ReSolve Riffs with Options Ninjas Benn Eifert and Scott Maidel from QVR Advisors
Whether stemming from a recession, a policy shock, a terrorist attack, or a global pandemic, financial markets periodically go through major selloffs. It has always been this way. Euphoria eventually leads to panic, every time. Another way to look at these crashes is through the lens of volatility (and its commensurate rise), which has become a fundamental component of investment decisions. As time goes by, innovations can (and will) suppress volatility and can sometimes give the impression that risk has been eliminated, but that is always a fool’s dream. Eventually the piper must be paid.
Our guests this week were Benn Eifert (Founder & CIO) and Scott Maidel (Head of Business Development), of QVR Advisors, a boutique asset manager that specializes in strategies seeking to profit from volatility and all its downstream effects – including attempts to suppress it. We covered:
- How markets fundamentally changed following the Great Financial Crisis
- Call overwriting – the favorite strategy of yield-thirsty institutions
- Why ‘selling vol’ is too broad a term and has all but lost its meaning
- Everybody wants protection – reflexivity and the options tail that wags the equity dog
- The behemoth equity hedged strategy that now moves the market at the end of every quarter
- “Gradually, then suddenly” – the nature of volatility
- Gamma & Vanna – the second-order ‘Greeks’ and their outsized influence in short-term moves
- Execution is key – don’t trade against the Flash Boys
- Buying what you don’t want to build
- Systematic vs Quant
Benn and Scott also described in detail QVR’s two main lines of business – absolute return and tailored solutions – providing insight into their processes and competitive advantages. We also discussed the distinct nature of different market crashes, trade monetization, rebalancing, and much more. It was a fascinating conversation and a true lesson on the current structure of equity markets.
Thank you for watching and listening. See you next week.
This is “ReSolve’s Riffs” – live on YouTube every Friday afternoon to debate the most relevant investment topics of the day, hosted by Adam Butler, Mike Philbrick and Rodrigo Gordillo of ReSolve Global* and Richard Laterman of ReSolve Asset Management.
Founder & CIO, QVR Advisors
Benn Eifert is the managing member and CIO of QVR. He was previously co-founder and co-portfolio manager of Mariner Coria in New York. Before that he was Head of Quantitative Research and Derivatives Trader for the Wells Fargo proprietary trading desk, which became Overland Advisors. He has taught extensively in the Masters in Financial Engineering program in the Haas School of Business at UC Berkeley, and started his career as an emerging markets macroeconomist at the World Bank. He holds a PhD in Economics from UC Berkeley and BA in Economics and International Relations from Stanford.
Head of Business Development, QVR Advisors
Scott joined QVR from Gladius Capital Management where he was most recently a Director of Institutional Solutions. He was previously Senior Portfolio Manager, Equity Derivatives at Russell Investments and Associate Director, Global Trading and Trade Research at First Quadrant. Scott has over 15 years of trading and portfolio management experience with global derivatives. Scott holds a B.Sc. in Investments and Financial Markets from the University of Southern California, an MBA from Pepperdine University and is a Harvard Business School alumni of the Program for Leadership Development (PLD). Scott is a CFA charter holder and Financial Risk Manager (FRM) certified.
Corey:00:01:09The stiffest coffee I can find.
Rodrigo:00:01:12Yeah, you guys suck.
Benn:00:01:13I got my got my … here
Rodrigo:00:01:15… drinking, that’s all right.
Rodrigo:00:01:19Corey’s got an excuse. He’s got a big drinking night ahead of him with what is it? Celtic Soccer Gala.
Corey:00:01:26Gaelic Football Gala.
Rodrigo:00:01:30Yeah, that’s kind of the same.
Corey:00:01:32Which is sort of Celtic soccer. … and pick up on the bike which doesn’t go that well after a large number of beverages.
Rodrigo:00:01:41Yeah, don’t drink and bike. Before we get started though, I just want to do the quick disclaimer and remind everybody that this is purely for educational entertainment purposes only. This is not investment advice. Do not take advice from four dudes, at least two of the four dudes that are drinking here on a Friday night. But hopefully everybody gets something out of it that doesn’t get them into trouble, especially in the space that we’re going to be talking about today.
So why don’t we get started? Benn Scott, thank you so much for joining Resolve. Corey, thanks for pinch hitting. Adam had to bow out last minute, so I really appreciate your help on this. I know that this is an area that you’ve been interested in for a while. Corey had a couple of great episodes with Benn in his podcast Flirting With Models. So if anybody wants to kind of fill up their understanding what Benn and his team does, you can go visit his website and listen to those podcasts. But why don’t we get started with Benn and Scott, why don’t you guys tell us a little bit about your background. You guys run Quantitative Volatility Research Advisors, QVR Advisors. Maybe give us a little bit of background and a little bit about the firm.
Scott:00:02:53Go ahead Benn.
Benn:00:02:54Yeah, my name is Benn, I’ve been in the markets for a long time. I worked on Wells Fargo prop, did a couple other things. In the meantime, I have a PhD in Econ. QVR we started in 2017 out in San Francisco and it’s been a fun ride. We do, where I think of us as a boutique asset management firm focused on derivatives and options strategies. About half of the business is things you would think of as absolute return hedge fund strategies and the other half of the firm, bespoke institutional solutions focused on overlays and hedging and things of that nature.
Scott:00:03:40And hello everyone, my name is Scott Maidel, head of business development at QVR Advisors. Started my trading career for about 15 years back at First Quadrant in the mid-2000s. Spent quite a long time at Russell Investments, was at some places short, briefly before and after that, and transitioned over to the business development side for QVR Advisors recently, back in 2020.
Rodrigo:00:04:09Beautiful. Corey everybody knows you.
Corey:00:04:12Yeah, I don’t have to give an intro.
Rodrigo:00:04:15You’re good, but you know what? Before I start, Mike’s going to kill me if I don’t do this. Make sure everybody here if you’re like the content, please hit the Like button, share, comment. We’re live so we’ll be taking questions as we go through the podcast. Really appreciate it if you like the content, do what you can. Alright, Corey I think we discussed some interesting topics to start with.
Corey:00:04:36Yeah, I actually hit before we went live here back in the digital green room, I hit pause on one conversation because it’s where I wanted to start. I was personally professing the pain that I felt going into quarter ends in my portfolio and how that always seems to be just the luck of a draw going into quarter end. But we started talking about yesterday in particular Benn, this one trade that I feel like has been well known, starting to light up a lot of Twitter discussion, which is the quarterly rebalance of the JPMorgan Hedged Equity Fund. And I wanted to get some color from you as the (A) for those who don’t know what is this fund? What is it doing? And then (B), why has this become such a well discussed, well known trade? And what opportunities is it creating in the market?
The Quarterly Rebalance at JP Morgan
Benn:00:05:26Sure, the fund is a hedged equity fund and what they mean by that is lots of little details, but basically it’s equity index beta, passive equity index beta, with a put spread collar overlay. So a put spread collar is a popular type of hedge or anyway type of option overlay for an equity portfolio where let’s say I own some equities, I might sell a call, collect some premium for that and use that premium to go buy a put spread that gives me some protection against the market falling. That option structure together is going to have some short exposure to the market. So that’s going to lower the overall beta of my equity portfolio from one to, depends on whether it was maybe 60, or maybe 50. Depends on the strikes and so forth.
Initially, when I when I set up that hedge, and then in this case we’re just going to hold that put spread collar to expiration. We’re going to enter into a new one and it’s going to alter the shape of my, or their equity risk return distribution, they’re going to have capped upside. If the equity market rallies a ton, they’re going to give up some of that upside because they’re short the call. If the equity market sells off enough they’ll benefit at least to some extent from that put spread. And really, the only reason why anybody cares about this is just because the fund has been well marketed and has been popular and is now really big. So it’s I think $18 billion or so notional fund. And like a lot of these overlay style products, the end user here is typically high net worth individuals, ordinary individuals, RIAs. Simplicity is a focus of these kind of products. They’re not trying to do really complicated stuff and have lots of positions. They just want to be able to explain it to you really easily and so at any one time, there is just this equity exposure and this big put spread collar, and it’s a very large position in terms of the size of the options and that put spread collar, and then once a quarter that has to be rolled, and the size of that transaction to roll that put spread collar from an options market perspective, is extremely large.
And what happens when that trade is rolled really depends, and what kind of market impact it has, really depends on what the path of the market has been. So let’s take the example of this last week. The upside call strike, I think was 4430 on the structure that was in that fund. the S&P was below 4430 coming into expiration, but not sufficiently far below, I think the foot strikes, I forget exactly what the foot strikes were, but they were always down. So the whole structure is just out of the money and worthless. And so in the role of this trade, JP Morgan is going to have to go to their brokers and say, okay, we want to quote a new structure and this new structure by the way, it’s like a 50 delta or a 60 delta collar.
So it’s a sale of $11 billion of market exposure to go and do that. And that’s a lot of equity exposure, it’s not necessarily a lot of equity exposure to enter into over the course of a month or over the course of a week or something. But it’s a whole lot of equity exposure to enter into just on a trade where you call up your brokers and you say, Hi, I’d like to buy $11 or sell them $11 billion dollars of stock. And that’s why the trade gets exciting. And so then you get all the issues around, when are they going to quote this? When’s it going to come? When’s that delta going to get hit the market when everybody’s speculating about it and so forth. Anyway, long story short, huge lumpy transactions occurring that have big impacts on exposure sold in the market.
Corey:0:09:206So I sort of imagine there’s maybe three sorts of impacts. One, depending on the path dependency. Are the market makers having to take off any delta from hedging the prior exposure that’s now expiring? Two, what are the market makers have to do to hedge the new exposure? So that’s all happening sort of in the Delta One space. What’s happening, the impact to the S&P 500 predominantly, I’d be also interested in knowing what’s happening to the volatility surface itself, because these are very predictable strikes now, are you seeing significant kinks at this point in the surface?
Benn:00:10:07Yeah. So the way that this works is, in some sense, people will say, I think, generally correctly, that there isn’t usually that much volatility market impact of the trade when it is quoted and executed for these kind of large predictable roll trades. And that’s true, and that’s sort of what the brokers pitch to why should you should you execute this way. They say, look, we have a lot of transparency into what the trades are going to be and therefore we can be ready for it, and the term used within banks is “accumulation of inventory in anticipation of potential customer demand”. And interpret that as you may. So of course, what happens is the volatility surface shifts in anticipation of this trade coming in, as people accumulate the inventory that they need to be in a position to then execute this huge transaction.
And there’s nothing really nefarious about that. That’s just a reality of like, if somebody wants to execute this massive transaction in these kinds of markets, somebody is going to have to be able to facilitate that and work into those positions over time. So yes, you do see the skew surface shifting and the maturity that they’re going to be trading increasingly so as the strike ranges become increasingly clear.
Corey:00:11:33So, go ahead, Rodrigo.
Rodrigo:00:11:35No, so is the surface shifting a fairly predictable movement that market makers or alpha generating managers like you can very clearly snipe on a quarterly basis? Or, you’ve talked about how it all depends on what the path of the market was, what the positions are, but is there some sort of modeling that allows you to take advantage of that, or is it so different every quarter that it’s difficult to?
Benn:00:12:06It is certainly the kind of thing that market makers and volatility arbitragers attempt to do. And it’s their attempt to be able to provide the liquidity to these kind of transactions that has to occur. It doesn’t mean it’s easy because you don’t know what they’re going to do, is they’re going to trade a 95%, 80% put spread, and sell the call that makes that structure premium neutral. And you don’t know what strike that’s going to be in advance. So you can’t come in two weeks before and just do exactly the opposite of the trade that you know they’re going to do and have that right. What you can do is start to work into a range of exposure that’s probabilistically reflective of what they’re going to need to do, and do that more and more and more the closer you get, and so forth. And then what if the market moves a whole lot and all of a sudden you’re way off center on the type of exposure that you have and so forth. So it’s like everything else. It’s a risk/reward game.
Rodrigo:00:13:07I feel like we’ve seen this game play out over and over and over again. The fund gets popular, it gets massive, it starts doing a fairly predictable trade that most people know. Like I remember Good Harbor was one from a systematic trend perspective back in the day. Then you had the TVIX and the Volmageddon period where that became a predictable role that people took advantage of. Do you feel like this type of fund could have a similar Black Swan event, structural impact in the markets that could be destabilizing? Or is it a different beast?
Benn:00:13:43Well, I don’t think that. This is not a Black Swan type of thing. I mean, when you reference something like the VIX CTPs, the structure of the position of those VIX CTPs was for example, in XIV’s case, being short a huge amount of VIX futures, and then having to buy a lot more VIX futures mechanically as volatility went up. And like that was a very unstable equilibrium when that product got big. This kind of product doesn’t have those kind of features. It’s a put spread collar held against equities. The main thing that happens when it gets bigger and bigger and bigger as it has more and more market impact. And commensurately, you can think about how that might affect the return potential of that product relative to alternatives that are smoothing across strikes and maturities, and over time, and not having that kind of market event.
Corey:00:14:37You’re very amicable whenever I talk to you Benn about this or that, so I’ll just say it, in their prospectus they say the upside call they’re trying to sell is between three and a half and 5%. And they’ve historically been in that range and now they’re an $18 billion fund and I think last quarter’s roll, I might be wrong, but I think was 2.9%. I think this quarter is 3.1% on the upside. So you’re seeing them significantly below range, which I would expect is just a market impact issue. So anyone entering this fund today is going to be getting much lower upside potential than if they had entered it five years ago when it was a much smaller fund. I’ve said to a number of people that I think these structures are the smart beta structures of the 2020s. Everyone went into smart beta in the 2010s because they liked the concept. It got too crowded and none of the factors played out well.
I would argue I’m seeing so much money moving into this whether it’s the hedged equity funds, or the buffered note ETFs, or similar structured products, and I’d love your color on the structured product side, that I think people are ultimately going to be disappointed with the upside return potential they’re going to capture here. Are you seeing things any differently?
Benn:00:15:58Yeah. I think that that’s right. I think that part of it comes back to again the way products are marketed and the way that options are explained versus sometimes the more nuanced reality. So usually a put spread collar, the reason that these things are popular is they’re pitched as a zero cost hedge, like this kind of same premium on the call and the put spread. And, while they are a zero net premium outlay initially hedged zero cost, I think is a very misleading way of explaining this because if you own equities, you’re counterfactual your baseline as you experience the returns of the equity market, and if you put on a zero cost hedge but by the way, it caps out your upside over a quarter at 3%. If equity market goes up 7% that wasn’t zero cost, that was 4% you lost.
And also by the way, people think it’s a hedge. You’re buying optionality kind of – you’re not. These products actually are short optionality, a put spread collar and it depends on the path but take for example, let’s say you have that 7% rally and you only make three instead of making seven, and then next quarter the market sells off 7%. Well, so you bought a 95-80 put spread, you made two points back on your put spread but you still, so you say you lost five. So what did that work out? You actually lost money relative to just having been long the equity market.
Rodrigo:00:17:44What’s interesting is, I was talking to the guys at Standpoint because we had a podcast last week, I was ranting about the fact that a lot of these hedge funds are really just low volatility S&P. And he sent me this chart of the JPMorgan hedge equity fund again, 60% SPY, 40% cash, and they’re identical, like identical. So it’s interesting as you talked earlier about how a lot of advisors like to have simplicity and a simple roll structure. Honestly can’t get simpler than 60% SPY, 40% cash versus the simplicity of this options overlay. It’s kind of crazy how popular it’s gotten for what it delivers. That opportunity cost is key to understand.
Scott:00:18:30I would just add to that by saying if we take it up a few 1000 more feet and possibly talk about the history of the space, if you wanted to get into that, I mean a little bit that you can talk about is the whole idea of marketing these types of strategies whether it be a put spread collar, like with what JP Morgan’s doing, or whether it be overriding or cash secured put writing strategy, if you look at these strategies of pre GFC, historically they looked really good. And that upside cap specifically on JP Morgan type of structure would be fairly high. That’s come down over time, if you looked at the premium that you were bringing in for overriding or cash secured put writing, those premiums on those options were actually pretty reasonable. But post GFC, what we saw is just a lot of consultants, a lot of consultants putting forth in a lot of institutional investors and certainly high net worth guys as well just looking for defensive equity, low volatility equity solutions. Makes sense. I mean, post GFC, and certainly a lot of people will probably think that way.
So we’ve seen obviously a lot of money come into that space. JP Morgan, this fund has been a big beneficiary of that, there’s plenty of other firms that have done very well with very good marketing. The space generally markets this as defensive equity or low volatility equity, but there’s a price to pay for that. When the entire space increases many times over, it’s going to fundamentally change the value proposition.
Corey:00:20:12I want to actually want to keep pulling on that reflexivity threat a little bit Scott. When you have people pouring money into a space, it’s going to impact the underlying market itself. I love, and either of you please comment on this, to get a better picture of if this trade continues to grow, what do you think it would do to things like skewness? What do you think it would do to things like the VIX term structure? Would we expect structural changes as long as this trade remains as big as it is or continues to get bigger as a complex?
Benn:00:20:50Yeah, I would say that, first of all, this trade it’s certainly not just this one particular thing that JP Morgan is doing, it’s a whole complex of selling volatility relatively near the money upside. For example, call over writing, which as Scott pointed out, has become wildly popular among big institutions, and it has had a huge impact. One nice thing, when you think about factor investing and you compare it to derivatives markets, with factor investing questions about the impact of AUM growth and changes in the market are hard because maybe you can measure the inflows, but you can’t necessarily measure, you can look into the value hasn’t been working as well. Or you can look and say, quality hasn’t been working as well, or whatever it is, but you don’t have an intermediate point to point to, is it luck? Is it size? Is it what? How do you really prove the stuff out? In derivatives, you can just go look at the price, because we have vol surfaces and when everybody comes in and does a particular set of trades it just changes the vol surface. So, I think we know how to do screen share, maybe Scott maybe can pull it up.
Scott:00:22:05I’ll try and bring it up.
Benn:00:22:06… we can restructure by regime. Scott, I think you know which one I’m talking about. But, when you think back to, what did the equity index volatility term structure look like in the pre ’08 regime versus recently, versus some other regimes? First of all, if you go back to what the world used to look like when things were kind of quiet outside of a crisis environment, like that 2002 to 2007 regime, that’s the blue line there. The vol term structures used to be kind of 15 or so in front, some mild upward slope and then relatively flat out to the back. Then you had of course 2008, and vol went up a lot. And we all remember those days, 2009 to 2012, you have this post GFC elevated risk premium environment. But then really where we’ve come back into now in this red line, compare the red line and the blue line. 2013 to 2021 broadly speaking is a normal markets rallying. We had the COVID crash, which was obviously a very big deal but it was relatively brief. And the term structure is way lower in front, it’s showing 12 on average but that’s including like the COVID period. This sort of normal state and quiet markets now is short dated S&P vol is seven or eight.
And then extremely steep out the term structure, and then a little bit flatter out in the back. And it’s just a massive rotation of the whole term structure relative to what option markets used to look like. And everybody goes and looks at these 30 or 40 year back tests that the consultants bring them or the asset managers bring them or whatever of like what option selling used to look like back when nobody sold options. In short dated and in the blue line there. They like look, look at this great volatility risk premium. But then we just changed the price, because then we brought large public pension funds, meaningful allocations to short dated call over writing and cash secured put selling, and so forth.
And we’ve dramatically rotated the term structure and steep and everything. And people are selling short dated calls at five, it’s just a different world and you can see that intermediate input as opposed to again in some of the Delta One factor investing where you can see the returns and you can argue about it and you can try. Like AQR does some stuff about looking at the valuation of different factors and trying to see if that’s changed. But it’s harder here, you can just literally see the price.
Rodrigo:00:24:32And even though we’ve seen these, selling volatility, blow up once or twice in last few years, are we still seeing the large institutions continue to practice this?
Benn:00:24:44Sure. Selling volatility is sort of almost a word no… It’s so broad that it always gets massively misused. People blew up doing wild over leveraged tail risk selling. Nobody blew up doing call over writing. Call over writing programs are just another line item in a public pension’s 50-line item thing, that like has been underperforming what they’ve been told that it should perform for the last seven or eight years. But like, it’s a very unrisky thing. It’s just equities with less upside.
Scott:00:25:23Yeah, I would just say like the blow up which isn’t really a blow up is really the fact that market may sell off a lot. You restrike your option, the market then rebounds swiftly, much more swiftly current day, than historically speaking. The old saying was the market takes the elevator down and the stairs back up. And today it seems to be the elevator both ways. Right? So you’re tapping your upside as the market sells off, you restrike your options potentially, market rallies back and you’re capping your upside but there’s certainly no blow up risk.
Corey:00:26:02So, maybe I’m just living in an echo chamber. But I feel like there’s an increasing awareness not only of what’s happening in the volatility derivatives complex, but potential implications for reflexivity in the market itself. A lot of people talking about things like GEX and pinning and that sort of effect seems to be much more prevalent. But also, it seems like more people are aware that … calls, for example, that volatility risk premium may not be actually in practice anymore as wide as it was historically in these wonderful back tests. You guys are going out there and talking to institutions. How is that story resonating with them? I would have to imagine for those institutions that have adopted these types and styles of strategies, even it’s just selling some upside calls. It’s got to be a wakeup call to them.
Benn:00:26:54I would say, I mean, there’s really bifurcation. And sophisticated institutions that have people who have worked in the derivative space before understand all this and are quite aware of it. But those usually aren’t the institutions that have those kind of mandates in the first place, or have those kinds of programs. It’s much more, you can’t underestimate the pension fund consultants, pension, academic white paper exchange, white paper complex of decision making which is, the pension fund consultants really advise, vary quite heavily in terms of what does it make sense to be doing, and how should you think about these things. Public pensions are understaffed and underpaid and have a hard time really having the analytical capabilities internally to investigate these kind of things. So they largely adopt the kind of decisions that the consultants push.
Scott:00:27:53I think really the punch line is, when you think about option, strategies at the index level, certainly options have become steadily less expensive over time. It’s a nice way of putting it. So if you’re selling those, you’re obviously bringing them on the stream. But me think they have been flow just like with any risk premium that will rise and fall, we just happen to be in a very compressed level of risk premium for specifically volatility risk premium, VRP today.
Benn:00:28:24Especially again, at the at the front of the curve is what we’re talking about today. It’s typically where you’re benchmarking oriented call right programs. We’re going to go sell one month 25 delta puts, or two months 25 delta puts or something like that. Related skew is also pretty high. Now that does come and go. That I think, partly also is a result of a fairly persistent wave of hedging by a lot of different categories of investors these last six months to a year, with markets pushing new highs and people feeling really good about their games, but less certain about the market environment going forward and so forth. But skew is extremely steep.
So I think people have this sense of where they look at the VIX and they say oh, vol is really high. Haven’t you seen the VIX? It’s 18 or it’s 17 or it’s something, that used to be like when people anchor on the last five years other than COVID, they always think of that as like a stress level. So these kind of strategies must make sense. But again, sort of short dated S&P, near the money upside vol might be five or six. So the thing that has definitely been true post COVID has been the wings have been expensive. VIX is actually S&P variance, it’s not at the money vol, and variance is something that is like a thermonuclear bomb when you sell it or whatever. Most of the time you make a little more money selling variance than you would selling at the money except for once every five or 10 years when things go really wrong, and you have a squared term in your negative P&L, and you just blow up.
And the supply of short term variance has totally stopped. No one can sell one-month variance anymore. And so the level of the VIX as compared to say at the money vol is much higher, might be five or six points higher, which historically would be very elevated. Again, because it’s the price of the wings that’s expensive, not the short dated money vol.
Derivatives, or Not
Corey:00:30:27I’d be curious, one of the, I feel like narratives that came out of the last year, and perhaps shame on me because I kind of push this in my Liquidity Cascades paper as well. So I don’t think I have that much influence, it has been the sort of tail wagging the dog narrative around markets, both in the individual stock complex as well as at the index level. So not to name names but Jim Carson, for example, has been on Twitter very prominently discussing how vana flows and gamma is highly influential in short term impact on the market and forecasting key market levels. There’s other people who are saying, no that’s not true whatsoever. There is no tail wagging the dog. Curious as to where you sort of come down on the it’s all derivatives and has always been derivatives moving the market and nope, derivatives aren’t having an impact, where are you sort of on the spectrum?
Benn:00:31:24Certainly somewhere in between them. I think so is everybody one way or another. I mean, a great example I think I tweeted on was it was it Monday, the day that we had the decent sized, the last decent sized sell off. Something about the amount, the market was very long gamma. We’re very long gamma. We’re always the same way as the dealer community in long/short dating gamma on the back of all this overriding flow. We were going to have a lot to buy so my sense was like, I don’t know how we have a big sell off right here from whatever exactly is going on, and then go ahead, we went down 2.1%. Even then we had to buy a lot of equities that day to just get back to flat. But obviously, like if there’s really big fundamentally motivated selling or whatever it is, macro guys were out dumping tech exposure on the back of rates rallying. If there’s really large selling or buying on that basis by the investor community, of course, that’s going to be much bigger than whatever’s going on in derivatives markets.
But certainly on the margin, the net positioning that has to be hedged in derivatives markets can absolutely be impactful. Maybe you have to have your models and come up with these kind of things. But maybe on that day maybe there was $50 billion of stock buying by dynamic hedgers who are long gamma. That’s a lot. But clearly, you can still make markets go down 2% even with $50 billion of hedging by folks like us.
The Willing Losers
Rodrigo:00:32:59So what other players, we talked about JP Morgan is not the only player, what are the other big muscle movements in terms of like price insensitive funds or structured products that continue to provide unique opportunities or the willing losers that allow you to extract alpha, what are the other areas that you’re seeing?
Benn:00:33:24Sure. Certainly, the whole universe of short dated price insensitive option selling is one big one, and that’s many different players you think of who are the end users. A lot of those kind of programs go through the Parametric’s and Neuberger Berman’s and so forth of the world. And Wells Fargo Asset Management and so forth. At the long end of the curve, you typically have a structured product selling, volatility selling, which historically was more of a European story and an Asian story and the last few years has become a US story in equal size. So for the first time this year, structured products linked to US underlying’s were bigger than the South Korean market which historically has been the biggest market in the world for structured products.
Rodrigo:00:34:19And these are like the structured products are obviously a reaction to the COVID crash and providing some guarantee and some upside, with some complexity around it.
Benn:00:34:30Your typical structured products these days that retail trades are what are called reverse auto callable notes. So the thing that retail loves is you get a coupon and it’s high. So it’s, I put my money down and I’m going to get an 8% return if everything goes right. And the problem is, what if everything doesn’t go right? But typically what will be involved is, you get that return unless or until any one of several different stocks or equity indices in the basket goes down enough. And if that happens, sorry, you just lose 30% or 40%, or whatever it is. So it’s selling of long term crash risk for a coupon. In the old days, there were principal protected notes but that was a high interest rates world. That’s how you synthesize a principal protected note. In a low interest rates world, you sell it, you have to sell vol.
Rodrigo:00:35:22Right. With a zero coupon bond and you had some space to work with them. But no longer the case. It’s crazy that they’ve come back. I honestly thought 10 years ago that they were a dead industry. Now we have the US leading market. … The sad part is that I think it’s what percentage of that is retail versus institutional? It feels like it’s a very retail phenomenon.
Benn:00:35:41Oh, it’s a retail, it’s a retail and private bank, high net worth kind of market. If you go sit down, if you are someone with $10 million who sits down with your financial advisor, they’ll probably pitch you some of them. And if you’re certainly and especially in Europe and Asia, but increasingly in the US. Periodically my friends will call me and say, I know you hate these but look, can I send you a term sheet that my guy just showed me for like an Apple and Tesla and Netflix note and it pays 12% and it looks really good?
Rodrigo:00:36:15If the advisor doesn’t understand it then certainly the client doesn’t understand it. It’s…
Corey:00:36:20Rodrigo, you and I work with a lot of advisors that get the JP Morgan sheets.
Rodrigo:00:36:26I’m starting to realize that actually.
Corey:00:36:30Advisors, you and I, I know both of us work with, they’ve sent me the sheets to ask me about him. Do I have permission to completely change the subject here?
Why Launch a Fund?
Corey:00:36:39Alright, awesome. I know there’s a bunch of questions I’m seeing these, I’m going to try to get to them a little bit later. But I want to totally change the subject here. Then you mentioned QVR, just past four years turning on four years now. Why in the world did you decide to do this to yourself and launch a fund? As someone who has done this, it’s not something I would wish on my worst enemies. It’s horrible. What made you pursue this and what gave you the confidence that it was going to work?
Benn:00:37:08Good question. It’s certainly the kind of thing that’s a lot of work and a long road and all of that. Ultimately, there’s obviously different routes that one can go to start a business like this. We have the backing of my best relationship for a long time, a very large and very sophisticated institutional asset owner. And so at that point, it’s still a startup kind of exercise but it’s very different than like a bootstraps, two guys in a garage type of thing. So we had a institutional scale business day one, that was breakeven on a cash flow basis and was totally fine. I think it’s a very different proposition to do the thing where it’s like I’m going to start my own firm and I’ve got a couple 100,000 bucks and I’m going to hit up my buddies and I’m going to see if we can put up good numbers for seven years and try to turn this into…
Rodrigo:00:38:04A dream and some gumption.
Benn:00:38:06Yeah, those are two very different paths. So I think that in my case, and it’s not always the way these things work. It really depends. If you’re a long/short equity manager, it’s much more plausible that you could scrape together five or 10 million bucks between different types of relationships and you could keep an incredibly low cost structure just yourself for whatever it is for three years or five years and then get some people interested. This is not a business that works like that. This is an infrastructure heavy scale intensive business, where you need to be executing significant enough volume to have the best clearing relationships and you need very material technology and all this kind of stuff.
So it’s the kind of thing that only really works, from my perspective. I’m sure there are people who disagree but from my perspective, it’s very hard to do outside of this context.
Corey:00:39:01Well, you gave me a perfect layup there. I’m going to keep going Rodrigo then I’ll turn it over to you because I want to talk about the organizational alpha side of this, you’re talking about the infrastructure and technology curious as to your thoughts, day one for a business like yours, what is the necessary table stakes to even enter the game and have a reasonable shot of being successful?
Benn:00:39:26It really depends on what you’re doing and what really matters is probably revenue more than AUM per se. But, we were around 100 million initially. And you can run a business like this at that at that stage where you have kind of one client and you’re not doing any kind of marketing, and you’re on a ground up, what do you really need and what don’t you need kind of basis, like you can run that kind of thing for a million dollars a year. You need a million dollars a year of fixed revenue.
Corey:00:39:59But what about from like a technology prospective? Day one starts, assets hit, you’re starting to get the revenue, what are you building with your blank canvas in front of you?
Benn:00:40:12Sure. All that happened before obviously, because part of the thing with big boy institutional due diligence is that they don’t do that. I promise I’ll build it. I was on noncompete for all of 2016 doing that. But yeah, think of, it depends on exactly what space you’re in. But for someone like us you need a proper full historical and real time data environment for dealing with options and derivatives across the asset classes that you’re involved in. And you need the risk capabilities and the position management capabilities and the execution capabilities associated with that. So there’s certain things that you can buy. You always buy what people usually call an OMS, or an order management system, whether or not it actually manages your orders. So a Bloomberg game or an … or whatever it is, it has a bunch of embedded accounting functionality. So those kind of things, your accounting systems. You’re picking things that are going to work with your other systems as well as you can and you’re buying that. But all of your research and data type of infrastructure, that’s really what you do as a manager, and there are any kind of, you’re choosing vendors for data and so forth.
But there’s not going to be any kind of prepackaged analytics solutions that make sense for someone who, really what you do is very specific, very bespoke strategy work in the space. And so all of our infrastructures… In Amazon, you have big fast databases and you have big networks of compute capabilities that can spin up as needed and you have your end of day processes and their whole dependency tree, and you have your intraday environment that’s updating all of your research and all of your signals and all of your risk components. And if that’s not, you don’t pass institutional diligence until that’s all there and can be demoed live and works.
Rodrigo:00:42:21And that’s all built in house, like you’re all developing it in house. Are you a programmer Benn or?
Benn:00:42:29Yeah, the entire front office team. So we now have a head of technology also. But we’re all programmers.
Rodrigo:00:42:35Sorry Scott I interrupted you.
Scott:00:42:36I was just going to drive home the point, obviously, you buy what you don’t want to build. But we’re not going to build an accounting system or whatever. But the unique thing about I think about QVR was that Benn’s been managing this set of strategies for a very long time and it was okay, I have a blank canvas, how does Benn want to build his infrastructure from a risk management perspective, from a trade implementation perspective, portfolio management perspective, from the ground up and not try to fit what he’s doing into a prepackaged system? And I think that was a big differentiating factor for that technology step forward.
Benn:00:43:25Well, that’s a very good point. In some sense, some version of this infrastructure has been built and rebuilt over the years. And it sounds painful to say you rebuild it. But actually it’s a natural evolution and in this context, especially this time around, you can build it much better, 10,12 years ago doing the stuff, you had server rooms, you were writing C Sharp code, and reinventing the wheel across all kinds of stuff because there wasn’t really good open source and you had just much less of the world that venture capitalists have wonderfully subsidized small technology companies on providing all of these free or very cheap resources, and the Amazon Cloud and so forth. So it’s a great environment to be able to revisit how would I do this better.
Rodrigo:00:44:16With better or more, you said you code in Python, or there’s just better code that you can do. We’ve done it over and over again where you have the option of having this, you’ve patched up the old infrastructure so many times that the fix is where you want to requires, it’s a massive technical debt and you can scratch and rebuild with better code, better understanding what you want to get out of it and just a much more streamlined option for sure. I guess having a big investor allowed you to take your time to do that right.
Benn:00:44:50Yeah. I think we hear a lot of times big legacy, well known managers who talk about how their technology is a big proprietary advantage. And then you actually talk to the people who work there like the PMs and they’re like, Oh my God, our booking system was written in Fortran in 1969 and it’s like you have to telnet into the thing, and you have to like, and it’s just a total disaster.
Rodrigo:00:45:14And there’s one Fortran developer that sort of, insane amount of money to fix it.
Corey:00:45:21I don’t think I’ve heard the word telnet since 2002 Benn, you really pulled that one out.
Benn:00:45:29There’s really, it’s very difficult in large organizations with all the legacy business and technology issues. Those get very complex and it’s very hard ultimately to keep them fresh.
Rodrigo:00:45:42So, the other thing is data management. We very much shied away from options based trading because it is, when you’re dealing with futures is very linear. You know exactly what you’re getting, you have X amount of data, you need to clean it up, you need to fix the rolls and so on and so forth. But options trading has so many levers that I imagine that cleaning up that data is 95% of yours and your developer’s job. How do you guys manage the data infrastructure?
Benn:00:46:16Yeah, absolutely. It’s sort of the running joke of what people think you spend your time on as some fancy quant manager, versus what you actually spend your time on, right. So clean, well mapped security masters. But when you’ve got different vendors and different SMP options, but there’s SPX and there’s SPXW and there’s ISP, and there’s SPY and how are all these things related? And how does this guy treat it versus that guy treat it? And like making that totally ironclad? Yeah, that’s like it’s a huge project. And same thing with ingesting option prices, cleaning option prices, fitting vol surfaces in a robust way, both for single names and index.
So like those are very large scale projects. Again, it’s not our first rodeo or anything, but that’s a huge percent of the time historically that was spent building a lot of that stuff. Now hopefully, once you’ve done a good job of that you still have to improve it on the margin, and it still takes time. But it’s not on a forward looking basis as big of a time sink. But then you add, you want to do futures options and now you have a whole new project because some of it’s the same and some of it’s different. So that’s just the nature of the beast. And by the way, I think it seems sort of obvious, but a lot of the time there’s the legacy volatility and derivatives managers world, which I came from originally, where what we used to do and what a lot of guys still do, is they trade OTC vol swaps or var swaps with brokers. They sit there on a Bloomberg and they have their Bloomberg chat and they have Excel and that’s kind of what they do. And we did more quantitative stuff than that. We wrote a lot of code back in the day and everything. But, you didn’t have to worry about fixed strike options, and the path dependence of fixed strike options and the complexity of the universe of fixed strike options, and you didn’t have to deal with fitting vol surfaces and you didn’t really have to deal with like real time data and all this stuff.
And like that world, there was lots of interesting things to do back in the day when it was very easy to trade a vol swap in big size, by quoting a dozen banks and taking down the guy who was …. That world is gone. That was a different world that existed because banks were taking huge amounts of risk and were super aggressive and there was super profitable business with asset managers and with the broader franchise. Now we live in like a post Dodd Frank post Basel free world with super tight risk control and banks just can’t and won’t do any of that. Markets are super wide, half of the guys won’t even quote the trade, the sizes are tiny but exchange volumes are really high.
The world in equities especially, has really migrated to lit exchanges and there’s a ton to do. That’s a very hard transition to make because you’ve gone from having your trader click the blast button on Bloomberg chat and blast out a dozen quote requests, stick them into the spreadsheet, find the lowest offer, lift it, check the term sheet, there’s lots of things you have to do right, but it’s just a very different skill set versus building large technology infrastructures to be able to handle this stuff in real time, be able to manage 20,000 option line items and the dynamic risk associated with that and the dynamic path dependence of the portfolio and its risk, and what do you have to do every day to manage the portfolio versus like, I don’t know. I have a vol swap and it’s going to, it’s going to realize that, I’m going to get the realized vol right.
Corey:00:49:56I was just going to ask, one of the things that I hear over and over again is, there’s not a lot of edge necessarily having a better vol surface model. There’s certainly negative alpha in having a really bad model but having a much better model doesn’t necessarily give you a positive edge. Curious as to your take, how much edge can be found in having a better technology stack than your competitors and being able to get better real time updates or better insight into the risk that you’re running.
Benn:00:50:27The way to think about it is, first of all, it depends on what your business model is and what your strategies are. So if you’re a market maker, the only thing that matters is having a really good vol surface, never being wrong and being incredibly fast and being really good at differentiating flow types, and thinking about how to hedge and so forth. If you are a lower frequency buy side strategy person who is thinking about dislocations in the market, where they come from, what the end user flows are, how they’re creating opportunities, how to structure trades and so forth. It’s a very different set of problems you’re working with. You need to have really good execution technology to minimize transaction costs and so forth. But like, your sensitivity to a little wiggle someplace in the vol surface is lower because if you’re a market maker that has a little wiggle someplace in the vol surface, you’re going to be trading with Citadel Securities all day, and in every trade you’re going to be losing money on.
In the case of someone like us, the important thing is that people like us don’t make money because we know this one formula that’s this really secret formula, and we figured it out and nobody else knows, and if they knew it would be really bad and we go out and we see the thing that’s too cheap and we buy it. It’s like a whole back to front process of understanding from a starting point what types of dislocations there are in the market, in the areas that we focus on, that we’re good at thinking about, and how to track those, and how to measure those, and how to do the historical research around those, and how to structure trades around those, and then how to actually execute and implement those trades, how to control the risk, how to put a bunch of strategies together. And it’s the quality of every step of that process and being reasonably good at every step of that process that’s important.
So, for example, if you have a lot of those things as part of your process, but by the way, you don’t have particularly good execution, you just call a broker to shop around the orders, then you’re not going to have a firm that works because you’re going to be paying a bunch of spread on all these trades, and your returns are going to be terrible in this environment. Because in the old days, actually you could call a broker and they could pump out some guys and they could get it done, and that used to work. Now being a liquidity taker doesn’t really work. You need to be able to work into positions and out of positions in a really efficient way.
But same thing with if your research infrastructure is really terrible and you have this idea of like what the opportunities are but you can’t really measure, you can’t really test things historically, can’t really understand how to hedge it, understand all these kind of things. So every piece of that puzzle needs to be reasonably good.
Launching a Fund
Rodrigo:00:53:16Alright, so let’s get into, you’ve built the infrastructure, you build it in a way that makes sense for you and what you’re good at. You launch the fund, there’s so many areas you can tackle because you also do consulting. What is it that you’re good at and what does your fund do for people?
Benn:00:53:35Well, we have an Absolute Return Fund that’s a big part of the business. And Absolute Return is all about understanding dislocations in the marketplace and creating market neutral trades around them in a return stream that doesn’t make or lose money based on whether the market goes up or down. And that’s one big part of the business. And we also, given the infrastructure that we have as part of this business, it’s very easy for us also to work with big institutional clients who want to do hedge overlays in their portfolios for example. And it’s not a consulting business. We manage large pools of assets in hedging overlay programs, in funds of one that we design for institutions. Leveraging the same set of skills and knowledge and option markets in the same infrastructure, but solve different problems for different kinds of investor. So I think our view is, generally when you have a business like this, you have different choices as you grow the business.
I think that one thing you see in the derivative space is sometimes organizations take those absolute return programs in hedge funds and they keep raising more and more and more money into those programs. But it’s really a pretty niche business and it’s a business that really from our perspective, it’s really important to not be overscaled to the point where you can be nimble. Derivatives markets dislocations come and go, the flows come and go. This is not a business where you end up in just systematic strategies based on some 40 year back test that you always do. You will be in a big trade, will love it, three weeks later we’ll be totally out of it and the other way. And if you’re too big you can’t do that. So part of what you want to do is rather than scaling, just by making the core absolute return strategies bigger, you want to find synergies that use all the same skills and infrastructure but do different things that solve different problems for other kinds of people.
Corey:00:55:40So on that absolute return style strategy, are there times where you’re just straight on the sidelines? Where there’s no interesting opportunities for you and you’re not deploying capital? Or is there always, sort of with the markets the way they are, some sort of opportunity available to you typically?
Benn:00:55:59I suppose that would be hypothetically possible. I’ve never been in that kind of environment. Think of we and we have a wide range of different strategies that are recurring thematic strategies where there’s some type of dislocation that either is often there over time in some size, or where there sometimes, and across enough strategies we’re always going to have two or three or four things going on at a point in time that are interesting. Sometimes there’ll be more, sometimes there’ll be less. But yeah, if literally we just thought there was absolutely nothing to do in the market, we wouldn’t have any positions on it. That’s I think, a very rare kind of situation though.
Corey:00:56:39I have to imagine that these are difficult strategies to communicate and for a lot of institutions to understand. Scott, I’d be really curious to get your thoughts on what do you think the most misunderstood thing about what you do is?
Scott:00:56:56It’s a good question. So misunderstood, if we were to go down to the strategy level, I think if you start getting into things like maybe dispersion, if there’s a lot of moving parts, we at times may be long or short, for example, maybe some of the strategies that are a little less line item intensive, such as maybe just European dividends or say trading volatility versus beta, it’s fairly straightforward. But I think what we’ve seen over the past 10,15 years it’s actually quite amazing. When you think about where we are today, where you have people literally trading options from their iPhones to where we were 15 years ago, where it was like some vol selling strategies such as covered calls or pure vol selling strategies such as using variance swaps, that was pretty fringy stuff for like the US pension and maybe endowment foundation community, versus where we are today.
So I think the education level is way ahead of where it was in years past but still, most asset allocators don’t necessarily want to get down into the weeds about specific line item positioning’s and talk about Greeks and stuff like this. The bigger asset management community, all they talk about is outcome oriented investing, so on and so forth. So I think there’s that fine line where you really have to create nice digestible content depending on your core audience or, excuse me, depending on delivering it to the broad audience, but being able to go deep for those guys who truly understand and perhaps we’re even in the business of what’s going on the trading side.
And I think that good content, because consistency of delivering good market color within the space and that transparency, and honesty, is what it takes. And then when they finally do come to potentially make an allocation in the States, it’s like, yeah, those guys at QVR they’ve been sending us stuff every quarter for the past year or two years and it’s been really good, straightforward and interesting and I think my board or my trustees would actually understand the way that they talked about it. I think that’s the key difference today.
Rodrigo:00:59:40I’m just curious because you guys are clearly systematic. You’ve got developers, you got quant, use a lot of numbers. But you’re systematic but you’re not a quant. You talked about finding opportunities as they arise, you might be long one day short one day, so being transparent is actually not detrimental to you because you’re not showing an algo that people may or may not be able to copy. It really continues to be your expertise over the years that help you get that unique P&L. But how do you differentiate between what part of what you do is systematic and what part of you is good old fashioned trader?
Benn:01:00:25That’s a spectrum. Think of at one end of the spectrum you have kind of purely gut feel based discretionary trading or something, and the other end of the spectrum you have fully automated signals data and trading and transactions. And we’re probably a seven out of 10 on that spectrum or something, where we have a set of recurring strategy themes where each one is its own unique strategy bottom up that reflects some kind of dislocation or market relationship that we understand, that has its whole research and technology base behind it and then we have a framework for how to in a standardized way, compare the risk and reward opportunities available across those strategies and how to do portfolio construction on the back of the strength of signals and so forth. Nothing that we do flows straight through into any kind of automated execution. We have a lot of execution automation tools to help with implementing a decision once a decision is made, right.
But generally speaking, I think the reason, you don’t ever see full automation in the broad based derivative space, data is too noisy. There’s too many dimensions of uncertainty and you really have to be able to stop and say, okay, our model really likes this trade right now based on X, Y, and Z. Well, X, I think, actually is a little bit noisy, Y there’s kind of a regime change going on here. And I think there’s a good reason for Y, and really I think the expected return is significantly lower than the model seems to think. And not running these kind of strategies in that way, I think just leads very quickly to potential big disaster. And there’s all kinds of stories that one can tell you about that.
But I would importantly though, I think people sometimes confuse, quant and systematic get thrown around a lot and what does that really mean. Dynamic and quantum, dynamic and systematic are fully compatible. Something does not have to be I do the same trade every day because of a 40 year back test, or something to be quantitative or to be systematic. You can be very systematic about something where a lot of the time you have no trade and then you have a trade on sometimes, but in a manner that reflects certain data generating process about those decisions.
Handling New Regimes
Corey:01:03:03So how do you handle new regimes, either regimes that are so fundamentally chaotic, they’re breaking all the risk metrics like March 2020, regimes like I don’t know, oil trading negative or even like as we entered post 2020, sort of the call option spree of retail buyers, which I know you have a lot to say about, but correct me if I’m wrong, there’s actually no trade you guys ended up implementing as a relates to that, at least the last time I spoke to you on that subject, maybe it’s changed. So how do you think about (A) navigating when … models maybe like just either aren’t giving you right answers or the world is chaotic and the systems you’ve built aren’t designed for that world, or the world is fundamentally changing and there are new opportunities arriving and figuring out what sort of models you need to build for that.
Benn:01:03:55I think the world’s always changing and that’s part of the whole point. And the conversation is about, are there variables that we’re missing in how a strategies model is set up? So for example, think of variance convexity basis got very expensive after COVID and there are strategies that we have that effectively trade a linear format of that variance convexity basis. And based on historical data up to that point, the way that our models were looking at things, you would have wanted to bet very aggressively on convergence of those spreads. But you also knew because you hadn’t had a convexity blowout like that, really, 2008 in a way, but actually it wasn’t the same, to March 2020 was actually a much more severe convexity blowout than 2008. 2008 was a big crisis that kind of steamrolled on and got twice as bad every month. March 2020 was like this month’s volatility is 10 times higher than last month. And those are two very different things.
As a result, the world lost all of the sellers of tail convexity and you know they’re not coming back soon. And so there’s just no reason to think that your model would be right anymore for how to measure the expected returns of some kind of, where should VIX futures trade relative to S&P at the money forward?
Corey:01:05:26What the fair convergence backward be?
Benn:01:05:29Exactly. So you think, okay, maybe in five years you think you have where it’s going to go to or even two years, but not in two weeks. Whereas if, and so you have to stop and think about that and you have to think about, okay, we need to probably look back and put more weight on actually the term structure variance basis and where spot variance basis is, because that really matters a lot, and go through and really think about things that maybe didn’t matter as much before or you didn’t realize how much they matter, but that have since become much more salient.
So it drives sort of re-engineering. Very rare that it’s just like nothing makes sense. I mean we’ll have times like after March 2020, we absolutely just, there were some trades that looked good that we just didn’t do during March of 2020. Because a period that crazy you’re working a lot, you’re doing a lot of things, your attention is getting pulled in a lot of different directions, you’re trading all day, and you know that there’s a value to having focus all efforts on the highest risk reward and highest ratio of risk of reward to complexity. Opportunities, right? Don’t go out and do things where now I need to trade a ton of different option line items and put on this very nuanced trade that I have to leg into, because in this environment that’s going to be extra hard, and then every day I’m going to have to pay attention to it and maybe miss this other thing. And are you going back and rewriting your whole portfolio construction models to do that? No, you’re just not doing that trade. That’s very easy to do.
Rodrigo:01:07:02Yeah. So let me continue down the path of understanding where you grab your P&L from. Adam actually sent in a question, approximately what proportion of your P&L is derived from what might be described as quasi arbitrage or casual trades versus taking directional vol or delta risk?
Corey:01:07:22He meant causal trades?
Benn:01:07:24Right. I was like casual trades?
Rodrigo:01:07:28Don’t ask a Peruvian with ESL to read some English in a live show please.
Benn:01:07:34There we go. So we take no directional risk at all. Full stop. Arbitrage is a very strong word, I don’t think of anything that we do as arbitrage but we do absolute return.
Rodrigo:01:07:47Right. So relative value, market neutral.
Corey:01:07:51Rod, if it’s cool I’d love to grab another question here that came up. It’s going rewinding back to some of the earliest discussion we had, but Peter van Anson was asking about, with the current term structure of say VIX, the old pre 2020 consultant argument may have been there was a volatility risk premium you could harvest. Is there now the potential for an emergence of a sort of volatility term premium that can be harvested?
Benn:01:08:21There’s always been a volatility term premium, right? Just to back up a step, a lot of people will come with the question. They’ll say, well, volatility risk premium looks kind of low in the front of the curve, so why don’t you say the front of the curve is 10, but this point four years out the curve is 20. So isn’t volatility risk premium at the four-year point if realized is eight, isn’t it 12 points? And what I think any vol guy will say is or vol girl will say is volatility risk premium in terms of, is a word people throw around a lot. There’s a risk premium for short term implied, versus realized. And that’s a risk that you can generate trading short term options and delta hedging an exposure to short term options, and when you trade a longer term option, the further out the curve you go, gamma is fully fungible, you’re just getting a smaller and smaller and smaller amount of gamma exposure, exposure to realize vol further out the curve, and more and more of your risk is driven by vega risk, by changes in the implied volatility of the option. And you can create a forward volatility position by buying longer dated, selling a little bit of shorter dated, and actually having no gamma, no risk to realized volatility, only risk to implied volatility. And of course, that’s a directional risk factor. If I buy forward volatility, that’s going to tend to go up when the market goes down, and vice versa.
So that’s an exposure. It’s going to have risk premium characteristics. That risk premium won’t be reflected in implied versus realized, by definition. It gets reflected in what’s the shape of the curve relative to, and what does that turn into carry P&L over time if nothing happens, or along different scenario paths. And so there is always a term premium concept in vol markets. There’s different levels of term premium that you see in different market regimes. Depends on flows, who’s buying or who’s selling vol at different points in the term structure. That’s the reason that in the normal state of affairs, term structures are upward sloping because that’s how market charges you carry costs to be long volatility, effectively hedging a risk position.
Absolute Return vs Tail Hedge
Rodrigo:01:10:50So your fund is an absolute return fund. I imagine in periods like March it should do a good job. But you also have funds or other institutions that come to you explicitly for tail hedging, I understand. So what’s the difference between providing an absolute return fund that possibly does well in the environment versus providing a pure tail hedge? How do you differentiate those two?
Benn:01:11:18Sure. They’re very different things. So absolute return, the point of absolute return is to take advantage of dislocations that exist in the market and try to generate returns over time, and a return stream that’s not correlated with the market. And in our case, we make sure that we’re not short convexity or short tail risk, but we won’t necessarily be long it. And there’s no directional risk to the market. It’s not a long volatility product or short the market product. If equities are down 7% in a month I can’t tell you what the P&L is going to be with any kind of high confidence. Typically, when a large asset owner is having a conversation about tail hedging, they’re thinking about something very different than that. They are thinking, I own $10 billion of equities. What I’d really like to do is find a way to set aside a hedge budget of 1% to cover theta costs and some potential vega mark to market if I have some options that go down, and in exchange for that, try to get back some significant amount of the loss I might incur if the market’s down 25 or 30, or 35, or 40. And know how much the slope of my protection is accelerating down there. Know where I’m fully stopped out. And then think about how do I manage that over time? How do I rebalance that between that hedge exposure and my equity exposure so that I’m generating a big pile of cash in a sharp big equity market sell off to redeploy into equity markets?
That’s an extremely different conversation. And so the portfolios around that generally are fairly simple. It’s a long term strategic program where you’re targeting certain convexity profiles and range of cost of carry clearly, very specifically defensive, always going to have some uncertainty about how does it perform in X scenario, but a lot more specificity around that than you would from some absolute return product. Again, it isn’t targeting any kind of particular convexity profile to underlying equity markets.
Scott:01:13:26Now, I would just add to that too. Again, like Benn said, we’re using the same infrastructure. We’re using the same trade implementation capabilities. This isn’t something where, a lot of overlay providers will say, okay, well, we put on a collar. If it’s red collar, we buy his puts, or we put on this trade structure, and then they come back in a month and roll it, or they come back in a quarter and roll it. What we’re doing is something completely different. We’re looking at these portfolios every day. We might not trade them every day, but we certainly probably are every week, slowly rolling the exposures forward in bits and pieces, participating with the volumes on the exchange. Never going out to market and trading 1000s or 10s of 1000s of options at the same time. Transaction costs are all obviously a very big deal. Right? It’s in the solution space as well. So we approach it the same way as we would our Absolute Return portfolios.
Corey:01:14:26Are you thinking about that triangle trade off of the attachment point. Sort of the cost and the basis risk that you can take when you’re designing a tail hedge? I mean, is it really customized per institution so that as some say, hey, we really need the low cost high convexity so we’re willing to take the basis risk. Others say, hey, we need protection at this particular attachment point to prevent any sort of future funding problems with our pension or endowment. How’s that sort of conversation work from the customization aspect.
Benn:01:15:03Sure, every client is absolutely different. But generally speaking, the key question is what’s the shape of the convexity profile that a client really needs. It costs a lot more to have a hedge that is going to really make a material offset, say down 15 or 20, as opposed to a hedge that’s going to kick in later but really make a lot of money down 30 or down 40. And so that’s going to be a big driver of that kind of, the static cost of carry budget that somebody needs to have. And that relative to vega to market. Basis risk, that conversation, usually it depends on the underlying investor. Generally speaking, doing trades that are longer dated and have more of a vega component is going to have somewhat more basis risk than shorter dated trades. We’re willing to work with people along some spectrum there. We tend to strongly discourage going out into cross asset, what about yen swap receiver swaptions to hedge equity markets?
I think there are good institutions that pitch those kind of things and that show, well look, in August 2011 you would have made X in this currency trade. But when you look at the spread of the outcomes, it’s extremely wide. Qualitatively like in more of a systemic sovereign crisis, or macro crisis, those things are somewhat more likely to work. In something that’s really an equity market led event, they’re much less likely to work. Like in 2018, we had a couple of pretty good market sell offs that didn’t really move cross asset relationships at all. So we tend to strongly discourage in like a direct hedging mandate, where what you’re really trying to do is provide a certain convexity profile, you just have no idea how very off the run cross out of proxy type of hedges are going to perform in that environment. Same thing with like gold or gold vol or something like that. If you really have equity risk and you really want to hedge it in a reasonably precise way, you need to have optionality to what you own.
Rodrigo:01:17:21I’ve always found it, the most interesting part of tail hedging is when you actually get your payoff and what do you do shortly thereafter. If you have a mandate where it’s, you are explicitly a tail hedger for my fund, my organization, and it pays you off at a certain point, how do you decide to start getting out of that trade? And then the second part of that is, do you have the freedom generally speaking to just say, look, everything’s expensive, take off that the tail for the next six months and then we can start getting back on? Or are you always mandated to continue to bleed as volatility collapses?
Benn:01:18:04This is all client decisions. We’re not sort of going out there and just doing stuff. Think of back in March 2020. It was an intelligent framework for this kind of thing. We’ll have built into it in advance, sets of parameters for discussion about the expectations shared between the manager and the clients about what they want to do and how they want to manage the program, including monetization and rebalancing. But it also generally shouldn’t be a really naive one. So if you look back at March 2020, let’s say you owned a bunch of long dated downside options that were making a lot of money back in March 2020, one thing you could have done is go out into the market and try to sell those out and pick your points and maybe ladder down. It turned out actually you would have done much worse doing that than just aggressively rebalancing and buying delta against it, because long dated vols never really went up that much. They went up a decent amount. They went up to like 30. We were moving 12% a day. And if you just came out and put on a big old delta buy, rebalance at the bottom as your rebalance between your long equity portfolio and your tail hedge, then you in short made 100% on that.
And actually, having a thoughtfully put together framework in place, ex ante is really important. So the client knows, so you understand what the client wants to do, how they’re thinking about it, but then having those conversations with the right balance of making sure the client’s on board with what you’re going to do and then doing that is really important. But in these kinds of things, we’re never just going out there as a manager in the way you’re doing in an absolute return fund where it’s QVR making decisions. I have to run a kindergarten pickup folks.
Corey:01:19:56Yeah. Wait, I got one question for you Benn. I know you’re a huge Warhammer nerd, and I say that with the utmost respect, but I’m going to take it into my realm. I’ve got a question here from Brian Moriarty. If you were a, if you were playing D&D, what would your character be?
Benn:01:20:13D&D? Oh man, it’s been a while but probably like a Dark Elven … of some variety with lots of fireballs and things of that nature.
Corey:01:20:24I think it speaks to the character, speaks to you.
Rodrigo:01:20:28I appreciate it. Scott, thank you for your time guys. Sorry to keep you so long.
Rodrigo:01:20:35Good luck with your, what was it again?
Benn:01:20:38Kindergarten pick up on bike. Yeah, Celtic soccer for…
Rodrigo:01:20:43And you’re doing the Gaelic on the bike. That’s right.
Corey:01:20:47Appreciate the time gentlemen, thank you so much.
Rodrigo:01:20:49Thank you all, and thanks Corey for helping out. Thank you. That was an awesome discussion, we’ll have you back again in another six months probably.
Rodrigo:01:20:59Alright, thanks all.
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