Join us for our inaugural episode of the “ReSolve’s Riffs” series where the team will go live on Youtube every Friday at 3pm over cocktails to discuss topics that are in the immediate zeitgeist of the investment world.

In this episode we cover the very heated tail protection debate. The team discusses the challenges with different types of tail protection implementations including:

  • the difficulty in sourcing the right strategy
  • the challenges of different fund structures,
  • whether diversification alone is enough to manage tail risk and,
  • the benefits of tail ensembles.

We also cover the behavioural challenges at all levels of investor sophistication that make it so difficult to stick with tail protection as a strategic long-term allocation, and make a case for the type of investor that might benefit from these approaches.

We hope you enjoy the episode and that you’ll join us to riff live with the team!

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Transcript

Speaker 1:                             00:00:06             Welcome to Gestalt University, hosted by the team of ReSolve Asset Management, where evidence inspires confidence. This podcast will dig deep to uncover investment truths and life hacks you won’t find in the mainstream media. Covering topics that appeal to left-brain robots, right-brain poets, and everyone in-between, all with the goal of helping you reach excellence. Welcome to the journey.

Speaker 2:                             00:00:28             Mike Philbrick, Adam Butler, Rodrigo Gordillo, and Jason Russell are principles of ReSolve Asset Management. Due to industry regulations they will not discuss any of ReSolve’s funds on this podcast. All opinions expressed by the principals are solely their own opinion and do not express the opinion of ReSolve Asset Management. This podcast is for information purposes only and should not be relied upon as a basis for investment decisions. For more information, visit investresolve.com.

Rodrigo Gordillo:                00:00:55             Cheers to Friday night drinks.

Adam Butler:                        00:00:57             Cheers.

Rodrigo Gordillo:                00:00:57             To the-

Adam Butler:                        00:00:57             What’s everyone drinking?

Rodrigo Gordillo:                00:00:59             To the first episode of ReSolve Riffs. What am I drinking? Drink a little rosé, a New Zealand Rosé.

Mike Philbrick:                     00:01:06             Nice.

Rodrigo Gordillo:                00:01:07             How about you?

Mike Philbrick:                     00:01:07             I too will not tell you exactly the brand I’m drinking of brandy because I don’t want to advertise. They haven’t paid for any kind of advertising on our session. So it’s just brandy.

Adam Butler:                        00:01:20             I don’t mind it. I got a local brew, 12 Star Session Ale from Stone City Kingston. It’s yummy.

Rodrigo Gordillo:                00:01:27             Shameless. Shameless. How about you, Jason? What are you drinking?

Jason Russell:                       00:01:30             I’m going to have a West Avenue Cider soon, but right now I have Oakville vodka.

Rodrigo Gordillo:                00:01:34             Oh my God, this is precisely every one of our personalities. We literally picked the alcoholic beverage that matches our personality. Clearly the sophisticated one.

Mike Philbrick:                     00:01:43             Clearly.

Rodrigo Gordillo                 00:01:44             The small town beer drinker Butler. Philbrick, the elder statesman drinking hard oak God knows what type of alcoholic beverage-

Mike Philbrick:                     00:01:57             It’s a cognac.

Rodrigo Gordillo:                00:01:56             Hard like beverage.

Mike Philbrick:                     00:01:57             Trying to get my nitric oxide in me.

Rodrigo Gordillo:                00:01:59             And then the CCO drinking water. Fantastic.

Adam Butler:                        00:02:03             Safety boy.

Rodrigo Gordillo:                00:02:05             Safety boy.

Mike Philbrick:                     00:02:06             I got to fix my hair. Here we go.

Rodrigo Gordillo:                00:02:08             All right. Well, ladies and gentlemen, today we have… we’re trying something out. We’re going to do some live sessions every Friday for a little while. They talk about topics du jour that seem interesting to us and try to bring some of the internal conversations we have with this crew to everybody else and hopefully we’ll have some future visitors that can pipe in and join the conversation either through the chat or we might even bring them in with their video, who knows. It might be-

Adam Butler:                        00:02:32             I like it.

Rodrigo Gordillo:                00:02:32             Might go in many different directions.

Mike Philbrick:                     00:02:34             Really.

Rodrigo Gordillo:                00:02:35             For those of you… Go ahead, Mike.

Mike Philbrick:                     00:02:36             The idea stems from the fact that through history, through hundreds of years of trading markets. Generally those trading in markets took place in either cafes and then evolved to bars and then the after conversations that occurred in those watering holes, once those markets moved to areas where they traded at, whether those be in the pits in Chicago or New York, and what have you, there was a good discussion about how one might approach the problem of investing or speculating or however you want to look at that particular problem, and I think this conversation is a way in the current paradigm of having those conversations with people in remote locations while we’re sequestered I guess.

Rodrigo Gordillo:                00:03:17             Loosening up a bit with liquid courage so we can actually say what we really feel rather than what we want to …

Adam Butler:                        00:03:22             Because we’re also shy.

Mike Philbrick:                     00:03:23             Yeah.

Jason Russell:                       00:03:24             Well, that’s the way it was done.

Rodrigo Gordillo:                00:03:25             I think Mike and Adam are pretty visible on Twitter and a lot of the marketing that we’ve done, but I think Jason, you’ve been in one of our podcasts before, Jason Russell.

Jason Russell:                       00:03:37             Yup.

Rodrigo Gordillo:                00:03:37             Why don’t you just give everybody here in introduction where you came from quickly and then we can-

Jason Russell:                       00:03:37             Sure.

Rodrigo Gordillo:                00:03:42             …move on to the conversation du jour.

Jason Russell:                       00:03:45             Yup. I’ve been in the investment business for about 30 years. I started in the early ’90s in the equity derivatives group at Bankers Trust. Moved from there into the advisory business in Canada. Always very interested in alternatives, portfolio construction, asset allocation, et cetera, and always had a very strong interest in futures and there wasn’t really much in the way of futures managers in the early ’90s, but basically through time, through the advisory side worked my way into starting Acorn Global Investments, which was one of the larger CTAs here in Canada for many years.

                                                                                We’ve worked close with you guys for a long time, and as you guys know a few years ago, it made a whole lot of sense for us to amalgamate and get together and join the group. So that’s a real quick rush through history.

Rodrigo Gordillo:                00:04:30             Awesome. So you know a thing or two about crisis alpha, tail protection and the topic that we want to kind of chat about today.

Jason Russell:                       00:04:38             Crisis alpha, alternatives, tail protection and running a business in this wild and wacky industry of ours.

Adam Butler:                        00:04:46             Yes. Actually it probably would be useful to hear Jason’s story about how his futures fund performed in 2008. Like what was that experience like for people in the trend future space and how does that inform how people interpret or think that they should use trend futures in portfolios?

Jason Russell:                       00:05:06             Yeah, and I think I can compare that to what we’ve just experienced in the last few months as well. In 2008, sort of the shot across the bow first happened in September, August really of 2007. Throughout 2008, the equity markets began to roll over and began to lose momentum, which for a trend investor is optimal. We’ve got time to react, respond, to get positioned and by spring ’08 were certainly quite short equities and were in a great position through the fall. I happened to be working with a large number of equity managers and long short equity managers and the hedge guys, and the strategy performed extremely well through very tough times. It was very gratifying from a strategy perspective and terrifying from a corporate perspective just because all the other funds were going through extreme pressure as was everybody.

                                                                                Many of the other funds were focused on small cap equities and more edgy if you will, equity ideas. In the end basically, that’s what caused me to kind of spin out and hang out my own shingle. But that period, as it compares to this period where we saw strong steady markets all of a sudden drop in a matter of days and weeks. Very different environment for a trend manager. It basically shone light very clearly on what sort of parameter set you might be using when you’re looking back at trend. What is trend, you need to understand generally is can be defined by looking at a time period. Is it short? Is it long? Is it average of a bunch of them. In the end, everyone’s got some exposure to time.

                                                                                A big disparity and results from extremely positive performance to devastating result in 2020. So very, very different. The approach like all others has its time to shine and it’s about putting all that together and today we’re looking at tail risk, which is kind of out on the end of the spectrum, and is it something we should be thinking about and considering, where does it fit in the mix?

Rodrigo Gordillo:                00:07:16             Well, it’s certainly the strategy that has gotten the most fanfare in this period, right? If you see true tail protection strategies in play, then you had a massive win over the last couple of weeks… Well, for a few days, maybe. Maybe a week or so after, and now that’s the big conversation now, right?

Jason Russell:                       00:07:36             Yeah. … was a star in ’08 and then it ran into the toughest long-term challenge in a very long time, so you wonder whether anyone’s going to care about tail protection eight, nine years from now, who knows. Everybody’s going to pour into it for the next year.

Rodrigo Gordillo:                00:07:52             We’ll see.

Adam Butler:                        00:07:53             But it does prompt the question about what is tail protection. How should you define it? How should you define success like a successful strategy X post from the perspective of how well it protected against tail events. There’s different types of tail events that unfold over different horizons, and just speaking of trend, if you simulate… I did this recently, but you sort of simulate a thousand perfectly reasonable diversified long short futures trend strategies and over lookback horizons from sort of one month out to a little over a year, and depending on how you define them or specify them, but half of them had a really nice positive response to the tail event in 2020 and about the other half had very strong negative response.

                                                                                A lot of it has to do with the type of option like profile you’re trying to create with the trend strategy. There’s lots of grist for the mill and how to think trend, the trend impulse as a proxy or trying to imitate different types of option profiles and what that looks like over the short and long-term.

Rodrigo Gordillo:                00:09:05             What’s interesting about that work that you did is that you can also look at a wide variety of public CTAs. Look at how well they did over the last two months and see that same type of dispersion. The topic of tail protection in the way that I think people imagine it, which is this long-term put protection, that’s going to be there. That’s going to cost you money, almost like an insurance premium and then when you need it, the most it is going to be there to really offset losses and more than anything ends up being the S&P, right? Because that’s where you have the most liquidity.

                                                                                The problem with analyzing how well tail protection strategies did, so I’m not talking about CTAs here. I’m talking about the idea of these option based sale protection strategies is that a handful of them have shown public results but it’s very tough to discern who won here, who did well, who blew up, who didn’t get the right parameters right, and even if you want to model it up, doing it with options ends up being very, very difficult, right?

                                                                                It continues to be kind of this obscure strategy where everybody that I talk to likes the idea of it, but very few people like to pull the trigger on it because it happens to be offered by, let’s say, one manager with a unique set of parameters, but they don’t necessarily trust those parameter sets so they need to aggregate a bunch of these to even feel comfortable and it’s not as systematic as the type of people that we talked to like to be, and so it just hard strategy to really wrap your mind around.

Adam Butler:                        00:10:30             And behaviorally to stick to, I mean, you really were at the forefront of trying to get private clients to stick with a strategic allocation to these types of funds around 2008 and after. Actually that story is really interesting. You should share it.

Rodrigo Gordillo:                00:10:47             Yeah. Well, I was always… everybody I think that has listened to our podcast before knows that I had an interesting formative experience in Peru and hyperinflation blow up, money lost by the family and so on that led to a constant paranoia of these tail events and so positioning for myself and my clients into 2008 was very much into CTAs and tail protection strategies like those. As I built up a bigger book, I sourced and found a legitimate like permanent tail protection strategy and it was one of these where you add a one or 2% of your client’s portfolios in these strategies, they’re going to try to put together an options strategy that is going to be as long-lasting as possible but inevitably that one or 2% would need to fade out into nothing.

                                                                                It was a unitized product, right? So I wasn’t buying directly. It wasn’t separately managed accounts. This is across a private wealth book. That fund unit that you bought for clients would eventually go to zero and then you’d have to re-up.

Adam Butler:                        00:11:48             Well, you’d buy a series, right? You buy a series in the fund and over some time period it would decay to zero and then you’d have to re-up.

Rodrigo Gordillo:                00:11:56             And re-up. We did that for a few years, right?

Adam Butler:                        00:12:01             How do clients react to that?

Rodrigo Gordillo:                00:12:02             Well, it was just… At first, everybody bought in. It makes total sense in the long-term, right? If you compare this with your long positions, yes, it’ll hurt but not if you actually look at it as a unit, but the problem is that nobody looks at it, as a unit, right? And so it became untenable. It became an impossible thing to hold for clients without constantly having to be on the phone and reiterating the value of it. And sadly, it just never saw the light of day. It never got the opportunity to shine even though the narrative was it’ll take 10 years before we see this work, but when it works it’ll be there for you, right?

Adam Butler:                        00:12:37             Mike, notwithstanding the economic arguments for, or against a strategy like this. Why is this so difficult for clients to stick with this for the long-term? And I mean, we’ve had a couple of interesting blow ups recently with CalPERS. Pulled their allocation to this type of tail edge strategy just in advance of the recent crisis. One of the pension plans in Alberta, same thing. So it’s not just retail investors that struggle with committing to a long-term allocation here. What are the big bugaboos behaviorly that make this so difficult to stick with?

Mike Philbrick:                     00:13:11             The confirmation of your peer group is a huge part of this. If, as Jason, you alluded to, if people do pile into tail hedge protection strategies, it legitimizes the fact that you’re there with a company. This is indicative, I think, of a complex dynamic system, which we come back to theoretically why if the efficient market hypothesis were to actually be true soup to nuts from zero to a hundred, then there is no need for any tail hedge protection strategy.

                                                                                If we accept that markets are… this is a feature, not a bug, markets, are efficient through some periods of time and then they go through periods of time of sort of these rapid adjustments. How should we deal with those rapid adjustments? And theoretically, if we say, okay, we agree that it’s a feature, not a bug. These rapid price changes will occur and we have to have something in our suite of strategies that deals with that, the next question is how many of our peers accept that as truth and are willing to engage in that, and so behaviorally, you can go through a period of time of 10 or 15 or 20 years as long as the collective memory of the market fades to a point of forgetting and then only the few that were able to have the rigor to withstand the performance drag are the ones who can stick to the process of buying the insurance.

                                                                                There’s a couple of feedback loops there that are really, really tough, right? You’re a particular manager, whether it’s for a retail client or for an institutional client. Your strategy has been a drag on their overall performance and their job depends on that performance and that drag can be a decade long.

Rodrigo Gordillo:                00:15:02             It was also in the face of the popularity of being shortfall for the last three years, right?

Mike Philbrick:                     00:15:08             Yeah. Precisely.

Rodrigo Gordillo:                00:15:09             Immense pressure on the institutional side to take up the shortfall trade. Immense pressure, even on the retail side. Not only are you saying, “Hey, no, that’s a bad idea. I don’t want to get that juicy return.” From a behavioral perspective, you’re also saying, and you’d be better off losing a little bit instead.

Mike Philbrick:                     00:15:26             Precisely, and if your friends aren’t losing, if your peer group is not engaging in that same trade, then the fact that you look dumb or you underperform however you want to talk about that particular instance of underperformance, that’s how you are perceived.

Jason Russell:                       00:15:43             It’s fraught with behavioral challenges and among them also just the complexity of executing on something like this. We’ve all been observing these ideas for a while and start out with puts. You can delta hedge or gamma scalp, however you want to call it. Vol products like VIX and variance futures, dedicated short sellers, credit default swaps, all of these things have varying elements of liquidity. There’s no real consensus as to, yep, this is the way to do it and we’re all trying to find, what’s the least expensive way, which typically is also the least liquid way, and then the other wild card is we’re all looking at things like the S&P 500 and when it bounces back, like it has in the last few weeks, people think, well, what do I need to tail protection for? How would I have timed the exit?

Adam Butler:                        00:16:34             There’s a lot of moving parts. Yeah. Yeah. This is why I love to map this to an insurance metaphor, right? Where-

Mike Philbrick:                     00:16:41             Totally.

Adam Butler:                        00:16:41             …you sort of have… Imagine you live on an island and the island has on average through the centuries, gotten a hurricane once every 20 years and you decide that you’re going to buy a home there and you’re going to buy hurricane insurance and you pay whatever it is, a thousand bucks a month. So 12,000 bucks a year on hurricane insurance, and there’s no hurricanes for five years but you continue to renew your policy. You pay the hurricane insurance. Another five years goes by, there’s a hurricane, right? You’ve given up 12,000 a year in after-tax income while your neighbors are out using that for an extra vacation, they put an addition on the house. They’ve got a nicer car, you’ve paid all this insurance.

                                                                                How long do you continue to pay this insurance while your neighbors are reaping the benefits of the excess cashflow? And there’s only… Like it takes a really safety oriented or long-term oriented person to continue to pay that cost in the face of the month to month and day to day realized disadvantage that’s right in your face. You’ve got a smaller house. You’ve got fewer vacations and you get a less fancy car and you look stupid for decades.

Jason Russell:                       00:17:55             The responsible guy loses and reality is our costs just been our taxes because the taxes are paying off in a lot of cases right now for the risks that the responsible would pay for, who knows. That’s another tangent.

Mike Philbrick                      00:18:10             Two things come to mind on that. One is the thinking about it as insurance and looking at Wimbledon and how Wimbledon has paid for something like 10 or 15 years of insurance for the potential for a COVID issue and actually is collecting a massive benefit from that because they were able to just cancel Wimbledon and they received their payment but they forwent. I think it was $2 million a year was their premium. It’s maybe seven or 17, memory, there’s a seven in there somewhere.

                                                                                Kudos to them for paying for that insurance and incorporating that into the profit margin of the business and thinking about that as a legitimate outcome. Maybe Bill Gates is on their board or something. The other thing that’s so interesting about this, as you describe it, Adam, the hurricane on an island and some islands have mandated that you must pay for insurance. So now we have the hockey helmet issue.

Adam Butler:                        00:19:05             Right.

Mike Philbrick:                     00:19:06             I don’t know if you remember the behavioral stuff.

Adam Butler:                        00:19:08             I do and I love this. Really good analogy.

Mike Philbrick:                     00:19:10             If you ask hockey players, hey, helmets help you. They protect you and the visors and whatnot. Hockey players will say, no, it’s a competitive disadvantage. When I’m on the ice, I have a disadvantage. Unless you legislate the helmet and the visor to equalize the playing field for safety of all, then you will have these uneven competitions where people choose to just forego to have those extra vacations that you talked about, to have that extra lifestyle or whatever the case may be to win some short-term mandates in the institutional framework and so on islands like Grand Cayman, it’s not an option you must pay for your hurricane insurance. It is law, thus all players to make the… bring the analogy full circle. All players must wear visors and helmets, and everybody must figure out how to play competitively within that framework.

Adam Butler:                        00:20:00             Let’s extend that metaphor, Mike. How could you create policy, for example introduce it to a risk, a policy or a pension… What sort of policies could you enforce or introduce to mandate some kind of risk management and force everybody to have to take… pay some kind of cost for this type of insurance in the asset management field.

Mike Philbrick:                     00:20:25             Wow.

Adam Butler:                        00:20:26             Is it worth it? Is there…

Mike Philbrick:                     00:20:29             That is the question, Adam.

Adam Butler:                        00:20:31             You can totally do it.

Mike Philbrick:                     00:20:32             That’s the question. I think you can, but…

Adam Butler:                        00:20:34             I’ll give an example. Like you could, for example, legislate that there’s a penalty or you violate regulations if you take greater than a 20% shortfall on your pension assets in a single month or something like that. I mean, obviously I just threw it out there this obviously requires more thought than just this, but that type of policy and enforcement would force people to think about what the best way to pay for probability weight, that type of outcome.

Mike Philbrick:                     00:21:05             Certainly you’d probably place limits on leverage too, right? Because even when you allow this infinite leverage in portfolios, the market becomes more efficient, but it becomes less stable. I think you’d have to approach it from a full market perspective. There’s an overarching body that decides what the guidelines and limits are on all of these things in order to ensure that the system itself can operate. I think we’ve talked overall. You have a couple points you were trying to get in .

Rodrigo Gordillo:                00:21:32             No, I just think that it’s… The whole idea of insurance, can you guys hear me? Okay.

Adam Butler:                        00:21:36             Yeah.

Rodrigo Gordillo:                00:21:37             The whole idea of insurance is a good analogy because you’re saying you’re paying a little bit in order to get something else, right? But the truth is depending on when this whole tail protection thing started, it was this idea of buying a put option, right? 10% out of the money, 20% out of the money. Like that’s a real cost. It’s not the same as an insurance. When I pay my life insurance or my home insurance, it is a tiny fraction of the cost of what I receive from working stuff.

                                                                                When you look at the cost of varying types of tail protection, they can account for as much as 12% of your annualized rate of return. I think one of the first things that we did back in the day, shows that a naive put option strategy costs that much yearly. What’s difficult about it is that the ones that really do work, the ones that are permanently there, the whole idea of tail protection is that you have to be there, right? You can’t predict it’s going to happen and if you’re not there, you’re not getting paid. Right? Well, those ones are really expensive so you have to get fancy and try to finance them using straddles and strangles and stuff like that.

                                                                                That didn’t sell for the longest time it didn’t sell, right? Because there wasn’t that analogy of insurance didn’t play because it was way more expensive than insurance. Then you get into, okay, maybe we don’t do that permanent thing. Maybe we play more of the dynamic ball game and this is where the narrative shifted to for tail protection strategies, where in that first week of February, March, they didn’t pay, right? Because they weren’t positioned to pay. Only after the weeks… the couple of weeks after when they finally positioned themselves into really benefit from a tail protection push did they actually pay out but there’s no way to have… it’s a small insurance premium without taking some directionality.

                                                                                Even the successful… the ones that have lasted this long for the last five, 10 years have had to take directional bets and not really had a full on tail protection strategy in place and so this is where it becomes complicated to choose a tail protection manager, right? Which one has the right speed by which they’re going to get into the trade and also ones that aren’t going to cost me a lot of money while I wait to get paid.

Adam Butler:                        00:23:45             Well, there’s also the… just to proceed with the insurance analogy. There’s also the deductible, right? You can imagine the further out of the money that your protection kicks in, then the cheaper it is to buy but then the larger the loss you need to take before you get any insurance payout and so you’ve got all these non-linearities. For example, imagine the recent sell-off had only caused the market to drop by 19.9% and you had all these 20% out of the money put buyers.

                                                                                Well, those 20% out of the money put buyers… Well, those 20% of the money puts are a little cheaper than the 10% of the money puts, right? They’re more expensive than the 30% out of the money puts. You paid a lower premium over the years, but also you needed a greater than 20% loss in order for that to kick in. What if it was at greater than 25% or greater than 30%. Now you’ve got way more gamma, the further out of the money you go so the more of a hero you look like if you happen to own puts that were further out of the money, but the probability that the market actually drops that far in a period of time that triggers that payoff is unmeasurable small, right?

                                                                                There’s all these non-linearities combined with the fact that you’re in can be counted on only a few fingers on one hand so that it all ends up being completely random and just completely random luck. How far did the market fall? Over what time horizon? That’s going to dictate that a few guys who happened to be positioned for that exact type of environment won the lottery, everybody else that was hedging different types of tails look like morons and 99.9% of investors can’t differentiate between luck and skill.

Mike Philbrick:                     00:25:33             Well, I think your last comment is bang on. Like the ability to differentiate is really, really tough. I think some of this stems from the point of how do you want to hedge that potential left tail. There are a couple of ways to do that –  one is adaptability. One is building a resilience in the portfolio. Resilience could be built in with the diversity of asset classes the way you access the beta from the various asset classes. Do you incorporate all asset classes? Do you use factors in those asset classes when you build those asset classes? Do you use something like more defensive stocks in order to source that beta and then adaptability, how much would you adapt to the various circumstances in the shorter term? What’s the quickness that you would respond to that?

                                                                                It goes beyond just the put type strategy in a tail hedge protection. I just want to add that color to that discussion because I know you guys were talking more specifically about-

Adam Butler:                        00:26:28             No, it’s a really important point, Mike and it points out something that we sort of threw out in the beginning but never asked you to find. Like what is tail? What tail are we protecting? Right? Is it a weekly-

Rodrigo Gordillo:                00:26:38             That’s a very important point.

Adam Butler:                        00:26:39             Is it a daily tail? Is it weekly frequency tail? Is it monthly? Is it quarterly? And depending on the type of tail you want to protect often need a completely different type of strategy to protect it.

Mike Philbrick:                     00:26:49             Yeah. You can argue it’s certainly five, 10, 15%, 25%, not a tail at all. Let’s just draw it out.

Jason Russell:                       00:26:56             Well, it’s a feature. It’s a feature of market.

Mike Philbrick:                     00:26:59             Do we manage that with diversification? And at what point do we begin to include a tail? And that again, it gets hard.

Rodrigo Gordillo:                00:27:08             That is even important point there.

Jason Russell:                       00:27:11             This becomes behavioral now, right? It becomes behavioral. The influence of what your peers are doing based on what they’re perceiving as what a tail is, which I think is probably a non stationary, a changing perception in the marketplace.

Adam Butler:                        00:27:29             Yeah. You’re only a winner or loser relative to your peer group, right? Nobody in the asset management or very, very few people in the asset management business actually care about absolute results, right? It’s how did my pension fund do relative to my peer pensions? How did my endowment do relative to the other endowments that I mark against? How did my client’s portfolios perform relative to the people that my clients are going to be speaking with at their next cocktail party?

Mike Philbrick:                     00:27:54             Oh yeah.

Adam Butler:                        00:27:54             These are the only things that matter. The absolute results take a far backseat until you get into periods like 2008 or 2000 and 2003, where you actually have a middle class that is genuinely hurting and unable to make ends meet, and people are losing jobs and that’s when the absolute level of wealth losses begin to kick in, but 95% of the time it’s a relative game and the only thing that matters is relative status.

Mike Philbrick:                     00:28:20             And that’s the behavioral aspect that is just really hard.

Rodrigo Gordillo:                00:28:24             It makes it really difficult. This is why, I mean, what Jason said was key, is how much do you want to be different here? There’s been a bunch of S&P plus tail attempts over the years and what they’re coming out with now is like, look, this S&P plus tail outperformed S&P. Yeah but from point A to point B it did, but there were many years where that tail protection strategy not… didn’t underperform by one or two, but it took away five percentage points in a single year, right? It’s not, there’s no alignment. They don’t have the alignment that people think they’re getting. They think they’re getting… it’s going to cost you 1% a year, but sometimes it’s going to cost you five. Sometimes you’re going to get three. That one beat makes it even more difficult to really stick to. You got a question. Why hasn’t there been a massive uptake in these tail protection strategies, plus a portfolio.

                                                                                It’s because maybe, just maybe better diversification does the job, right? Maybe the diversification that a better portfolio construction does a better job from point A to point B, maybe and that’s a discussion that needs to be had.

Mike Philbrick:                     00:29:38             Well, I think both of those are true. You do… They are true until you get a liquidity crisis. A liquidity crisis then creates all kinds of issues for everybody and we saw that, saw whatever… it was mid March, where even the things that should be responding well to the shock were being sold off. I mean, it was a liquidity issue, potentially call that a solvency issue versus a credit issue and so you need the lender of last resort to step in. Now we get into an area of the central bank has to be the lender of last resort, but they have to pretend that they’re not and they have to hold it out to the world that they won’t be till they have to be but they’re not, right. It’s a game of chicken. We’re not, but of course we will be because the system can’t collapse upon itself, but we’re not, but we are, but we’re not. It’s this Princess Bride

Jason Russell:                       00:30:30             As an asset manager, I wonder about including a strategy like this. Like a true tail, is that better left in the hands of the client to decide so you parse this off separately or should asset managers be looking to include tail strategies in their portfolios?

Adam Butler:                        00:30:49             It’s a really good question. There’s two dimensions to that answer that I’ve given quite a bit of thought to, right? One of them is behavioral. If you don’t have a line item on your investment statement that shows that this instrument has gone down for 80 months in a row and you had to continue to re-up. Like eventually investors just get sick of looking at a losing investment over and over again, month after month and that’s the quality of a lot of pure tail hedges, is that they tend to just be constant money losers that you kind of… Actually, most people kind of hope they don’t even end up paying off, right? You hope that you never have to go through a crisis period. You’re just going to continue to pay you this premium. It’s like being in life insurance, you don’t want to die.

Mike Philbrick:                     00:31:33             It’s Wimbledon. Wimbledon never wanted to have the COVID pay off. That’s not-

Adam Butler:                        00:31:38             Right.

Mike Philbrick:                     00:31:38             And if you approach it like that, I think that’s a key to having the framing around the mental allocation that you can withstand the drag.

Adam Butler:                        00:31:48             It helps for sure. I don’t think… I mean, demonstrably it’s not sufficient, right? Because most clients cannot-

Mike Philbrick:                     00:31:53             Yes. En masse.

Adam Butler:                        00:31:54             With good framing they cannot stick with it. Behaviorly, it’s better to have it inside another investment where you can sort of cloak or mask the constant decay.

Mike Philbrick:                     00:32:07             A bunch of Sci-Fi nerds here, just like  …  cloaking here.

Adam Butler:                        00:32:11             That’s right. It’s a cloak of invisibility on the losses that investors just don’t see. Like it’s opaque to them. From the behavioral standpoint, I think it makes a big difference. Also from a financial standpoint, I think it makes a really big difference because if you build tail hedge strategy as a constant capital size sleeve alongside a broader suite of strategies, then what you can do is actually gamma scalp, like you said. You got the sort of constant allocation. You’re maybe short so you’re selling insurance. Some of the time you’re harvesting those premiums. Some of the time you’ve got the opportunity to flip long, but as you take losses on that, you refund it out of the gains from all of the other strategies in the portfolio and when you have a payoff from your insurance bet, that pay off immediately goes back into the other fund so that you’re keeping a constant capital exposure to that strategy and therefore you’re actually able to implement a gamma scalping overlay on a-

Mike Philbrick:                     00:33:21             Don’t giveaway the magic by ….

Adam Butler:                        00:33:22             …diverse basket of strategies, which is obviously how we chosen to implement it.

Rodrigo Gordillo:                00:33:28             We didn’t do that. I mean, maybe we did, but we probably didn’t. We did.

Adam Butler:                        00:33:32             So I’ve been told, you’re right.

Rodrigo Gordillo:                00:33:35             Because you’re dealing with such obscure products, right? When you’re trying to find this from a third party manager, when you want that tail protection, you not only want that payoff, but you also want to be able to capture that payoff at the time that you want to capture it. There is an issue with a lot of these sell protection strategies that are monthly liquidity, where you might’ve said, okay, I need this now but like sorry, we can’t do that. You’re going to have to wait 15 days. It’s just the whole nature of it is complicated. Even when you find good managers, it’s tough to get what you need when you want it to, and so that your point of putting that product together in one makes a lot of sense, because there… I imagine I’m going to do it for you. They can do it internally even at that point, having a monthly liquidity is not a problem but if you’re just having that pure tail protection as a separate stand-alone, it could be complicated, right? It could create issues. You’ll never get paid off.

Adam Butler:                        00:34:24             You’re so right but what’s the flip side. The flip side of that is that now you’ve got a multi scratched strategy that’s got a sleeve of the portfolio that may be sucking returns for a decade at a time.

Rodrigo Gordillo::               00:34:39             Which goes to my point of like, not only sucking returns but you might have a year where it took away 10%, maybe over the full 10 year period, it’s net neutral but for that one year, it took away 10% returns and then when you have to explain why…

Mike Philbrick:                     00:34:52             Yeah. Tracking error is huge.

Rodrigo Gordillo::               00:34:53             You’re done.

Mike Philbrick:                     00:34:54             Yup.

Rodrigo Gordillo:                00:34:54             It’s a big issue.

Mike Philbrick:                     00:34:56             I would add the behavioral side of that is if you’re selling to a group where you’re suggesting that you’re going to take their job is another challenge in that particular issue, right? If now you’re saying to a sophisticated institutional endowment board that you’re going to do that and they have several people whose job is specifically to allocate to different strategies and structures and reallocate to them at opportune times to your point Rod, which doesn’t quite allow them to take advantage of that because it’s a month end type thing rather than a moment type issue and I think this is really important because the discipline that that can bring has tremendous value.

                                                                                If you think about… except this is my premise that financial crisis are sort of like earthquakes. They’re very hard to predict when they occur. Their occurrence is a prelude to other occurrences. Okay, but also if the occurrence happens and more time passes, it’s less and less likely that you get another occurrence. For an earthquake, as an example, you have a major tectonic event. The chances of having another event the next day are very high. They’re like 50%, but 10 days later, they drop to 10%.

                                                                                To your point, if you think about… it’s not exactly how they work in financial markets, but take that timeline and walk it forward in a… A financial event happens. There’s a crisis moment. There’s an opportunity to own longer term positive risk premium assets, which may recover by month end and you only have this monthly fractal from which you can view that particular opportunity. There’s lots there that just prevents the market from acting as a really-

Adam Butler:                        00:36:41             Yeah, you live on a hurricane. Not a hurricane belt. What is it? You live on a fault line but you can only evacuate your home once a month.

Mike Philbrick:                     00:36:50             Right. Precisely.

Adam Butler:                        00:36:52             That’s the analog, right? If it happens intra-monthyou’re kind of screwed.

Mike Philbrick:                     00:36:58             Yup and this is the other thing, I think the hurt that fault line references, you only know who’s house was built up to specs, like earthquake specs after the earthquake. When you look around the neighborhood and you see five houses on the ground and the two houses that are standing, then you know and this is the challenge with allocators and investors and those financial intermediaries that are charged with allocating assets that they’re going to forego returns in the short-term. They’re going to have less returns over a 10 year period, but they’re going to say, listen, your house is earthquake proof and the person’s going to say, but we haven’t had an earthquake. Then the earthquake happens-

Adam Butler:                        00:37:41             And by the way, your bonus is linked to the four year moving average of your average alpha. If you don’t have an event in that four years, then you’re foregoing compensation. There’s a massive misalignment of incentives.

Mike Philbrick:                     00:37:56             It comes back to one of our core values that we would like to have some sort of connection between the realized risk adjusted returns for our clients like that… and so we want to think about making sure that you’re there for the returns as they occur and I think there’s where there’s another gap or a convergence of how that kind of manifests in portfolios in real time.

Rodrigo Gordillo:                00:38:20             I mean, the debate is really… Let’s look at the AQR /Nassim Taleb debate that’s raging right now. Let’s put aside the pettiness of the actual Twitter discussion, but it is… One is arguing for the amazingness of tail protection. The other side is saying, it’s good, but by the way, diversification is really solid and it may possibly be better versus a naive approach. Which one of those two approaches is… Is one better than the other? Is there a right or wrong, or is it all personality based? Right?

Adam Butler:                        00:38:51             Well, one of them, at least you can kind of sort of wrap your arms around, right? I mean, we all need to acknowledge that even if we’ve got 40 years of data, maybe that only really captures a handful of different regimes. Maybe 40 years is really an N of five in terms of market state. I’m just throwing numbers around, but at least you’ve kind of got… it’s probably not five. It’s probably, I don’t know, there’s 10 or 15 or something. Right? The thing about tail events, like all these tail managers with the thousand percent return plus in March, these guys… there were other mechanisms to deliver better average returns and better average results and better average diversification for portfolios even during other tail periods, unless you go all the way back to 1987.

                                                                                Like literally 2000 to 2003, ’90 to ’91, the long-term capital management, Thai baht Asian crisis, Russian default in ’98, all of those things were very well managed through some combination of diversification or trend or other types of strategies that have long-term positive expectancy. Really the only strategies… Sorry. The only periods that were not well managed by those other types of approaches was October, 1987 and the recent crisis and keep in mind, the recent crisis played out twice as fast as 1987.

Jason Russell:                       00:40:30             Yeah. It’s velocity. Like a lot of tail events here.

Adam Butler:                        00:40:34             Exactly.

Jason Russell:                       00:40:35             The velocity is really, really key and that’s something that’s similar in ’87 and similar in just in the last couple of months. If the same depth was reached over, even just double the number of days, I think you’d see a dramatically lower bump here.

Adam Butler:                        00:40:50             No, Jason it would completely-

Jason Russell:                       00:40:50             Back to the original question. Yeah.

Adam Butler:                        00:40:51             It would completely reorder the winners. The guys that won this time would have looked like morons and a whole other group of people would have looked like heroes and it would have been purely due to randomness.

Rodrigo Gordillo:                00:41:04             Well, who’s saying that it’s a CTA or a tail protection strategy. I honestly think that there is… I think you need to have a certain type of personality. You, Adam need to wrap your mind around that stuff. You need to have all these data points you need to… I understand tail. I understand the benefit of having a lot of positive convexity when I need it in a way that CTAs that were midterm to long-term just didn’t have and we all knew wouldn’t have in a big correction like this. They would eventually adjust. I honestly think that there is a place for this for a lot of peoples’ portfolio, just not everybody’s portfolio and I’m one of the guys that likes to have that near certainty, although there’s… we can tie up a discussion about what tail we’re trying to protect against, right.

                                                                                We’re talking about the S&P here, but there’s a lot of tails that we need to think about as well, right? It could be bond, tail risk and all that stuff but from the perspective of, is it valuable? It’s insanely valuable for certain people that can take a medium turn hit.

Adam Butler:                        00:42:02             How do you even create a strategy? You could absolutely create a tail head strategy that protects against a very specific type of tail. You can even have a basket and ensemble of tailored strategies, but the ensemble will still only protect against a certain shape of tail, a certain magnitude of loss in a specific market or group of markets over a very specific time horizon. It’s just a shape.

Rodrigo Gordillo:                00:42:29             Why do you say that?

Adam Butler:                        00:42:31             Well, you can’t hedge against every risk. How do you hedge every risk? Like demonstrably delivers no returns over the long-term?

Mike Philbrick:                     00:42:38             Well, it probably has a significant cost actually.

Rodrigo Gordillo:                00:42:40             I see. I was thinking about the S&P 500 collapsing. You create an ensemble of managers that can actually… will have different parameters and will respond faster, slower, deal with this different convexities and provide value on average for that particular S&P 500 event. Which I think has merit, the whole idea of the equity markets.

Adam Butler:                        00:43:00             But what you’re missing is that there’s a shape to that. Whatever the hedge ensemble you’ve created has its own shape. It is an optimal event that will work for that specific hedge portfolio and if it’s not that specific shape of event then you’ll have paid a lot of premium for-

Rodrigo Gordillo:                00:43:21             That applies to absolutely everything that you do for the rest of your portfolio, right?

Adam Butler:                        00:43:22             …not getting the insurance one.

Rodrigo Gordillo:                00:43:22             It doesn’t mean that you shouldn’t try it.

Adam Butler:                        00:43:25             Except that most of them have positive expectancy whereas tail head definitionally, the closer you get to shorter term hedge, the closer you get to approximating a long put strategy, the closer you get to negative expectancy, short-term trend, like ultra short-term trend demonstrably has negative expectancy, but-

Rodrigo Gordillo:                00:43:48             Killed it in March.

Adam Butler:                        00:43:49             …it did great in March after like 10 years of negative return.

Mike Philbrick:                     00:43:53             This is the craftsmanship that also understands social influence of what is the market of choice today in the current zeitgeist and that social influence is that what are portfolio managers most concerned about? And I’ll just… I’ll turn it over to you, Rod and you can take it from there.

Rodrigo Gordillo:                00:44:11             Okay. The social aspect is whether you can withstand being different from your neighbors, right? I think I had this conversation with [Christian … over drinks from ex teachers I think we have on the podcast. We did have on the podcast and our conclusion was the same. If you want to use tail protection strategies that you can count on, you’re going to have to take a return hit, but you won’t suffer from those big gaps that you see when equity markets collapse. The thing about equity markets collapsing that’s unique is that it tends to coincide with economic markets collapsing. It tends to coincide with liquidity across everything drying up. It’s a good proxy to want to tail hedge against, right?

                                                                                As we were facing the abyss during this particular period, there were nights where we were like, oh my God, shit, are we going to wake up tomorrow? It’s going to be 30% down.

Mike Philbrick:                     00:45:01             It was the market closures too, the potential …

Rodrigo Gordillo:                00:45:03             Yeah. It was like the only thing that will protect… If it’s a liquidity event, it doesn’t matter whether you hold bonds or gold or stocks. If it’s a liquidity event, the only thing that’s going to be there are these pre-set tail protections have strategies, right?

Adam Butler:                        00:45:18             Really. So your put strategy on the S&P and yes, futures are closed over ops and expiration. What’s your payoff?

Mike Philbrick:                     00:45:26             Yep. Great point.

Rodrigo Gordillo:                00:45:27             Well, that is a very specific type of event. I’m talking about the most likelihood which we’ve seen over and over again in these type of periods.

Adam Butler:                        00:45:35             So now we’re talking about probabilities. We’re talking about the probabilities of tail events.

Mike Philbrick:                     00:45:39             Well, we’re talking about the craftsmanship of social influence-

Rodrigo Gordillo:                00:45:41             We’re not. Do not even go there.

Mike Philbrick:                     00:45:43             …and what people care about, but I think you have to take all of these issues into consideration.

Rodrigo Gordillo:                00:45:48             That’s a very personal thing.

Adam Butler:                        00:45:49             The worst possible outcome is you paid all this insurance and you actually don’t pay off.

Mike Philbrick:                     00:45:54             Correct? I don’t think either one of you are wrong. I think you’re both… You’re both right.

Jason Russell:                       00:45:58             Beyond tail risk we’ve all heard this before. Well, if that goes, we’re all screwed. There’s a point where things bend and they break and we-

Rodrigo Gordillo:                00:46:07             Arguments you mean. Specific arguments.

Jason Russell:                       00:46:10             Everything. When something breaks then it’s like, ugh, can’t hedge against that anyways and you can argue tails up close to that and look at what happened to the futures market in the last few weeks, going negative in crude and I recall from 2008 counterparties blowing up all over the place, like massive high quality counterparties, the rating agencies, AAA meant nothing. It was a whole bunch of that risk that gets introduced at a time when you’re expecting the tail to pay off. I think understanding where the tail is is important and where is that other point beyond tail where we’re all screwed anyways happens? I think… I don’t know the answer ….

Mike Philbrick:                     00:46:51             I would posit that’s where central banks come in to be the lender of last resort and provide the liquidity.

Jason Russell:                       00:46:56             They’re in way before that.

Mike Philbrick:                     00:46:58             This is really an interesting question because they are timing their influence in order that they’re not perceived to have been there, but their job is to prevent total financial collapse. It’s kind of in their mandate to be that lender of last resort and I think that’s what they learned in that 29 episode, letting depositers and banks go bankrupt and those bank depositers weren’t really risk takers and so they have been emboldened obviously by the process of long-term capital management, or in 1987, leading into long-term capital management, leading into the 2008 crisis, leading into the current crisis. I think they’ve been emboldened more and more to take earlier and more extreme action and that’s just a function of the market getting used to that. Whether that’s right or wrong I don’t know, but I think-

Adam Butler:                        00:47:47             Oh no, the next time we look at crisis in the teeth, markets are going to rally massively in anticipation of overreaction by central banks. This is the new tail. The new tail is a spike higher.

Jason Russell:                       00:47:59             Is that what’s happening now?

Rodrigo Gordillo:                00:48:01             Possibly. You’re talking to a particular personality that has seen massive blow up in his personal life that I will always be willing to give up the upside any given year to make sure that if the market doesn’t just drop 20 in a single day, but drops 80, because that’s who I am. I want something to be there that has the possibility of paying out that nothing else can be. Because it’ll be a liquidity event.

Adam Butler:                        00:48:27             And I think a lot of clients would agree with you, but what we’ve observed is that people agree in theory as the conversation occurs in the beginning and as months go by and you get months after months after months of losses, that argument people feel that they hate this line item. They feel it and therefore they’re looking for any excuse to sell it and you end up fighting an uphill battle.

Rodrigo Gordillo:                00:48:58             Can I be honest? I don’t think I… and you guys, because you guys were part of it for a bit. I don’t think you and I did a good enough job at educating and I think a lot of what we’ve done with our followers, our client base with the books is we’ve educated them to do better and care less about the S&P. I mean, nobody that deals with us that’s been successful cares about what the S&P does in any given day. We did that through education and I just don’t think you’ve had enough of an… I think you used to make more of an effort in order to… if you’re going to do a tail protection strategy, to make sure that the clients that you’re attracting stick to it, by making sure that we’re constantly pounding the table on the reasons that you signed up for it and understanding also the downsides, right?

                                                                                Understanding that you will not have a better return necessarily over long periods of time as you would if you didn’t have the tail protection in place.

Adam Butler:                        00:49:50             Yes, it’s a fair point.

Rodrigo Gordillo:                00:49:51             We can do education.

Mike Philbrick:                     00:49:52             This is the challenge, Rod. This is totally 100% the trade off. You go through 10 years and you have your 10 year track record that underperforms your peer group by one and a half to 2% based on your tail protection strategy and the next gap in the performance reporting is not 11 years, it’s 15 and so the last crisis happened 15 years ago where you can show the payoff but if it didn’t, if it happened between year 10 and 15, there is no indication that you have any expertise in this field. I do agree that is an educational thing and the whole concept of tail protection comes back to a… you have to go back to first principles and think about it from a theoretical perspective so that you can come to a conclusion of belief and that conclusion of belief has to be higher than the potential reality checks along the way, which are going to question your ability to stick with the program.

                                                                                This is where the rubber meets the road. This is where it’s really tough. It’s a lot of behavior.

Rodrigo Gordillo:                00:50:56             There’s going to be a lot of people willing… and there’s going to be a lot of converts.

Adam Butler:                        00:51:00             Just like everybody flocked into trends-

Rodrigo Gordillo:                00:51:01             Good question.

Adam Butler:                        00:51:02             …strategies in 2009. I agree. Where is the Man AHL fund here in Canada now?

Rodrigo Gordillo:                00:51:07             The question is… Oh you didn’t. That served me really well. I know wait by the by.

Mike Philbrick:                     00:51:12             Just because you bought it after doesn’t mean… Listen, you and the other four people that were in it, Rod, like you and those four guys did great.

Rodrigo Gordillo:                00:51:20             Okay.

Adam Butler:                        00:51:21             It’s the same thing for the strategy with the tail protection fund, you’re going to look really smart once every 10 or 12 years. Unfortunately when the tail hits, you’ve got no assets because you’ve underperformed your benchmark by two and a half percent a year for 10 years.

Rodrigo Gordillo:                00:51:34             This provides an opportunity… Look, the world has changed a ton over the last 10 years, right? Look at what we’re doing right now. We’re evolved.

Mike Philbrick:                     00:51:41             10 days are gone.

Rodrigo Gordillo:                00:51:42             We’ve gone from written podcasts, to books, to audio, now video, right? We’re going to invite people in. People are empowered to learn more. I have a tendency to look at the bright side to see that there is actually better than what we’ve seen in the past from clients, from investors, from just human beings generally. We’re a better educator than we’ve ever been before. Everybody’s jumping on the tail protection bandwagon right now and a lot of the rhetoric is yeah, but nobody will stick to it. Right? We started with this conversation in the beginning of this podcast.

                                                                                I believe that we’re better equipped now than ever. Though, for those who jumped in the bandwagon to keep as many of those people in the bandwagon long-term, if indeed suits them for their long-term benefits. I have to and I strongly believe.

Mike Philbrick:                     00:52:27             Just to be understanding of a complex adaptive system. The more people that jump on this, the less effective-

Adam Butler:                        00:52:27             The less effective.

Mike Philbrick:                     00:52:27             …it’s going to be.

Rodrigo Gordillo:                00:52:38             The more costly it’s going to be actually.

Mike Philbrick:                     00:52:38             Cost can actually shrink, but the less effective it would actually be because there is a whole bunch of buying at some point in the market to cover off those pseudo shorts that happen so corrections become… it’s a self reinforcing cycle until it’s not.

Rodrigo Gordillo:                00:52:52             Oh, don’t get me wrong. I’m not going to buy tail protection until 10 years.

Jason Russell:                       00:52:56             It’s beyond tail. I think just thinking about like just risk management period has a big cost. Even just asset allocation. Forget tail at all.

Adam Butler:                        00:53:05             Very good point.

Jason Russell:                       00:53:07             Even with a 15 or a 12% drawdown, anyone who’s trying to manage risk by allocating to bonds saved investors in the heart… in the teeth of this, they’ve saved them some real money and lost them that in the recovery sometimes, but that’s all looked at in a short term lens and a lot of people obviously with recency bias, that’s where they live. Looking at the last three months or in this case three months can make a one year number look dramatically different.

Adam Butler:                        00:53:39             Or a 10 year, in the case of the real tail, your tail hedge guys.

Jason Russell:                       00:53:43             A lot of tactical managers right now are underperforming the S&P over the last month.

Adam Butler:                        00:53:47             Actually, this is a really good point because what is a tail for a tactical manager?

Jason Russell:                       00:53:50             Who the hell is right? I actually think it’s not the worst idea to be underperforming right now guys, like if there’s another leg down, which there may very well be, you’re in a much better place now. Hey, the first immediate snap hurt, that’s not a typical depth tail event. That was a velocity event if you want to call it. It’s a risk management.

Rodrigo Gordilo::                00:54:09             We’re in that 66% Fibonacci level. We’re hittin’ it boys.

Adam Butler:                        00:54:16             It’s a really good point though, Jason, on what is a tail event for different types of managers. Obviously for managers who are mostly… the risk budget is mostly equity beta then the tail event is a major drop, like a short-term drop in equity beta, but for a tactical manager or managers of Vol size, for example, the big tail of end for those managers has been the V-shaped recovery that we currently experienced. Right? Lots of strategies that use trend or vol size had very, very little exposure come mid-March. That second sort of 15% drawdown in stocks, trend-followers didn’t experience. Risk parity didn’t experience but 60, 40 experienced, but now those strategies are positioned… They’ve got a very high bond position. They’ve got a low equity beta and you’ve got a V-shaped recovery.

                                                                                The tail in mid-March for a lot of strategies was to the upside. Different strategies need to think about hedging different types of tail risks and those tail risks are highly conditional.

Rodrigo Gordillo:                00:55:32             Yeah and look, to be fair when I speak to prospective clients and I tell them about the fact that we try to minimize tail by being diversified both in asset allocation and strategies and so on. I do say like if you’re the type of guy that can’t handle X amount of loss, that tends to be directional in nature, equity markets losing money, then you might want to consider adding a tail protection strategy on top of this and explain to them they’re going to probably lose a little bit of the benefit that they would get, the return that they would get from being… just focusing on diversification, taking your lumps. Right? Like a lot of tactical managers took a hit, but they didn’t take the last hit. Right? But they also didn’t recover from here.

                                                                                That last hit, I’ve explained that to clients and they’re like, oh yeah, I can take the first leg as long as the second and third leg doesn’t happen and that’s kind of what tactical managers then for the most part, right? The problem is that we haven’t seen a second or third leg happen for 10 years and so it’s a difficult pill to swallow, but the choice is clear. I would say 90% of them didn’t take my advice. They’ve taken a tabletop strategy. The other 90% just said, look, I want the long-term returns and I’m okay with taking that first hit. That insurance, what do you call it? Not the premium, but the-

Adam Butler:                        00:55:32             The deductible.

Rodrigo Gordillo:                00:56:38             Deductible. Yeah.

Adam Butler:                        00:56:40             Yeah. There’s been a lot of deductible payments and very little insurance payouts over the last 12 years.

Rodrigo Gordillo:                00:56:46             Yeah, exactly right. Yeah. There’s been a lot of deductibles we embed.

Mike Philbrick:                     00:56:49             The thoughtful practitioner would sort of understand the bifurcation of thought here which is, one is that there’s an equity risk premium and that’s going to be manifest in the long-term and if you’re in a taxable account, you might want to take some of your money and just put it there and forget about it and have a sleeve of that in your portfolio and then you’re going to want to have a sleeve of your portfolio that does these other things. In various ways covers off the ability to adapt, ability to be resilient. Sort of covers off these other angles and that way you’re kind of covered by both.

                                                                                You’ve got some sort of low cost factor exposure. One of those factors, beta. One of those factors can be value, can be a capsize or whatever. However, you want to look at that and you’re just going to hold those for through outside these power law events, understanding that that’s a feature, not a bug and you’re going to have another portion of the portfolio, call it whatever it is, half a quarter, two thirds, whatever your risk parameter is that adapts, that uses all the various potential ways that you might think about the tail protection, but then it has to also rebalance so that between the two, there’s actually an extra little bit of advantage that comes from that longer term.

                                                                                It doesn’t quite manifest the way people think it does. I think they probably think that that tailwind is probably bigger than it is, but I think a thoughtful practitioner at all levels of financial intermediary would want to think about it in that way from an applicability perspective. I don’t know what you guys’ thoughts on that are.

Adam Butler:                        00:58:31             Yeah. I guess it’s what are the relative and absolute risks that the client is concerned about, right? Are they concerned about underperforming their local market, the global stock market, a 60, 40. Are they concerned about absolute losses versus absolute gains? And I think what we learned… I mean, we have the benefit of having been advisors and asset managers and I think one thing we learned is that client preference has changed through time, right? The way that the focal point of investor anxiety when markets are ripping is on under-performance. The focal point for investor anxiety when markets are dropping is on loss of wealth.

                                                                                Really if you were to ask most clients, what do you want? Well, I want a strategy that outperforms on the upside and doesn’t take losses. That’s the holy grail, right? And if you don’t deliver that as an asset manager and advisor, then you’re disappointing, right? Whether they vocalize it or not, you’re disappointing clients and so much of the effort we have made from an educational standpoint is to try to highlight, shine a bright light on the fact that you can’t suck and blow at the same time, right? How can you balance it out the best?

Mike Philbrick:                     00:59:40             And you have to explicitly recognize that someone in Houston, Texas may have a different set of preferences than someone in California.

Adam Butler:                        00:59:48             Yeah.

Mike Philbrick:                     00:59:49             And that is a real consideration behaviorly in the whole portfolio construction process.

Adam Butler:                        00:59:55             Yeah.

Rodrigo Gordillo:                00:59:56             All right. Well, we’ve been at it for just over an hour now, guys. I think we’ve covered a lot of aspects of this topic. Anything that we missed, that you guys want to touch upon?

Adam Butler:                        01:00:03             There’s lots of directions we could go, but I think we’re better to cap it and save it for next time.

Rodrigo Gordillo:                01:00:08             We might think about bringing in a tail protection practitioner and see if he can defend himself.

Adam Butler:                        01:00:12             There’s nothing to defend. I mean, I’m not sure where the bones of contention are, right? I mean…

Rodrigo Gordillo:                01:00:16             Yeah.

Adam Butler:                        01:00:18             Yeah. It may have a place-

Rodrigo Gordillo:                01:00:20             There’s room for everybody.

Adam Butler:                        01:00:21             What boogeyman are you trying to defend against?

Rodrigo Gordillo:                01:00:24             Amen.

Adam Butler:                        01:00:25             And I’m not sure you’re willing-

Rodrigo Gordillo:                01:00:26             It’s great.

Adam Butler:                        01:00:25             …to pay for protection.

Rodrigo Gordillo:                01:00:26             All right. Excellent.

Mike Philbrick:                     01:00:27             All right. Well, we’ll end up having another two hour conversation after this and then I am going to-

Adam Butler:                        01:00:33             I’m craving another beer.

Mike Philbrick:                     01:00:34             We’ll totally have that.

Rodrigo Gordillo:                01:00:38             Yeah, there we go.

Mike Philbrick:                     01:00:39             Another two hours ago. I never left the bar till five o’clock.

Rodrigo Gordillo:                01:00:42             Guys, I hung up now. I’ve hung up.

Mike Philbrick:                     01:00:45             Let’s actually say what we feel.

Rodrigo Gordillo:                01:00:49             Alright, awesome. Thanks guys. Nice first session. Hopefully we’ll try a few of these. Hopefully bring some people on board and we hope you enjoy it. Give us some feedback if you did, and just keep it yourself if you don’t.

Mike Philbrick:                     01:01:01             All right.

Mike Philbrick:                     01:01:02             Perfect.

Adam Butler:                        01:01:03             Thanks guys, have a great weekend.

Jason Russell:             01:01:07               Thanks, see you.

Speaker 1:                             01:01:08             Thank you for listening to the Gestalt University podcast. You will find all the information we highlighted in this episode in the show notes at investresolve.com/blog. You can also learn more about ReSolve’s approach to investing by going to our website and research blog at investresolve.com, where you will find over 200 articles that cover a wide array of important topics in the area of investing.

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