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- [00:00]
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- [00:31]
Joe Weisenthal
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Vineer Bhansali
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Joe Weisenthal
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Vineer Bhansali
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- [01:00]
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- [01:50]
Tracy Alloway
Hello and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.
- [01:54]
Joe Weisenthal
And I'm Joe Weisenthal.
- [01:56]
Tracy Alloway
Jo, I've been reflecting on this year. It's been a busy year.
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Joe Weisenthal
Yeah, go on.
- [02:01]
Tracy Alloway
In fact, we're recording this. We're on yet another trip.
- [02:04]
Joe Weisenthal
I know.
- [02:04]
Tracy Alloway
We're in Huntington beach for this year's Future Proof conference, which is always a fun time, an event I always enjoy. But we have been on the road a lot.
- [02:11]
Joe Weisenthal
We have.
- [02:12]
Tracy Alloway
And I feel like the entire year is starting to feel very surreal for me. It feels just very different to prior years.
- [02:19]
Joe Weisenthal
Yeah, it does.
- [02:20]
Tracy Alloway
For many different reasons. But I was also thinking one of those reasons is because it's it seems harder and harder to do portfolio construction nowadays. And I know that sounds really weird given that like, markets are still at record highs and everything seems to be going reasonably well, even though we had that terrible jobs number. But if I think back to the big leg down that we saw this year it seemed really scary because basically everything sold off at once. Right?
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Joe Weisenthal
You know what I really like? I like how you started this with this philosophical thing, we're out on the road and all this.
- [02:53]
Tracy Alloway
And then I was like, how do I protect my portfolio?
- [02:57]
Joe Weisenthal
And then the surreality of the times and now we bring it around to portfolio construction. But no, this is true. And there's a couple of things going on. So one is the sort of like cross asset class moves. The other thing is and is very related to that. I mean, it's the flip side of this, which is correlation breakdown. And then there is still this other element that I think is at play where at least, like I would say there's two more things, which is that one, within U.S. assets, the winners are still the winners, right? Especially a lot of these big tech names. So you haven't gotten the sort of.
- [03:25]
Tracy Alloway
Secular and people have been talking about overvaluations for forever.
- [03:30]
Joe Weisenthal
And then the fact that, you know, you're not getting paid much to take on volatility risk or volatility measures are still very low. So there's a lot of difficult, unintuitive things going on.
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Tracy Alloway
And I don't even know what a tail risk hedge actually looks like at this point because I would have thought like, well, obviously maybe you diversify into long duration bonds or something like that. But then in April when we had the big sell off, long duration did not do that well either. So it kind of has me scratching my head about if you were worried about stuff, both literally and figuratively perhaps blowing up at this point in time, what would you be doing? Like, what does a tail risk hedge actually look like nowadays?
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Joe Weisenthal
You, like, buy gold that's already at record highs, so. Yeah, it's confusing.
- [04:10]
Tracy Alloway
Yes. Okay, so on that note, I'm very happy to say we actually have the perfect guest to talk about tail risk insurance and just tail risks in general. Someone who's been working on Wall street for a really, really long time and has a very storied career. Lots of stories involving big names that you and I would definitely recognize. We're going to be speaking with Vineer Bhansali. He is of course the founder of Long Tail Alpha and again has worked at many, many firms previously. We'll get into all of that. Vanir, thank you so much for coming on Odd Lots.
- [04:40]
Vineer Bhansali
Thank you for having me.
- [04:41]
Tracy Alloway
So I should just go ahead and ask you to give a sort of five minute summary of your career because it is kind of amazing. But the important thing is you didn't start out as a trader. You started out as a mathematician.
- [04:54]
Vineer Bhansali
Yep, I started out as a theoretical physicist. I was finishing my PhD at Harvard, and this is 1991. The recession had just hit. I didn't know what a recession was. I wanted to be a professor, but my job evaporated because I was going to go work at the super collider, the superconducting super collider that got canceled by Congress. 1990s, I had a postdoc lined up in France and one, I think it was in Texas, in Austin. And I got a call out of Wall street, out of Goldman. They were looking for quants like me to work on options trading or options model building, rather, I should say. So I went and interviewed, mostly because it was a free trip to New York. So I went there, got interviewed by an elderly gentleman who was taking notes saying, doesn't know any finance. Full disclosure, I knew no finance. I had no interest in was Fisher Black, who was interviewing me. Oh, wow. I decided, Black, Scholes fame. Little did I know, when I turned that job down from Goldman, I took another job at Citibank trading derivatives, because in my mind it was a sabbatical. I was going to do this for about six months to a year and then go back to physics. Well, little did I know that my whole life would become basically very deeply connected to option trading. So that's what I've been doing. And we'll talk a lot more about tail risk hedging in a second.
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Tracy Alloway
Wait, I gotta ask. Why did you decide to turn down Goldman, given that Fischer Black himself was doing the interview and you chose to go to Citi at that time?
- [06:15]
Vineer Bhansali
Well, one was a research job at Goldman and the job at Citi was actually trading derivatives. And since trading was so far away from what I knew, and this was really supposed to be a vacation for me for about a year, like, sound like a good thing to do, a fun thing to do?
- [06:29]
Joe Weisenthal
Rather, did you ever feel like I'm always so curious about stories from the early days of physicists going to Wall Street. Was there a period where you felt like it was a bit beneath. I mean, you call it kind of a vacation job? Did it feel intellectually beneath you for a while and then did it eventually become sort of genuinely intellectually satisfying in the way that maybe you had anticipated an academic career to become so interesting?
- [06:51]
Vineer Bhansali
So the modeling served me at those days. Seemed a little too naive. So, for instance, I'll give you an example. Very first trade that we did, large trade. I was a citibank at the time. And it was an interest rate cap on yen, interest rates linked to the dollar yen. So it was basically a two factor option called a hybrid option. And it turned out that as a physicist I was very easy. It was very easy for me and I was very able to write a Monte Carlo to write this knockout cap. But for the finance people it was kind of tough. So the math was very easy. But I also learned that trading is not just math, trading is a lot of behavioral stuff and so on, and that I just obviously had to learn. And I have some great stories of stuff that I did really badly back in 1994.
- [07:36]
Joe Weisenthal
Tell us the story about how you did badly.
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Vineer Bhansali
Well, the 1994, if you remember 1993, the Fed had eased and rates were quite low and everybody was long the front end of the yield curve and buying eurodollar futures contracts.
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Joe Weisenthal
Wait, didn't a town around here go bankrupt?
- [07:50]
Vineer Bhansali
Yes, we'll get to that. Exactly. So February of 1994, the Fed raised rates by 25. And then very surprisingly, April 18th of that year they did an intermeeting increase. And at that time bond market really sold off quite a bit. And I just did what human beings do, which is bet on mean reversion. So I tried to buy the bond market and tried to buy the bond market again and again and again until I realized that there's something called trend following and exit. And I think the bond market sold off a good 15, 20 points. And finally I recouped it all. But it was a brutal few months of literally getting my face ripped off.
- [08:30]
Tracy Alloway
So one other thing I'm curious about the sort of early days of quants, but what exactly was the pitch to scientists, whether they're mathematicians or physics guys, when these big banks or big trading firms are trying to recruit back then, because quant was in the. I know we had 1987 by then, but it was still relatively in the early days. So I'm really curious what they told you about what you would be doing.
- [08:54]
Vineer Bhansali
On the modeling side. It's pretty straightforward. The Black Scholes equation and stochastic calculus. Stochastic finance is basically what's called the heat equation or the diffusion equation in physics. And that's something that every physicist learns when they're in early graduate school. It's like solving a partial differential equation. So the math is exactly identical, the math of finance. And maybe that's a problem actually in retrospect now that having done this for 30 years and 30 plus years and survived, maybe that's the problem because the beauty can somehow hide the frictions that are underneath it. From the trading side, when I first started trading, I think it was very simply being mathematically sharp and quick and being able to answer quizzes just made interviewers feel like they were getting smart people on the desk that they could train, right, the blank canvas, so to speak.
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Joe Weisenthal
So once people on these desks got armed with PhD physicists and understanding of like Brownian motion and stuff like that, did that change how the actual markets traded from your perspective, like sort of pre and post that. Did assets conform more to as models anticipated because of the model effect on them? Like what was your observation of actual existing market behavior pre and post the physics revolution?
- [10:12]
Vineer Bhansali
Oh, absolutely. And this is a very important question because if you Fast forward to 2018, the big XIV debacle and the Volmageddon and a lot of things that happen now and actually fundamentally what we do now, what I do now is related to this fact that there's a very tight feedback loop between models and markets and models. I'll give you a very simple example, right? If you have an option that you've sold to somebody and you have to manage the risk, of course when you sell the option you're getting a volatility premium. That's why you sell it. You're getting an insurance premium, so to speak. But then to manage the position you have to Delta hedge. But Delta hedging means that you have to buy and sell the underlying asset. And some higher order Greeks as well, Gamma Vega Theta that you've all read about. But delta hedging requires people to be able to buy and sell so that they are the seller. The market maker is locally flat. Of course, for the market maker, that's what you do and that's how you earn your keep, earn your fees, so to speak. The problem is that there's an idealization in mathematics or mathematical finance that you can do this at an unlimited size and size doesn't matter, but it matters. Liquidity is actually not there. The basic assumption of Black Scholes is that you can continuously trade with almost zero transactions costs. Well, that's just not true in real markets. As a matter of fact, in the last maybe two years even you've seen liquidity in the E Mini futures contract, which are possibly the, I would say the 0th order hedging instrument for the equity markets go down relative to the high levels, frequently go down to maybe 120th or 150th of its level. So people just can't get out. So what happens is that people sell options, then they start delta hedging. Delta hedging results in the options market reacting to the delta, then results in new hedges coming in. So this feedback loop gets tighter and tighter and tighter until something breaks. And when something breaks and the bots shut down, which is today's environment, you actually have no liquidity. And that's when you get these crashes, like Liberation Day on April 2nd.
- [12:11]
Tracy Alloway
Vomageddon was definitely one of the more weirder events in markets because everyone could see what was going to happen when the VIX curve actually inverted. You could see that all these products were going to go absolutely belly up. And no one seemed to react to it until it was like, much, much too late. That reminds me. So one of the reasons that we are interviewing you here in Huntington beach is because you used to work at Pimco with Bill Gross. And the last time we spoke to Bill Gross, I think, was actually at Huntington beach two years ago. And one of the things we spoke to him about was volatility selling. And Bill kind of became the poster child for a little bit of volatility selling, at least in the bond market, in the sort of like, because it would have been 2015 around then, mid sort of 2000 and tens area. I'm really curious who's selling volume now and how has it changed over the course of your career?
- [13:03]
Vineer Bhansali
Yeah, so great little side point there. So Bill and I have been great friends. As a matter of fact, I went to Pimco because I heard Bill speak at a talk when he was advertising in book back in 2000. And Bill's an amazing genius, great investor, and one of the best compliments I got recently. I was communicating with him and he said, I have your paper at the top of my reading list. And I said, which paper, Bill? And he said, this paper that I wrote with Larry Harris on the volatility selling ecosystem that basically grew up before 2018. Bill actually, in a sense, invented this whole idea of selling volatility in fixed income, especially through buying mortgages or explicit selling of straddles and strangles. And what we realized. And again, I was head of analytics at Pimco. So over the last, over 15 years or so I was there, I got to see and help him manage the quantitative risks of those portfolios. We ended up educating a lot of our clients at that time about volatility selling, harvesting volume premiums and so on, which did end up adding quite a bit of, as Bill calls it, structural alpha to the Pimco Portfolios and you know, 20, 30, 40 basis points every year. What happened is that everybody got educated and it became part of the academic lore and everybody realized it. There was a lot of crowding and it's a little bit like selling insurance, right? So when you find that one insurance policy selling works then you say why don't become a multi line insurance provider? So you start selling insurance policy on everything. And so what has happened now over my career it I've gone from institutional selling where first it was hedge funds, then it was large sophisticated mutual funds like Pimco who could actually still fit it inside of the mutual fund complex because selling naked options is not really allowed unless you cash back it. And then over time it has now gone to all the do it yourselfers. So all the wealth, offices and family offices and large endowments and this whole area which is now called alternative risk premiums is based on this idea that you can go and sell volatility in various forms, explicit forms or implicit forms to generate income. Everybody's doing it.
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Tracy Alloway
Yeah, that's the answer. Everyone, even more people are doing it. So when we see alternative risk premia, it's basically vault selling overlay, is that it?
- [15:23]
Vineer Bhansali
Yeah, I mean you can make it more or less sophisticated. I mean it's a little bit naive to say it's only volume selling, but vault selling is a very important component of it. And there were some great papers by people from AQR who took every asset class, so equities, bonds, credit, foreign exchange and then also sliced it down in various types of strategy, style and quality and momentum and so on. They made like a 16 by 16 matrix and then they recreated this what I consider to be more sophisticated sounding volume selling. But it really is volume selling. And what people do, just to be very clear is it's not just volume selling. They also layer on other things like trend following on top of it to create a counterbalance to the volume selling. Because trend following is naturally a volume liking or volume long volume type of strategy.
- [16:19]
Joe Weisenthal
Foreign.
- [16:26]
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- [17:37]
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- [18:35]
Joe Weisenthal
Going back to I hadn't realized that about the declining or the collapsing liquidity within the E Mini futures, but is there some sort of, I don't know, law of thermodynamics or something? I don't know if that's the term or that's the analogy in markets where such that when some instrument becomes the hedging instrument of choice, the more popular that gets, the less capacity there is for liquidity in that instrument. Is that sort of what's going on here?
- [19:02]
Vineer Bhansali
Yeah, so in this case the E Mini futures contract are basically a speculation vehicle. They're a cash equitization vehicle. So they serve a lot of different purposes. But I think the biggest thing that's going on here is that starting maybe about 10 years ago and somewhat surreptitiously the market morphed from human market makers. So when I started trading it was human market makers. I still remember when I was in the 1990s, Tommy Baldwin on the pit of the CBOT floor, Chicago Board of Trade floor, you would do a trade and Tommy Baldwin, he was legendary. Obviously he would lift his hand up and the market would stop and Turn and go the other way. Humans could do that. What has happened surreptitiously or very strangely over the last 15 or 10 years maybe is that the human beings have sort of left this market making area and 90 plus percent is being made by bots. And what bots know very well, self survival is extremely important to them, is as soon as they see a liquidity tidal wave coming, tsunami coming at them, they just get out of the way. The liquidity just becomes very episodic. And Mohamed El Erian used to call it latent illiquidity, which is just a fixture of the markets today. It looks liquid and when you don't need it, it's there, but if you need it, it's not there.
- [20:15]
Tracy Alloway
So how do you actually deal with that? As a trader?
- [20:17]
Vineer Bhansali
Yeah. So as a trader, this comes back to the role of options fundamentally. Right. So what do options in the world of quantitative finance? You can option, you can replicate it by doing delta hedging and so on, basically looking at the partial derivatives of an option pricing equation. Or you can say, I'll just buy the option. So an option is a contractual agreement between you and the option provider. So if there's illiquidity and you believe this is a fixture of the environment that we're going to live in, then there is no other way than to actually have a contractual agreement with somebody where you're delegating the illiquidity risk to them. And so you are buying it when the premium is cheaper. But trying to delta hedge it yourself is like literally trying to put an elephant through the eye of a needle. People just cannot work out. I mean, I just can't imagine the market collectively trying to get through that needle these days. There is just nothing there.
- [21:15]
Joe Weisenthal
Let's talk about April for a second and maybe that period between April 2 and April 9, because that was a market event for sure. And it was also a real economic event with many things going on that, that weren't just lines on a chart, et cetera. And we know what sort of happened there with the tariffs and then the reversal of some of the tariffs and so forth. Since then, we've seen some of these correlation breakdowns that some of our previous guests have talked about. From your perspective, whether it's April 2 through April 9 or April 2 through now, what happened then such that maybe some. Maybe. Is it a new regime what changed in that month?
- [21:50]
Vineer Bhansali
Yeah, so I think one of the things that is going on is we are slowly undergoing a regime shift. And I like to always paint this picture, and I'll come to your question right after I give you this big macro picture. From the 60s to the 80s, 60s to the mid-80s, you had this period of rising inflation, rising volatility, non credible central banks and stuff was kind of breaking and people were behind the curve. Then you had the Volcker increase of interest rates starting in the 1980s and until the maybe late 20s, 2020, call it 2021 Covid was an accelerant. You got negative yields and falling volatility, credible central banks and so on. And I think we've actually turned the corner again. So starting in 2020, 21, I think we are probably going to look more like the 60s to 80 than 1987 to 2020. Now, having put that backdrop in front of us, I think the issue really comes back to yes, there is a regime shift both in terms of people's response function and how quickly things happen. So one data point that I can relay since I started trading is in the past when crises would happen, even including the gfc, which I lived through and did fairly well. It used to take months, maybe weeks for things to correct and you had time to plan and time to execute. Then Vaughageddon maybe took a few days, 2020 Covid, it maybe happened in a few days to a few hours. And then starting this year, it feels like things are actually happening on an hourly to maybe minute basis. For instance, in April when the big crash happened and the correction happened, all the action, including some of our trading, happened in the pre, pre market. So the markets had not even opened up. And if you needed to do something, you had to do it during the night session because that's where all the action was. So I think that's one fixture. What's going on right now is that stuff is happening much faster and it does feel like the balance is tilted in the favor of more automated trading rather than human driven trading.
- [23:50]
Tracy Alloway
Let me ask a philosophical question about tail risk projection, which is whenever there's a blow up, we suddenly get all these stories about tail risk funds that have done phenomenally well out of last month's chaos or whatever it might be. And then no one talks about them for like the next three years.
- [24:07]
Joe Weisenthal
You don't know how they're bleeding you dry during those other months. Right?
- [24:10]
Tracy Alloway
That's right. Until we get another blow up and then the cycle repeats itself. In your mind, what is the purpose of tail risk protection?
- [24:18]
Vineer Bhansali
Yeah, this is very simple. And I've been trying to do this. This is actually one of my missions since I started our firm is not just managing the risk but also trying to educate people on what the purpose is. The purpose is very similar to insurance and not everybody needs it. If you don't live in California earthquake prone zone or in Florida hurricane prone zone, you don't need the insurance. But if you're going to run a large equity heavy portfolio, and by the way equities have demonstrated over the last hundred years and maybe going forward are the one way to create long term wealth because people go to work. The first thing I learned when I was at Citibank, my boss told me was just look at log GDP versus log S&P. The charts are aligned. Basically if people work, the market goes up. So what that means is that you need to be invested in the stock market. And the more you invest in the stock market, the more likely it is that you're going to make higher compounded returns over time. But also you will suffer big drawdowns. And one of the biggest problems with people's behavioral function is that when the markets collapse, they forget their plans and they liquidate. Right. So what tail risk fundamentally does, it's not a fund that you should look in isolation and say is this fund a good performer or not? Just like you would not go back home and say well, what was the total return on my home insurance policy? It's just negative, whatever, negative 100% every single year. So would you quit buying insurance? You won't because home insurance or car insurance is not an investment. It is the cost of doing business. So that's the context in which one should think about tail risk hedging is it allows you to first protect yourself from yourself in the bad events. And then secondly, when the markets are down, the value of those hedges going up allows you to buy assets on the cheap, which results in compounded growth.
- [26:02]
Joe Weisenthal
Why hasn't Wall street created an instrument where you could sell away your liquidity to protect it from yourself? Automatically I'm going to invest in this fund and I cannot sell until the year 2060.
- [26:15]
Tracy Alloway
Isn't that called lockups?
- [26:17]
Joe Weisenthal
But do those funds actually exist? Could I buy that? And then there's two things that intuitively seem that A, you protect yourself from yourself, B you diversify automatically by the fact that you're across time. And then C, presumably that would be more stable for securities lending and collect a little instrument. Has Wall street created a funds that one can't get out of?
- [26:40]
Vineer Bhansali
I think like Tracy just mentioned, hedge funds like to have lockups.
- [26:45]
Joe Weisenthal
I should just be able to buy an ETF that I can't sell.
- [26:47]
Vineer Bhansali
Yeah, I think if you can get over the regulators. I think we are living in a world where mark to market daily nav, et cetera for ETFs and full transparency is required. But I do think, I mean, one very sophisticated institutional investor who was a client of ours actually said, I would pay you more if you sold me a product that actually had a longer lock.
- [27:06]
Joe Weisenthal
Because this is a question I have about portfolios and diversification in general. And it goes back to the point that you made about how stocks have done very well. And the expectation is that as long as the economy grows, stocks will continue to do well for a while. 60, 40 was a craze. Right. And this is a good portfolio where your treasuries and your stocks balance out. But why should. What is the case for diversification? Let's say setting aside the behavioral fact that people sell at the lows, what is the case for diversification when there is this asset class that does so well over time?
- [27:42]
Vineer Bhansali
Yeah, so this is great though. If you could guarantee that this asset class would keep growing always, then you would 100% be on stocks only. Now, what bonds traditionally used to do was they provided you with income that when the stock market wasn't doing well, at least you wouldn't go completely broke because you would have some yield. But I think it got taken to an extreme, right? I mean the greatest example, and I wrote a whole book on this topic is, is the European Central bank, followed the Japanese Central bank and then they started buying at negative yields and they convinced all the indexers to keep buying bonds with them. Right. I mean, think about this. You were buying bonds, meaning you were lending somebody money and you were paying them interest. At that point, diversification is an insult. I mean, you don't want to buy a negatively yielding bond along with stocks because it does nothing for you. And we're living the consequences of it today because the bond market over the last five or seven or ten years even has had absolutely dismal zero returns.
- [28:33]
Tracy Alloway
Joe, do you think people who want positive yielding bonds are entitled still? That was your position for like a whole year.
- [28:39]
Joe Weisenthal
I still think that. I still don't think anyone is entitled to yield. No, I don't. If you want to take the risk, go get it. But the sort of moral demands that the government must provide you yield for what? For not spending and doing anything. Give me a break.
- [28:51]
Tracy Alloway
Joe spent a good year making fun of yield, the old barks.
- [28:56]
Joe Weisenthal
That's great. Go out, collect your yield. I'M happy for you. But don't pretend that it's some sort of moral insult that the government isn't providing you risk for yield. That is my only. That is my only stance.
- [29:06]
Tracy Alloway
That's, I would argue, the US Government's most important role. Anyway, let's go back for a second. So it's not just the insurance idea. You touched on this, but it's also the idea that, like, you can get a massive windfall when there's a market crash and then you can use that money to actually go on a buying spree at a time when markets are cheap and everyone else is short on cash and they can't do the same. How do you actually deploy that into practice? And how do you scale, for instance, an expected windfall against the type of assets that you could potentially buy?
- [29:37]
Vineer Bhansali
Yeah, I think this is where the first principles thinking becomes really important. So you have to look at every portfolio is different. So one of the other mistakes I think people make is they think you can just pick up a Finance 101 book and say every portfolio is identical, it's all risk neutral, and everybody's exactly the same is just not the case. Public fund that has a 40% or 50% funded ratio is very different than a 90% or a bank that's 120% fully funded. So everybody has different needs. The first thing that you do is you look at the underlying portfolio posture, how much loss can you take, look at the systemic risk shocks that they can actually withstand. So you run a shock, you run a full distribution analysis and figure out what is the outcome under which they will be under so much distress or so much duress that they might end up having to liquidate assets. And there are actually quite a few like that right now, where if the stock market went down 20% and privates went down about 20%, in order to raise liquidity for distribution, they would have to actually sell seed corn. Right. So it's really, really bad. So that's an existential risk that you want to quantify. So the first thing that you do is figure out what that risk is, a full distribution of outcomes. And then you look at the instrument set that's out there in the marketplace. Starting from the most reliable and surprisingly enough, like Joe mentioned already, the cheapest one, which is equity option volatility. You can buy those put options, but people who are not willing to pay a lot of continuous premium, you can do more sophisticated tricks where you can buy indirect hedges. For instance, credit default swaps. Today, the CDX index If you don't see the charts, it's actually tighter than it was pre the gfc. It's the tightest it's ever been because people are buying it for cosmetic yield reasons. So there are a lot of derivatives.
- [31:24]
Joe Weisenthal
It's cosmetic yield.
- [31:25]
Vineer Bhansali
Cosmetic yield simply means that the total yield, if you look at the yield of a corporate bond today, it is basically treasury yield plus some spread. So the treasury yields are at call it 4.5% 4%, but the spreads are actually very tight, only 50 basis points on the CDX. So you're getting a 5% 6% yield, which in the context of where we were three years ago looks like it's cosmetic. It's cosmetic. It looks good, it looks good, but it's actually you are taking.
- [31:52]
Joe Weisenthal
I hadn't heard that drip. Okay, keep going.
- [31:54]
Vineer Bhansali
Yeah, it's a cosmetic yield, your decorated yield. So to me the yield is not justified by the risks that underlie it. So there's various instruments that you can use and create a portfolio of these types of hedges.
- [32:19]
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- [34:57]
Joe Weisenthal
Is tail risk hedging like insurance from a business? From a structure of how people buy it? Is it like insurance where people sort of reload every year in a sort of okay, start of the new year? What is the tail risk I want to put on, et cetera, or something that renews and they have to keep paying a fee? Or is it just sort of something that can be set it and forget it. A permanent allocation that sort of the tail risk hedge. Like talk to us about the business of selling a tail risk hedge.
- [35:26]
Vineer Bhansali
Yeah, so definitely. So it goes up to the highest level where this becomes part of where you guys started portfolio construction. It's an asset allocation decision.
- [35:33]
Joe Weisenthal
Yeah.
- [35:33]
Vineer Bhansali
It's not a trade. So the context has to be that if the agents are all lined up, meaning boards and trustees and so on, they think of this decision as protecting the portfolio or making a more robust portfolio as part of the DNA. The tail risk becomes part of how you rebalance your portfolio over the long term. Okay, so that's how you set up the strategic portfolio. But then to your point, every year, yes, you have to renew this policy. You have to recommit premiums. Now you can pre fund for the next five years if you wanted to. But because options decay, in order to have this reliable hedge, you sort of have to buy new options.
- [36:11]
Adobe Acrobat Announcer
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- [36:12]
Tracy Alloway
What would be the worst kind of tail risk hedging in your view? Is it too expensive or does it not actually work when there is a big market crash? What is the ultimate sin of a tail risk strategy?
- [36:24]
Vineer Bhansali
Ultimate sin absolutely is the one which promises to work but doesn't work. Right. So a lot of people try to reduce your cost by creating synthetic strategies. I already mentioned futures markets aren't very deep when you need them but there's a lot of strategies which actually use a futures replication strategy like the 1987 crash also purported to do. And those strategies typically don't work. And so there's many that promise and they look like they are cheaper and they don't cost any bleed, but they also do not deliver, which again, going back to April 2nd, the only thing that worked during that April 2nd to April 8th period was reliable hedging using index options. Nothing. Duration didn't work, Trend following didn't work. A lot of other altruist premium strategies didn't work. So that is the cardinal sin. You just do not have the luxury to go to the constituents, your clients or whoever's bought it and said we were trying to be too smart and oops, it didn't work.
- [37:20]
Joe Weisenthal
As you mentioned that to even talk about buying a tail risk hedge, you have to sort of understand is what is the existential risk for the fund. And different funds have different flavors of existential risk depending on how funded they are. And so obviously an entity that's 120% funded is going to have very different risk scenarios than one that's 40% funded. But you said something interesting, which is that, and I've been thinking about this a lot in a different context, which is how levered is the financial system or the real economy to an ongoing rise in the stock market? How important is that? And at what point does even a sideways stock market, let alone a decline, become risky for something that could break? And you know, we used to think credit is the thing that breaks, but I wonder if it's in the stock area thing now where you really get the problem with the equity values don't go up. Tell us more about what you said about what happens to various types of economically important players if the stock market one day stops going up for a sustained period of time.
- [38:19]
Vineer Bhansali
I think you have a big problem, right? So not only is the stock, the whole system, 401ks and public pensions, they're all levered up to the stock market because that's the only way you can get to your 7 and a half or 8% actual yield. So if the stock market doesn't keep going up and keep delivering those kind of returns, it's very hard to get to that point. Maybe if inflation rises, at least again, cosmetically, maybe the long bond gets up to 7% or 8% and everybody can just lock it in and immunize and you're there. But in real terms, you're not going to have the income that you need 30 years from now to retire.
- [38:51]
Joe Weisenthal
I'm fine. I have a zerbier mortgage. So I have a mortgage that's locked in from that one week period of time.
- [38:57]
Vineer Bhansali
Yeah, exactly. So the system is very levered. And then corporate credit, clearly it's very, very concentrated. We all read about fangs and so on. But corporate credit, based on the Merton model again that connects equities to corporate credit spreads, is also leveraged the stock market. So the stock market suddenly had a big sell off. Corporate credits widen out, which is the real problem. Because if corporate credit widens out and the cost of borrowing goes up for all the corporations, maybe not the Fang stocks, but the 493 other stocks, then how does the system produce? Because our whole system is based on borrowing. And I don't think very many companies in the US can function if your cost of operating your business was 10% of your.
- [39:40]
Tracy Alloway
Okay, well on that note, we would be remiss to have a tail risk person here and not ask what's the big risk that you see on the horizon in let's just say the short to medium term?
- [39:50]
Vineer Bhansali
I think for me the biggest risk right now is what people have been talking about is the so called, and I call it so called Fed independence paradigm shift. Because I don't believe the Fed was ever really fully independent. But now it's coming to the fore that the fiscal and monetary authorities are actually one. So what happens in the aftermath if the Fed actually becomes part of the central government, the fiscal authorities? I think at that point all bets are off because that's the one anchor that everybody, whether realistically or not, has held onto. But if interest rates can change just based on the need to finance something that totally upsides down the financial system. So to me that's the single biggest risk right now.
- [40:33]
Tracy Alloway
So would that materialize into an inflationary risk, for instance? And then would you be focused on what you can do to offset that?
- [40:41]
Vineer Bhansali
Yeah, inflationary risk. And I think one of the best option trades, again, this is not a direct option. So going back to what you were asking before, you don't always just have to pay premium. The yield curve steeper, where you buy the short end of the yield curve and you sell the long end of the yield curve. Today you can do it through using swaps and all that for essentially zero net carry. So here's an option very similar to shorting the negative yielding bond market in Europe a few years ago, where if you put a yield curve steep NER on either in a hyperinflationary, maybe not hyper, but a lot high inflationary scenario or in an aggressive Fed cut, the yield curve steepens. So yes, so that environment is an environment in which the curve steeper could work. And yes, my zeroth order prior forecast would be that if we lose explicit independence of the Fed, the yield curve actually steepens a lot more.
- [41:31]
Joe Weisenthal
Something I'm interested in. So, you know, you were talking about the recent eras and the, the 60s and 80s and things may have gotten a little unglued. And then the Volcker era, and then the post Covid era, and now this question about whether what's left of Fed independence is at risk. You know, you're a physicist and a lot of people in your space are mathematicians. Is there a limit to how much you can sort of math it out, so to speak? Because a lot of these questions are external to mathematics. And so how do you think about the limits of quantitative analysis when we're dealing with things like will the political system allow the Federal Reserve to remain independent?
- [42:10]
Vineer Bhansali
Yeah, I think a lot of it is actually non quantitative. And what I've learned, even though I come from a quantitative background, is not the math itself, but it's the sequence of logical arguments that you can make to get to a conclusion. Right. So for instance, we knew even before fancy mathematics was discovered, Lagrangians and so on, that gravity exists. Gravity's existence has been known before. Maybe math was invented, but gravity has been there. And so I think there's some central laws of finance which will still continue to exist regardless of the mathematical modeling of them. And Bill Gross, when I used to work with him, he used to say some things we can take for granted, I'm paraphrasing it, but the steepness of the yield curve, the fact that the yield curve needs to be upward sloped for the financial system to function because people lend money in order to get something in return, those are not mathematical devices. Those are really just the way the capitalist system works. So I think you can take the quantitative modeling to its own limit. But there are certain things that have happened in our system where we are at a point now where gravity, so to speak, of the financial markets, are going to have to take over.
- [43:17]
Tracy Alloway
But presumably also if you can't predict the politics, because it's very difficult, especially nowadays, if you can't predict the politics, then maybe. Right. Sizing your positions becomes more important. And so the maths actually becomes one way of dealing with the very uncertainty, non mathematical element of what's going on.
- [43:35]
Vineer Bhansali
Yeah, exactly. And I think to take that Point one step further. So correlation has been the greatest gift since the 19 mid-80s to 2020. So you got stocks and bonds, just say 60, 40. Stocks went up, bonds went up and they were diversifying, which is what a beautiful place to be. Right?
- [43:51]
Tracy Alloway
That sounds nice.
- [43:51]
Vineer Bhansali
Yeah. So that was a freebie. And again, this goes back to financial gravity, just so to speak, that state of affairs, that free lunch should not exist. So I think we might be entering a phase where stocks and bonds maybe are actually not diversifying and you have to look at other things. Gold, of course, as you mentioned, maybe Bitcoin, who knows? But I think the fact that reliable insurance or portfolio protection is so available today, using the options market, to me would be the place where I would look.
- [44:20]
Joe Weisenthal
When you look at the long end of the yield curve today in the US is there an element in which these concerns about the loss of Fed independence are being priced in right now? If suddenly you could snap your finger and know for a fact that the Fed will operate as it has been for the last 20 years, for the next 20 years, would there be a change? Is there some margin that's concerned there? You know what, I don't know if the Fed is going to be a committed inflation fighter as well as it has been in the past. Therefore, I'm demanding extra yield today.
- [44:51]
Vineer Bhansali
No, not yet, I don't think so. Maybe a slight amount of premium has gone up. But one of the most striking features of the system is that if you look at the treasury yields, look at the 30 year bond today is 470. But you look at the 30 year interest rate swap, it's trading at, believe it or not,389. So it's almost 85 basis points under the US Treasury. Now you ask why would somebody take the swap market at a lower yield? And I've been trading swaps since its inception back in the 1990s. Swap spreads are negative 85. And that goes back to the receiving of interest rate swaps to hedge liabilities by a lot of large institutions. So they have certainly not priced in inflationary effects into the swap market. But at some point this has to also equilibrate. So in my view, it has not been priced in. Maybe it's too early to price in because maybe the Fed does not lose its independence and rises as Phoenix from the Ashes. But I'm a little bit pessimistic about it.
- [45:50]
Tracy Alloway
Just going back to your storied career on Wall street for a second, how good were you at playing liars poker?
- [45:56]
Vineer Bhansali
I was actually pretty Good, I think. I mean, I learned it after I joined Salomon Brothers. It was a good group of people. And I think the first year maybe I lost a bit, but I think in the third year that I was there, I won it. And I was actually, I think, the one who took the biggest part. And I also. My boss gave me his 18 foot fishing boat, but he was buying a new one as part of the settlement that I knew. Yeah.
- [46:20]
Tracy Alloway
In lieu of cash. He was like, here, take my old cash.
- [46:22]
Vineer Bhansali
Well, cash plus the boat, I think.
- [46:23]
Joe Weisenthal
Wow, that's a really big pot.
- [46:26]
Vineer Bhansali
That was a big pot. Yeah. At that point, you used to spend after the trading day was over, every day we would print out randomized liars poker sheets. Usually about 24 or 30 of them, and we'd play about 30 rounds every day.
- [46:38]
Tracy Alloway
Wait, Liars poker sheets? I thought you played with. With actual cash.
- [46:41]
Vineer Bhansali
Yeah. So actual cash, you play with dollar bills, but if you're playing 24 rounds, there are not enough dollar bills flying around.
- [46:48]
Tracy Alloway
I never thought of that.
- [46:49]
Vineer Bhansali
Yeah. So you randomize based on how the dollar bill numbers are generated.
- [46:53]
Joe Weisenthal
Is there going to be a future in finance for a young physics student or a math nerd in high school? Today people worry about this with AI and so forth, but a young person who's quantitatively minded, do you feel confident that there will be a role for them in finance in the future?
- [47:10]
Vineer Bhansali
Absolutely. I think finance has existed from the very, very beginning because it's based on the two fundamental emotions, Right. Greed and fear. Right. So as long as there's greed and fear and there's smart people around, and again, going back to math and physics, it's not so much that the toolkit itself is teaching you anything special, it's just it teaches you think in a disciplined, logical fashion. And I think with tools like what we're seeing with AI and so on and coding becoming completely democratized, I think the ability to ask important questions rigorously becomes even more important. I think it's going to be even better than it's been.
- [47:44]
Tracy Alloway
Vanir, that was absolutely fantastic. Thank you so much for spending time with us at Huntington beach at the Future Proof Conference. And that was great.
- [47:52]
Joe Weisenthal
Yeah, thank you so much. That was fantastic.
- [47:54]
Vineer Bhansali
Thanks for having me.
- [48:08]
Tracy Alloway
Joe. That was really fun. We should have an era back and just do like Stories from Wall street in the 1990s episode. We could do that.
- [48:15]
Joe Weisenthal
I love the stories. We could do a lot more on the stories. And I'm also interested in basically the philosophy of portfolio construction. I mean, obviously there's the math of portfolio construction. But I do have a certain dissatisfaction with many conversations about portfolio construction, including this. Well, I diversify of stocks have almost always gone up. Has every insurance. I mean, I guess another question that I could have asked is, has every insurance contract on the stock market essentially so far been a waste in human history because the stock market is at all time highs? I have questions about that.
- [48:47]
Tracy Alloway
But the counterpoint to that is, and I've come to realize this as I get older in my life and in my portfolio is there is something nice about like waking up during a sell off and going like, oh shoot, my 401k has been absolutely decimated today. But if I look at, you know, some other position or some other tail risk hedge that I have, like that's actually up a little bit and it's offset some of the pain. And if I actually had to cash out of my portfolio on that day because of whatever I had to make a mortgage payment or whatever, then I would have some extra cash to spare and you could get an extra return by having that extra cash available to you to then go into the market and buy stuff on the cheap.
- [49:27]
Joe Weisenthal
I think that we really should have an odd lots ETF that is advertises its illiquidity that you can't sell this if you need cash. Now this is not the instrument for you. If you are putting your money in this, don't expect to see it again for 30 years. But the plus side is it will keep you from making bad irrational decisions on a day when everything is red.
- [49:46]
Tracy Alloway
I mean, there's a value in that. There's a value in that. And there's also a value in being able to, you know, sleep at night a little easier because you have different positions. But anyway, shall we leave it there?
- [49:56]
Joe Weisenthal
Let's leave it there.
- [49:57]
Tracy Alloway
All right. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracey Holloway.
- [50:03]
Joe Weisenthal
And I'm Joe Weisenthal. You can follow me at the Stalwart. Follow our guest, Veneer Bonsali. He's ontail Alpha. Follow our producers, Carmen Rodriguez at Carmenarmon, Dashiell Bennett at Dashbot and Kale Brooks at Kalebrooks. For more Odd Lots content, go to bloomberg.com oddlots we have a daily newsletter and all of our episodes and you can chat about these topics 24. 7 in our Discord, Discord, GG Oddlauds.
- [50:27]
Tracy Alloway
And if you enjoy odds, if you like it when we talk about portfolio construction, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad free. All you need to do is find the Bloomberg Channel on Apple Podcasts and follow the instructions there. Thanks for listening.
- [51:20]
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- [52:18]
Joe Weisenthal
Only Murders in the Building Official Podcast is now streaming on Hulu and Hulu on Disney. Join host Michael Cyril Creighton behind the scenes to talk all things Arconia with Steve Martin, Martin Short, Selena Gomez and more. Actors, writers and crew from Season five. Watch and listen to the new podcast series Only Murders in the Official Podcast now streaming with new episodes Tuesdays. Listen wherever you get your podcasts and don't miss Only Murders in the Building Streaming on Hulu and Hulu on Disney for bundle subscribers terms apply.
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