafe triggers.

Five of them failed, and there was only one that prevented

this disaster from happening.

Had that bomb had gone off, it would have spread radiation

all across the eastern seaboard, including DC and New York.

It's not unfeasible to imagine that if an accidental explosion accident happened

in North Carolina that it could have accidentally triggered Armageddon.

Well, this was around the time of the Cuban Missile Crisis right?

The '60s?

That's right.

That's in the '60s.

So there were multiple-- and this book is a true-- it's nonfiction,

but it's the most crazy horror, you know, novel you'll ever read because it details

all of these accidents.

But the point is that there is this peace-- we're not at war, but there's this

tenuous volatility hiding underneath the peace, this tail risk.

And the analogy being is that we are at the end of a multi-decade debt binge monetary

supercycle, and global central banks and governments have been taking tail risk, they've

been pushing tail risk into the future, they've been bringing returns to the present.

And what's occurred is that people have imagined

that they're destroying risk.

You can't destroy risk.

They've simply transmuted that risk, and they have actually even amplified it.

And I think the Cold War is an example of where you can have this competition and

incredible tail risk that's being driven by low volatility.

In today's market, we're sitting in a market where volatility persistence is at

88 year lows.

You can actually measure that using something called a GARCH model, I'm not going

to get into that.

OK.

But 88 year lows in volatility persistence.

We have extremely low equity volatility, extremely high mean reversion.

Stocks, as measured by enterprise value to EBITDA, are at-- and price

to sales PEs, are at levels that have triggered previous depressions--

And beyond, absolutely. --and beyond.

Fixed income, bond yields, are at the lowest levels in human civilization.

We've only moved debt from the corporate balance sheet to government balance sheets

and sovereign balance sheets, and now sovereign debt are at the highest levels in, really,

recorded modern history.

And there is limits to the efficacy of a central bank stimulus, and this is all occurring at

a point where rising populism is potentially

going to cause the post Bretton Woods world order to come to a collapse.

And this dynamic of the US protecting trade lines and ensuring trade dynamics, and also

protecting the world in terms of military, in exchange while we export our-- export our

inflation and export our middle class, this multi-decade dynamic is coming to an end as

populism is rising in the developed world.

It is a perfect storm.

So there is massive tail risk under the surface, but it's being hidden by this competition

of devaluation.

The same-- in the same parallel that maybe the Cold War could be an analogy

for.

Well you see, this is why I just love reading that piece so much because it's testament

to the success and failure of the central banks.

Right?

They've been incredibly successful in creating this perception of de-risking, everything's

fine, the can gets kicked but it's OK, it's OK, it's OK.

And that success will ultimately be their biggest failure.

We don't know when that will be but, to your point, the risk

is there, you can't eliminate it, it will happen at some

point.

But to me, their greatest success, in parentheses, is convincing people-- convincing markets,

convincing investors-- that this is under control.

Convincing them that you can buy the dip.

Convincing them-- and a lot of that comes from the point you made about these preemptive

strikes that they're having to do now because they can't allow anything-- they can't allow

a 5% drop in the S&P because where does that

go once it gets out of control.

Have they reached the end?

Because for almost two years now, I've been seeing, you

know, this is coming to an end.

It just eeks forward, and a lot of that, I think, is because

investors kind of do this.

They don't want to know, it's don't ask don't tell.

If you tell us it's all right, even though we kind of feel uneasy,

we don't have to invest like it isn't all right.

But how close are we, do you think, to the end?

I mean, I know it's an unanswerable question.

The limits of my understanding here-- I have been wrong about this for two years.

Yeah.

You and me both.

And I've-- yeah.

And so-- and it's possible if they-- it's one of the scenarios that I can imagine

is a scenario where, if they push through further deregulation, massive fiscal stimulus,

we could see a blow off top the way we did in

the late '90s.

I would expect that to be a period of-- most people don't realize the late '90s

was a period of high-- Incredibly high vol, right.

Incredibly high vol, yeah.

We had-- VIX averaged over 25, so over 10 points higher than

where it averaged last year.

We had multiple periods-- including the '97 Asia crisis, and

then also the '98 Russia's sovereign default LTCM.

Volatility tested 40, and in many instances averaged over 30 for more than-- so those

periods of blow off market tops tend to have the right tail risk, tend to have

high vol.

So it's possible to actually have high vol and high asset returns.

We might see that type of environment repeat.

We could see an environment where-- if it's a more reckless US

presidency, and as some of our-- China.

If we end up seeing a breakup of the European Union, and China tries to get in front of

a trade war with the US by maybe even potential

military action or there was a China blow up as a result of a trade war with the US

due to really kind of extreme reckless policies, we

may see a dynamic where-- where there is a crisis more immediately.

Either way, I think-- I think in stone, either way the way we get there I see higher vol.

It could break to the left tail, it could break

to the right tail and then go to the left tail, but I

don't see the equilibrium of volatility and high asset returns continuing.

This is amazing.

The statistic-- I actually went back and tracked equity returns going back 200 years.

You know, all these institutions all want to go into index funds.

Well, guess what?

Indexation beta has had one of the highest sharpe ratios

in over 220 years worth of data.

So if you want to talk about buying the top of-- I mean,

you can look at periods like 1998 and '99 that had high returns but there was high vol.

But the period really ending in early 2015 had one of the highest sharp ratios in recorded

equity history, going back on a rolling three year period.

I mean, if you're chasing your own tail or driving with looking in the view mirror of

course you're going to want to go in index funds

when it had the best performance.

That's come from this idea of-- I think I'll go off and

kind of talk a little bit about how-- what is driving

this incredible mean reversion in markets?

And you talk about one of the concepts in the

paper about preemptive strikes on risk.

It used to be that central banks responded to economic conditions.

So you had a recession, central banks would respond by lowering rates.

Some point, really, I think starting with Mario Draghi's whatever it's takes speech.

Central banks stopped responding to market conditions and started-- excuse me, stopped

responding to economic conditions and started responding to market conditions.

They started, in essence, doing preemptive strikes on financial risk.

Understanding that asset prices were driving this projection,

or this postmodern projection, of what the recovery was they began to treat asset prices

rather than the fundamental conditions.

This is analogous to giving a cancer patient amphetamines

every time they start to feel bad.

And instead of treating the underlying root causes of debt and deflation, they are treating

the symptoms and preemptively getting in front of it.

What's become shocking is that markets, like Pavlovian, have-- now have a

Pavlovian response to this.

So you can see this through numerous examples, but markets now

have embedded the expectation of central bank reaction function.

When the VIX went up to 40, the forward curve had the highest level inverse-- of inversion

in history, far more than 2008 anticipating mean version.

And it-- And it came.

And it came.

The forward VIX curve essentially bet on a zero percentile outcome.

Never before in history had volatility mean reverted

as fast as it was predicting, and it was correct.

But it was-- it was correct in not-- vol doesn't mean revert typically that fast over 100 years

worth of data.

What it was right in is anticipating the Fed would not raise rates.

That China would come in spend 20% of its GDP supporting its equity markets in the face

of a military parade, and that the ECB and the-- and the Bank of Japan would have dovish

statements.

You have guys like James Bullard coming out, the market drops 5% in October

2014 and James Bullard's talking QE4.

People forget about this.

I mean, when you talk about central banks preemptively getting ahead, this is what we're

seeing-- markets now build in that expectation.

But, you have an entire ecosystem.

So nowthis is a different topic, but central bank preemptive

strikes on risk-- the second dynamic, share buybacks at their highest levels ever,

have now actually-- They've started to roll over too, right.

Just sort of rolled, but they're still-- they're still incredibly powerful, by any measure

of history.

I mean, last year more than the operating earnings of the entire S&P 500 built on share

buybacks.

I mean, Larry Fink is talking about, well, if we allow lower taxes and repatriation

will companies just-- Yeah.

Just buy more shares, yes.

But what people are talking about is that this is a volatility damper.

This actually-- when you see-- if a company is looking at a scenario

and there's-- and you have a share buyback plan in place, if there's any sell off you're

going to buy into that.

And so that automatically reduces realized vol.

Then you have all of this-- all of these systematic trading strategies, which are not inherently

bad, but when you build in this factor where you have markets anticipating a central bank

response share buybacks-- buying-- compressing-- And then you have VaR rebalancing and systematic

VaR rebalancing strategies, CTA strategies, and even machine learning strategies--

which are using recent past and risk parity recent past in order to size their

exposure.

You have this reflexivity where all these factors are beginning to work in conjunction.

Then you throw on the prevalence of institutional short volatility sales, which actually

produces a gamma position the dealers have to head, which then is furthering-- so all

of these factors play with one another and interplay

where lower volatility started by a central bank but gets lower vol.

But they can all reverse violently on a dime.

Yeah, And this is-- this is what my concern has been and the thing I've been trying to

figure out because, you know, when you look at ETFs,

for example.

You know, here's another great dampener on the way up.

When we had good markets doing what they're doing,

they're always piling into ETFs.

The returns are scant, so if you can save some basis points

or buy an ETF and save yourself some work figuring out which stock to buy, great.

Again, a massive volatility dampener when all these things are just go around and buying

the basket, buying the basket.

When that does turn, and it will turn-- there's no way it

doesn't turn.

We're mostly seeing what reaction the central banks will have because when

it turns, and it turns violently, they are going to have to come up with something.

I can't even imagine what they're going to come up.

They could lock people-- they could lock money in the system--

Yeah, force people to buy --treasuries, capital controls.

But it's-- we're getting to that point now.

We're getting to the point where that's really all they have left at this point.

It's going to get draconian.

When you look at stuff like this, how do you as a vol trader in a time

when it's hard to make money being long vol-- you can carry it and you can continue to

chip away, but you you must have scratched your head100 times thinking where's the--

where's the 70 vol print that we should have had from that.

How do you-- how do you carry on, and how do you position yourself ready for that

moment?

Because you know there's a big payday out here-- it's sitting out there somewhere.

How do you-- how do you position yourself for that?

Well I think the framework is you find ways to carry vol effectively.

So I think in this environment, for example, where-- which is

characterized by low volatility but high uncertainty, it allows you to sell that first

order effect-- which is represented by the uncertainty-- and recycle it into tail risk.

So even though vol is low, if we look at vol term

premia, for example, skew-- these higher order effects.

Skew-- if we look at implied correlations, all of these factors are incredibly stretched

at the 90th percentile.

So this is almost like if you-- imagine you have a coworker, and the man

appears calm.

And so he doesn't seem to be panicking, he doesn't seem to be erratic, he's

just sitting at his desk calmly.

That behavior is vol.

But if you measured his cortisol levels, his stress hormones, you would see them off the

charts.

And in that sense, that's because he maybe is going to get divorced from his wife,

he's afraid-- he's got tons of debt and he's-- he's afraid he's going to get fired.

So he's not panicking, but his cortisol levels are elevated.

That's what we're seeing today in the market.

The cortisol levels are things like implied correlations, and skew, and vol term premia.

These are very expensive, even though vol itself

is flat.

The problem with this is that if you go ahead and you just buy outright hedges, or

just outright tail risk, you're buying that expensive uncertainty and you're bleeding

that premium tremendously.

So I think the framework that one has to use is one has to be very, very clever about saying,

you know what, we are-- we're going to not make money if markets drop 3%, but we'll

make a ton of money if markets drop 20% or 10%.

That's-- and you structure trades that that play off the vol arb in the uncertainty

that can carry more positively if volatility doesn't

realize while at the same time maintaining that constant exposure.

The other way you do it is you couple vol with data, and I think that's-- to us-- we

don't do that, but most of our accounts are sort of

SMA based.

And the idea being is that clients would take exposure and layer it on top of

beta exposure.

That way, in the event that you have-- in the event that markets continue normally and

we end up having a continuation of a bull market

and you're realizing that but you're-- you have a negative linear exposure combined with

a non-linear volatility exposure that will pay off in a crisis.

Now you spoke there about risk parity and you spoke about correlation, and there was

a chart in Prisoner's Dilemma which just astounded

me.

It's one of those charts where you think anybody that sees this chart is just

going to faint.

It's just that that idea of no correlation between bonds and equities going back over

time.

It's an astounding chart.

I mean, just talk people through it.

We'll put the chart up on the thing so they can see it, but it's so-- it's

remarkable.

It's horrifying because one of the things we-- everyone says risk parity-- I mean, it's

not just risk parity.

It's like, if I were in Austin, Texas and I go to any brokerage office and I say

well what do I do with my money, they'll say put in 60-40 stock bonds.

Right?

And then if you have a little bit more money, the risk

parity guys will say, oh, you know, you can lever

those bonds, and lever the bond exposure, and combine it with a stock exposure.

You'll get you get a better overall portfolio, look how well it performed in 2008 and

everything else.

Great.

So one of the things I said, OK, that's fascinating.

What if I go back and I look at stock bond correlations going

back 120 years?

Let's see how that relationship has played out over 120 years rather than

just over my lifetime.

It turns out that stocks and bonds are more-- have been more correlated

with one another.

They've been highly correlated with one another about 30% of the time, and they're only

anti-correlated with one another 11% of the time.

It just so happens that the period of anticorrelation has been predominantly since-- starting in

the late 1970s all the way up to modern times.

And that's-- really, you had a rates peak and rates have gone down, and

down, and down.

And every time there's a crisis, central banks lower rates more.

So hence, this anticorrelation.

Now if we look back across history, there'd be multiple times where stocks and

bonds have not only been correlated with one another, but they declined together at the

same time.

We saw this in the period of 1906 to 1912, we saw this in the '70s, where

you were getting hammered on both sides of your portfolio.

So a 60-40 stock bond portfolio becomes 100% a loser, and a risk parity portfolio becomes

a leveraged loser.

And this is not some sort of weird pie in the sky theoretical thing, this

has happened multiple times across history.

So if you are betting on this relationship as an

institution, and $14 trillion is betting on this relationship, you're in essence making

a bet that US treasury yields are going to go down

to negative 3%, negative 4%, negative 5%.

Could they go down that low?

Sure, anything's possible.

But the point is that you are making a levered bet on something that has never

happened in the history of human civilization, when I can clearly show a probabilistic expectation

of the other scenario happening.

This is why-- I don't understand why volatility, and managed futures, and contrarian macroI

don't understand-- in an environment where everyone is running away from these

strategies because they've sort of had mediocre performance over the last couple of years,

I feel like institutions should be running to them.

But this is just human nature, and it's a lack

of-- it's recency bias.

We see this all the time in finance.

You see it all the time.

And it's funny how-- you've done the work, and you've done-- you have the data

to prove this.

But you can sense just by reading all the headlines about active management

is dead, we all need passive management now.

You know that's a turning point.

You then go back it up with the data, but you know.

At any point in time where everybody's saying that's done, that's had its day, its finished--

in a period like this, where we are-- there is so much tail risk out there and this idea

of peace existing on the edge of volatility,

which is that great quote you had in there, you-- I

think in the next three or four years, you're going to need an active manager more than

you've ever needed an active manager before.

I completely agree.

Where does that turn come from?

What do you think it takes to finally break the market's

belief that these preemptive strikes will work?

I think there could be any number-- any number of breaks that could occur.

One of the factors could be a-- just a policy failure,

where we reach a point where we have a large enough crisis and central banks are-- and

governments are unable to respond.

They're unable to respond either politically-- because

there's so much political opposition, we've seen this rise of populism-- or they end up

having a policy response and the market rejects it.

So in one aspect, you could have a policy failure that drives it.

You could have a political failure.

I mean the rise of populism-- I mean, there was a-- I think one of my articles, and I

publicly stated this at the EQD derivatives conference saying that-- I didn't predict

Trump would win, but I said that he had a very,

very high-- much higher probability of winning than people were imagining.

And I understood this because I come from Michigan, and I understand-- my parents are

doctors in Michigan, and they treat all these people who've been laid off.

And it's about jobs, it's about the floundering middle class.

When people become protectionist, they become xenophobic when their security and

their financial security is at risk.

And this is happening across the developed world.

So it's not just-- if Brexit or Trump are Bear Stearns, the breakup of the EU is really

potentially Lehman.

And this is-- and and that leads into a whole other realm of geopolitical risks,

including potential war with Russia.

And then we're not even including China and the

financial state that Japan is.

So these factors really come into play.

This could be the tipping point, any one of these, and it could happen

politically.

You know, at that point, we'll have to see if they-- if they can't- if they can't print

and devalue, do they freeze?

And maybe bailing in is their next step on things.

But I think this is where we will see, and that's why I think

there needs to be sort of a coverage to both right and left tails risk in both of the scenarios.

Vol is more than just protecting against a 50% decline in markets.

Well, you know, you assign-- that's what you do on a daily basis.

You assign probability to events and handicap accordingly, and it's

interesting how you and I can sit here having a conversation about potentially World War

III and, you know, these kind of really extreme events-- you know, revolutions in countries

that haven't seen revolutions in years.

It's all happening.

We can see it all happening, but still there's this reluctance to accept it as a

probabilistic outcome.

Whether the probability is 1%, it doesn't matter.

We know the probabilities are rising, but most investors just have this-- there's nothing

with a probability of less than 20%.

You know what I mean?

It's like, well let me know when the probability's 20% and I'll notice and I'll

try and to do something to mitigate it.

But until then, I've got bigger fish to fry with my

60/40 over here.

I struggle to understand that mentality.

It seems to be shifting to me.

It seems to be that 20% barrier to caring is maybe down to 15% now,

and you can see it lowering.

And I don't know what it's going to be, but something

out there-- whether it's the IMF finally bulking the

grease this time, around who knows-- but something is going to come out of a clear, blue

sky that wasn't expected.

It wasn't supposed to happen.

At that point, what do you think happens to volatility?

Because you've reintroduced the idea-- suddenly, this one event, it is volatile.

Maybe Trump is that injection of volatility, which I think he has the potential to be.

It depends on how the policy events play through because in one aspect you could see--

you could see a scenario where, I talk about it in an old paper, how in Germany-- right?

I'm not predicting hyperinflation in the US, but in a scenario where you have runaway right

tail risk you end up having volatility rise dramatically.

Germany, during the hyperinflation, would have saw market volatility started around

19% and would have peaked out at about 2000% in 1923.

Of course, that's on a nominal basis.

The other-- the other scenario would be-- I mean,

obviously if there's an outbreak of extreme war you might end up having that left tail.

I think as a vol trader, you can play both ends.

What you're betting on is change.

So I don't think I'm smart enough to exactly predict how it might play out, but what I'm

trying to do, in my job, is to give people powerful exposure to change in a way that's

palatable for them to carry so that they're not down 50% carrying it, and that they have

that exposure to that change on either end of the spectrum.

And I think it's incredibly difficult to handicap all the different scenarios.

But I think if you purposefully seek out positive exposure to

change at a low cost, that ultimately-- ultimately those events can be portfolio and life enhancing.

I mean, I'm not-- you're not cheering for disaster, but the idea is to insulate yourself

and to have that positive exposure and nonlinear exposure.

For most-- for most people at home watching this, there will be a lot of people that have

access to vol and hopefully rethinking it as a strategy and rethinking allocating capital

to it.

But there will be a lot of people that sit there and think, well, OK.

Maybe I can buy the VIX ETF.

I can buy the short VIX ETFs, I don't believe in all this.

These products that create a liquid instrument around something that's

extremely illiquid when you most need it is another phenomenon that scares the bejesus

out of me, frankly.

What advice do you have to people sitting at home trying to understand volatility who

are going to get kind of-- when they Google volatility

it's going to say VIX.

Do you say stay away from this?

Are there are better ways to do it?

What advice can you give?

There's a point.

I mean, it's important to sort of not be-- there's nothing wrong with shorting

vol if it's done intelligently, and the problem is that-- I think the problem is that people

don't always understand the risks that they're taking

on.

They're not-- they're not imagining-- so I think in Prisoner's Dilemma

I talked about how the rise of the VIX ETP complex, many of these investors don't realize

that given the wrong vol spike and given the way that the market and the vega was being

placed back at around 2014, 2015.

But the exposures that were in the market that point

in time, you could have had even a spike that was on par with what happened in February,

2007-- where VIX went from 12 to 18, and theoretically the entire short ETP complex could

have been wiped out overnight.

And those are based on numbers that I put together, and that's my-- that's my opinion.

I don't feel-- ironically, I don't feel that

way as much now.

I think the market has come back and is much more balanced than it was in 2015,

but I think the problem, at the end of the day, is we're all short volatility.

Every institution in the world is-- the question is are you short convexity, or are you massively

short convexity, and do you understand that you are because, you know, we have a finite

amount of life.

At the end of the day, owning-- buying value stocks-- you're buying on--

buying on dips, you're in essence-- you know, if you have a portfolio of value stocks, in

some ways you're implicitly shorting correlation and betting on mean reversion.

That's a form of short vol.

But the margin of safety can be attractive at the right points in

time.

The question is-- do people really understand the risk they're taking on?

I think-- I think when institutions are entering into a lot of these different strategies,

and today this is just indexation to a certain extent, I don't think

they're really fathoming-- really have a pure conceptualization of all the risks that are

going on.

You talk about us all being short vol, and I have to ask you about your watch because

I remember you were writing about your watch.

You know, sadly-- sadly, I'm not wearing it.

I'm wearing my Fitbit today.

Damn it.

So sadly-- but yeah-- but the ticker is I just love this concept from a cosmology standpoint,

because there's a wonderful watch that I wear called a Tikker and it counts time-- it counts

time to your death.

Right.

Which, people are going to go, wow, that's morbid.

But it's-- but it's such a great idea.

It's an incredible idea because it's saying, you know, I'm in my 30s.

I've-- I've got 30 years of, you know, at least solid life.

I mean, I can-- you can-- nowadays, life extension and

better dynamic.

But really in terms of I'm already at my peak health.

I'm already my peak health.

So if I'm going to do things, especially things that rely on being in top physical

shape, I better do them now.

The time is finite-- time is our greatest resource.

And a lot of times, we are afraid to take long convexity that's in life that can have

huge payouts but might inconvenience us in the

short term.

And I think the idea of long vol trading can be applied in the cosmology of life.

Meaning that it's sometimes about-- you go out you

speak to an incredible thinker in Brisbane, and it opens up tremendous new ideas.

Reaching out to that individual, which takes effort on your part, you're putting something

forward is a long vol trade, and you end up with a convex non-linear result.

So surrounding yourself with people that-- and seeking out

people that can expand your horizons, purposefully challenging yourself in the short

term for non-linear gains, both intellectually, exercise, flossing, meditation, you name it.

All of these are examples of-- you're putting some-- there's a cost, there's a small time

cost, but there's a non-linearity to the pay out.

And some of that pay out can be in the form of

randomness.

Some of my closest friends and most amazing people I've met, I've met randomly because

I went out some night in New York and I met an interesting person, and

we kept in touch, and became great friends.

That's a perfect example of non-linearity.

It is.

And this idea of life is finite and it's not something-- I guess maybe once you get into

your 30s or 40s you start to think of it that way, and the parallels to volatility trading

are just extraordinary to me because when you're

young you don't think about risk.

I mean, It's just-- there is no risk.

You're bullet proof and everything's going to be good forever.

But it doesn't take-- I have this idea that people's careers and certainly their mindset

and how they position themselves, how they react

to markets, is shaped by the period when they enter markets.

You know, I was lucky that I came in right before the '87 crash so I very

quickly got punched in the face.

And that was invaluable to me because you know what

can happen.

You know that 20% of a stock market can go in that day.

Yeah.

Anyone that's coming into the market since then doesn't know that-- even the guys that

were around in 2008, they didn't see that kind

of draw down.

It was just a painful-- Lehman was a bad day, but it was one bad day in many.

'87 was a bad day, and then it almost kind of went away as quick as it came.

What advice-- as a vol trader and someone that has a really good grasp of how this idea

of volatility affects your life as well as your investing, what advice can you give people

who are perhaps not at the stage where this comes

to them naturally to think about?

Well I mean, you can extend that theory-- it's not just lives.

I mean, like, we talk about how all of modern financial engineering has been

optimized to an unusual environment of higher stocks, growth, and lower and lower bond prices.

But-- no, excuse me.

Lower and lower yields.

Yields, yeah.

Excuse me.

But the-- so in essence, a lot of times people are always looking in the rear view

mirror.

But this extends to, like, Neil Strauss Howe talks about Fourth Turning generational

cycles.

So entire generations where a generation embodies certain belief systems, which

then-- which then ensures certain historical mistakes occur over and over again.

So I mean, I'll sit down-- I read a lot of financial history.

I try to read a lot of history, and then I play with Bayes' theorem.

I'll do this-- I'll sit there and I'll do, like-- I'll run through

different scenarios.

What's the probability of the United States going into a civil war in the

next 50 years?

And what events might drive that?

And what events might cause-- you could play these games, and I think it's a creative

process.

Financial engineering is based always about optimizing to the past.

But when I was driving through America-- you know, you'd spend two

days driving through Iowa and Nebraska.

And if you optimize to the past, by the time you hit Colorado you'd fly off a cliff.

So I think the idea of-- I mean, I'm a systematic guy.

I'm optimizing, but we're always building in

failsafes and trying to imagine systems, or imagine a reality that's outside of the systems

that have been tested on.

And then ensuring that if we hit that alternate reality, it will help us and not hurt us.

And that's the-- that's kind of the power of consistently

following a pathway of long vol.

This is why I find it fascinating to talk to so many people with the Real Vision project

is that you get the chance to sit down with people

who will entertain the idea-- OK, what if the US

has a civil war?

Most people go-- that's a waste of time.

To your point about the optionality and actually putting the convexity by doing

that exercise.

Anyone that thought in 2004 about what might happen if the EU broke up,

they set themselves up to make some really good money.

They thought about Greece, they thought about the weak south and the strong north.

But it would have seemed like a ridiculous thing

to do back in 2004.

There was no stress on it whatsoever.

So just in closing, is there anything else out there that you're kind of sitting

down doing that probabilistic exercise about that you think, wow, I'm really kind of out

on a limb here?

No one's thinking about this kind of stuff, this is really kind of-- I mean, US

civil war would be a good one.

I mean, no one's thinking about that.

But is there anything out there that you see as a real- when you spoke about the black

swan going from fear to horror, is there any potential

horror out there that you think-- The concept of black swan is completely overused

because-- and I think I use the Cthulhu-- in HP Lovecraft, Cthulhu was a metaphor which

is, like, a horrific monster that's beyond our ability to comprehend.

Because, you know, the people talk about the black swan event

in 2008 as if 2008 was a black swan.

I don't think it was at all.

I mean, I went back and looked at volatility data from the depression

and you could clearly see that vol would have touched 80 multiple times during the Great

Depression.

It was not inconceivable at all.

What was the-- I think the true black swan in 2008, which

didn't happen but could have happened, would be the failure of the entire Fiat money

system.

That was-- that was the true potential black swan in that sense, and that didn't

happen.

So the-- it's an overused term nowadays.

So in my papers, I always end with-- I've always been doing this since 2012, which is

I put a graphic of liberty leaving the people.

And it's not because I'm a socialist, it's because I've always considered the real risk

to be the failure of our institutions and political

risk.

And I think that's the real danger of where we might go down where-- and I think the true

black swan or the true thing is something I'm

not even conceiving.

Right?

It's beyond-- but I think that's the real risk, and that was-- that

was hidden in those papers back in 2012.

I mean, literally there were hidden messages in

some of those papers.

But-- but I think now when we look at-- it seems much more feasible now, but the actual

failure of democracy-- the actual complete tumbling of the world order where, you know,

you have-- there is-- we've existed in this post-Bretton Woods system, and with rising

populism we could see a world 50 years from now that's radically, radically different.

And in that world, some of the institutions we take for granted-- you know, including

the efficacy of democracy-- might be challenged.

And I think-- and the very transferability of

money across borders and globalism might be challenged in a way that we've ever seen

before.

And it's very, very hard to-- if you're making bets within a financial system to try to

imagine how you would-- how you would hedge against that potential risk.

Or even how you would collect if you were right, potentially.

That's-- yeah.

I'm so glad you could do this, and I will urge everybody to seek out The Allegory of

the Prisoner's Dilemma and Volatility in the Age

of Trump.

And I'm going to read the Star Wars piece now because it's some of the clearest

thinking that I've read in the last number of

years.

So thanks for sharing with everybody, and thanks for sharing this hour with us.

Thank you.

I had a great time.