Vineer Bhansali on Losing Fed Independence as the Biggest Tail Risk Right Now

Everyone wants to buy the hedge that will save their portfolio in a time of collapse. But this is easier said than done. You need to understand the specific risks facing your portfolio. You also need to get the disaster state right. Plus, insurance of any sort is costly. This means tail risk hedging is far from a trivial exercise. On this episode, we talk to someone who's been working on the problem for a long time. Vineer Bhansali is the CIO and founder of LongTail Alpha, which works to develop hedging implementations to prevent against left tail outcomes. Bhansali, who started off as an academic physicist before going to Wall Street, talks to us about options theory, the role of quantitative techniques, the time he won big in Liar's Poker, and why he perceives the loss of Fed independence as the biggest risk right now. Read more:Wall Street Rallies as Fed Gets All-Clear to Cut: Markets WrapGold Surpasses Inflation-Adjusted Record High Set in 1980 Only Bloomberg - Business News, Stock Markets, Finance, Breaking & World News subscribers can get the Odd Lots newsletter in their inbox each week, plus unlimited access to the site and app. Subscribe at bloomberg.com/subscriptions/oddlotsSee omnystudio.com/listener for privacy information.

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• 0:00Speaker 00

  Finance is increasingly being built on digital rails. But as the adoption of virtual assets, tokenization and stable coins grows, can regulation not only keep pace but help accelerate it? Find out more later in the podcast.

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• 3:10Tracy Alloway?

  Hello and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

• 3:14Joe Weisenthal?

  And I'm Joe Weisenthal.

• 3:16Tracy Alloway?

  Joe, I've been reflecting on this year. It's been a busy year.

• 3:20Joe Weisenthal?

  Yeah, go on.

• 3:21Tracy Alloway?

  In fact, we're recording this. We're on yet another trip.

• 3:24Joe Weisenthal?

  I know.

• 3:24Tracy Alloway?

  We're in Huntington Beach for this year's Future Proof Conference, which is

• 3:28Joe Weisenthal?

  Always a fun time.

• 3:28Tracy Alloway?

  An event I always enjoy, but we happen on the road a lot.

• 3:31Joe Weisenthal?

  We have.

• 3:32Tracy Alloway?

  And I feel like the entire year is starting to feel very surreal for me.

• 3:36Joe Weisenthal?

  Yeah.

• 3:37Tracy Alloway?

  It feels just very different to prior years.

• 3:39Joe Weisenthal?

  Yeah, it does.

• 3:40Tracy Alloway?

  For many different reasons. But I was also thinking, one of those reasons is because 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's really scary because basically everything sold off at once, right?

• 4:08Joe 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.

• 4:13Tracy Alloway?

  And then I was like, how do I protect my portfolio?

• 4:16Joe Weisenthal?

  And I've been reflecting and then the surreality of the times. And now we bring it around to portfolio construction. But no, this is true. And there's two, a couple of things going on. So one is the sort of like cross asset class moves. The other thing is, and it's 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 US assets, the winners are still the winners, right? Especially a lot of these big tech names. So you haven't gotten the sort of secular.

• 4:46Tracy Alloway?

  And people have been talking about overvaluations for ages.

• 4:49Joe Weisenthal?

  Forever. And then the fact that 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.

• 5:00Tracy 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?

• 5:27Joe Weisenthal?

  You like buy gold, that's already a record high.

• 5:28Tracy Alloway?

  Yeah.

• 5:29Joe Weisenthal?

  It's confusing.

• 5:30Tracy 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 Vener Ban Sali. He is, of course, the founder of a long tail alpha. And again, has worked at many, many firms previously. We'll get into all of that. Vener, thank you so much for coming on Odd Lots.

• 6:00Speaker 07

  Thank you for having me.

• 6:01Tracy 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.

• 6:13Speaker 07

  Yep, I started out as a theoretical physicist. I was finishing my PhD at Harvard. And this 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 superglider, the superconducting superglider 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 of the 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.

• 6:56Speaker 07

  For disclosure, I knew no finance, I had no interest in it. It was Fisher Black who was interviewing me.

• 7:02Tracy Alloway?

  Oh, wow.

• 7:02Speaker 07

  I decided, you know, 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 Taylor's sketching in a second.

• 7:26Tracy Alloway?

  Wait, I gotta ask, why did you decide to turn down Goldman, given that Fisher Black himself was doing the interview and you chose to go to Citi at that time?

• 7:35Speaker 07

  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, it's not like a good thing to do, a fun thing to do, rather.

• 7:49Joe Weisenthal?

  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?

• 8:11Speaker 07

  So interesting, though, the modeling certainly at those days seemed a little too naive. So first, I'll give you an example. Very first trade that we did, large trade, I was at Citibank at the time, and it was an interest rate cap on yen interest rates linked to a 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 1990, 94.

• 8:56Joe Weisenthal?

  Tell us a story about something you did badly.

• 8:58Speaker 07

  Well, in 1994, if you remember, in 1993, the Fed eased and rates were quite low and everybody was long the front end of the yield curve and buying euro dollar futures contracts.

• 9:08Joe Weisenthal?

  Wait, didn't a town around here go bankrupt?

• 9:10Speaker 07

  Yes, yes, 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 inter-meeting 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 fifteen, twenty points. And finally, I recouped it all. But it was a brutal few months of literally getting my face ripped off.

• 9:50Tracy 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, you know, like quant was in the, I know we had nineteen eighty-seven by then, but it was still relatively in the early days. So I'm really curious, like, what they told you about what you would be doing?

• 10:13Speaker 07

  So on the modeling side, it's pretty straightforward, right? The Black-Schulze 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 thirty years and thirty-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

• 10:58Speaker 07

  feel like they were getting smart people on the desk that they could train, right? A blank canvas, so to speak.

• 11:04Joe 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.

• 11:32Speaker 07

  Oh, absolutely. And this is a very important question because if you fast forward to 2018, the big XIB debacle and the Volmageddon.

• 11:39Joe Weisenthal?

  Oh, yeah.

• 11:39Speaker 07

  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. So 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. So the market maker, that's what you do, and that's how you earn your

• 12:24Speaker 07

  keep or 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 cost. 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 contracts, which are possibly the, I would say, are the zeroth order hedging instrument for the equity markets. Go down relative to the high levels, frequently go down to maybe 120th or 150th office level. So people just can't get out.

• 13:07Speaker 07

  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 bot 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 2.

• 13:31Tracy Alloway?

  Volmageddon 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. Like you could see that all these products were going to go absolutely belly up and no one, 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, I guess it would

• 14:13Tracy Alloway?

  have been 2015 around then, mid sort of 2010s area. I'm really curious, who's selling vol now and how has it changed over the course of your career?

• 14:23Speaker 07

  Yeah, a 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 a 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. So yes, so 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

• 15:07Speaker 07

  of analytics at PIMCO, so over the last, or 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 vol 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? You start selling insurance policy on everything.

• 15:50Speaker 07

  And so what has happened now over my career, it has 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.

• 16:09Tracy Alloway?

  Right.

• 16:10Speaker 07

  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. So everybody's doing it.

• 16:35Tracy Alloway?

  Yeah, that's the answer. Everyone, even more people are doing it. So when we see alternative risk premia, it's basically a vol selling overlay? Is that it?

• 16:43Speaker 07

  Yeah, I mean, you can make it more or less sophisticated. I mean, it's a little bit naive to say it's only vol selling, but vol 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'd consider to be more sophisticated sounding vol selling, but it really is vol selling. And what people do, just to be very clear, is it's not just vol selling, they also layer on other things like trend following on top of it to create a counterbalance to the vol

• 17:25Speaker 07

  selling because trend following is naturally a vol liking or vol, long vol type of strategy.

• 17:46Speaker 00

  What's next for virtual assets? I'm Jacob Grease, host of Economy Scale, a series exploring growth in key global sectors. And in this episode, we're diving into the digital forces shaping finance. Sean McHugh from Dubai-based Virtual Assets Regulatory Authority has this to say.

• 18:02Speaker 08

  We're seeing a lot of institutional players come in, digital asset dedicated hedge funds, high-frequency traders and that sort of thing, and folks who service institutional clients.

• 18:11Speaker 00

  As more capital enters the market, adaptive regulation is likely to become increasingly key. Reece Merrick of Ripple says.

• 18:19Speaker 09

  A lot of regulators globally would like to keep the industry at arm's length. That's the opposite here. I think also what you'll find is that regulation and frameworks can come out, but some of them are maybe a slight iteration on some 80-year-old policy and not actually in line with what the technology can do and offer. And again, that's very different in Dubai.

• 18:38Speaker 00

  Listen to the full episode wherever you get your podcasts. This series is brought to you by Bloomberg Media Studios and the Dubai Department of Economy and Tourism.

• 18:48Speaker 01

  This is the Bloomberg Tech Minute, brought to you by ChatGPT. I'm Carol Muster. Getting hired at SpaceX requires exceptional ability and may include having Elon Musk review a candidate's resume. So writes Bloomberg Businessweek's Lauren Grush. She reports that the company culture is defined by Musk and job candidates must understand that a commitment to SpaceX means adhering to this culture and exhibiting loyalty to Elon Musk. To get hired, candidates must demonstrate their achievements from past jobs, and hands-on experience matters more to recruiters than advanced degrees, with the company looking for people with raw, innate intelligence. A spokesperson for SpaceX didn't respond to a request for comment on its recruiting

• 19:30Speaker 01

  and hiring practices, but according to recruiters, advisors and those who've interviewed for jobs there, it's the space exploration dream that draws people to the company, and Musk invokes that dream regularly to remind workers why they're there. Prospective hires are told that the job will require stamina, including in job ads that candidates, quote, "must be willing to work extended hours and weekends as needed." One major perk for all that hard work? Employees' access to equity, either the right to buy shares or payment in the form of restricted stock units that vest over time. That's the Bloomberg Tech Minute, brought to you by ChatGPT. Get started at ChatGPT.com.

• 20:11Joe 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?

• 20:38Speaker 07

  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, you know, in the 1990s, Tommy Baldwin on the pit of the CBOT floor, Chicago Board of Trade floor, you know, you would do a trade and Tommy Baldwin, and 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.

• 21:14Joe Weisenthal?

  Yeah.

• 21:15Speaker 07

  What has happened surreptitiously or, you know, 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 ill-liquidity, 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.

• 21:51Tracy Alloway?

  So how do you actually deal with that as a trader?

• 21:54Speaker 07

  Yeah, so as a trader, so this comes back to the role of options fundamentally, right? So what do options, in the world of quantitative finance, you can take an 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. 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. Ah. And so you are buying it when the premium is cheaper. But trying to delta hedge it yourself is like literally trying to, you know, put

• 22:39Speaker 07

  an elephant through the eye of a needle. It's just, people just cannot work out. I mean, I just can't, I just can't imagine the market collectively trying to get through that needle these days. There is just nothing there.

• 22:51Joe Weisenthal?

  Let's talk about April for a second and maybe that period like between April 2nd and April 9th, because that was a market event for sure. And it was also a real economic event with many things going on 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 what so forth. Since then, we've seen some of these correlation breakdowns that some of our previous guests have talked about. From your perspective, you know, whether it's April 2nd through April 9th or April 2nd through now, what happened then such that maybe some, maybe is it a new regime? What changed in that month?

• 23:27Speaker 07

  Yeah, 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.

• 24:10Speaker 07

  The sixties to eighty, then nineteen eighty seven to twenty twenty. 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 is 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 Volmageddon maybe took a few days. Twenty twenty 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

• 24:55Speaker 07

  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 of 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.

• 25:27Tracy Alloway?

  Let me ask a philosophical question about tail risk protection, 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.

• 25:43Joe Weisenthal?

  If you don't know how they're bleeding you dry during those other months, right?

• 25:46Tracy 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?

• 25:54Speaker 07

  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 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 a Citibank, my boss told me was just look at log GDP versus log S and 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.

• 26:39Speaker 07

  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 is 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? Right? It's just a cost of the negative of hundred percent, right? 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.

• 27:22Speaker 07

  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.

• 27:39Joe Weisenthal?

  Why hasn't Wall Street created an instrument where you can 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.

• 27:52Tracy Alloway?

  Isn't that called lockups?

• 27:53Joe 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 the little instrument. Has Wall Street created a fund that one can't get out of?

• 28:16Speaker 07

  I think like Tracy just mentioned, hedge funds like to have lockups and.

• 28:21Joe Weisenthal?

  I should just be able to buy an ETF that I can't sell.

• 28:23Speaker 07

  Yeah, I think if you can get over the regulators, I think that 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 one, 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.

• 28:42Joe 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. Sixty, forty was a craze, right? And this is a good portfolio where your treasuries and your stocks balance out. But why should, like, 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?

• 29:18Speaker 07

  Yeah, so this is great, though. If you could guarantee that this asset class would keep growing always, then you would a hundred percent 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.

• 29:43Joe Weisenthal?

  Yeah.

• 29:44Speaker 07

  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. And 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 10 years even has had absolutely dismal, zero returns.

• 30:09Tracy Alloway?

  Joe, do you think people who want positive yielding bonds are entitled still? That was your position for like a whole year.

• 30:15Joe 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.

• 30:27Tracy Alloway?

  Joe, Joe spent a good year making fun of yield bugs, as we call them.

• 30:32Joe Weisenthal?

  That's great. Go out, collect your yield. I'm, 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.

• 30:43Tracy 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, you know, 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 that type of assets that you could potentially buy?

• 31:14Speaker 07

  Yeah, I think this is where the first principles thinking becomes really important. So you have to look at, every portfolio is different, right? So one of the other mistakes I think people make is they think you can just pick up a finance one-on-one book and say, every portfolio is identical. It's all risk neutral and everybody's exactly the same. It's just not the case. Public fund that has a 40% or 50% funded ratio is very different than a 90% or a, you know, bank that's 120% fully funded, right? So everybody has different needs. The first thing that you do is you look at the underlying portfolio's 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

• 31:57Speaker 07

  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. The first thing that you do is you 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.

• 32:37Speaker 07

  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 derivative instruments out there. 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. So the treasury yields are at, call it four and a half, four percent. But the spreads are actually very tight, only fifty basis points on the CDX. So you're getting a five percent, six percent yield,

• 33:20Speaker 07

  which in the context of where we were three years ago, looks like an enormous yield.

• 33:23Joe Weisenthal?

  It's cosmetic. I see. It looks good. It looks good. Yeah, got it. Okay, okay.

• 33:27Speaker 07

  You are taking too much risk.

• 33:29Joe Weisenthal?

  Okay, keep going.

• 33:30Speaker 07

  Yeah, it's a cosmetic yield, your decorated yield.

• 33:32Joe Weisenthal?

  Yeah.

• 33:33Speaker 07

  So to me, the yield is not justified by the risks that are underlied. But there's various instruments that you can use and create a portfolio of these types of hedges.

• 33:57Speaker 01

  This is the Bloomberg Tech Minute brought to you by ChatGPT. I'm Carol Muster. Getting hired at SpaceX requires exceptional ability and may include having Elon Musk review a candidate's resume. So writes Bloomberg Business Week's Lauren Grush. She reports that the company culture is defined by Musk and job candidates must understand that a commitment to SpaceX means adhering to this culture and exhibiting loyalty to Elon Musk. To get hired, candidates must demonstrate their achievements from past jobs and hands-on experience matters more to recruiters than advanced degrees, with the company looking for people with raw, innate intelligence. A spokesperson for SpaceX didn't respond to a request for comment on its recruiting and hiring practices,

• 34:40Speaker 01

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• 35:21Speaker 10

  This is the Bloomberg Market Minute brought to you by Comcast Business. The markets faced plenty of challenges this year. Rising energy costs, higher interest rates, pushback to massive artificial intelligence spending. But through it all, stocks keep breaking records and some analysts think they still can with a focus on the fundamentals. Nadia Lovell is head of global equity strategy at UBS.

• 35:42Speaker 11

  Earnings has been good and continues to be good. And while, you know, we might be past the peak in earnings growth, we're not past the peak in earnings level.

• 35:51Speaker 10

  But others like Miller Tabak strategist Matt Maely say those challenges could eventually lead to a downturn.

• 35:56Speaker 12

  Whenever we see a significant rise in bond yields like we have and a significant rise in oil prices like we have, the stock market always or pretty much always ignores it for a while.

• 36:07Speaker 10

  And Wall Street may be starting to take notice. A recent Citigroup index shows more analysts cut rather than raise their earnings forecasts for corporate America for the first time in more than five months. That was the Bloomberg Market Minute brought to you by Comcast Business, one partner powering 90% of the Fortune 500 and millions of small businesses. When you add it all up, no one does business like Comcast Business.

• 36:34Joe 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's sort of the tail risk hedge? Like, talk to us about the business of selling a tail risk hedge.

• 37:02Speaker 07

  Yeah, 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.

• 37:10Joe Weisenthal?

  Yeah.

• 37:10Speaker 07

  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. And the tail risk becomes part of how you balance 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 really 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.

• 37:49Tracy Alloway?

  What would be the worst kind of tail risk hedging in your view? Is it, you know, too expensive? Or does it not actually work when there is a big market crash? Like, what is the ultimate sin of a tail risk strategy?

• 38:00Speaker 07

  Ultimate sin absolutely is the one where it promises to work but doesn't work, right? So a lot of people try to reduce your costs 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.

• 38:43Speaker 07

  A lot of other ultra premium strategies didn't work. So that is the cardinal sin. You just do not have the luxury to go to the constituent or clients, whoever's bought it, and said, you know, we were trying to be too smart and oops, it didn't work.

• 38:57Joe 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

• 39:41Joe Weisenthal?

  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.

• 39:56Speaker 07

  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 seven and a half or eight percent 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 seven percent or eight percent 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.

• 40:27Joe Weisenthal?

  I'm fine. I have a Zerpear mortgage. So I have, I have a mortgage that's locked in from that one sweet period of time.

• 40:34Speaker 07

  Exactly. So the system is very levered and then corporate credit clearly is 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 levered to the stock market. So the stock market suddenly had a big sell-off, corporate credit's widened out, which is the real problem, right? Because if corporate credit widens out and the cost of borrowing goes up for all 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% a year.

• 41:17Tracy 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?

• 41:27Speaker 07

  I think for me, the biggest risk right now is what people have been talking about is, you know, 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 on to. But if interest rates can change just based on the need to finance something, that totally upside downs the financial system. So to me, that's the single biggest risk right now.

• 42:10Tracy 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?

• 42:17Speaker 07

  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 steepener, 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 negatively yielding bond market in Europe a few years ago, where if you put a yield curve steepener on, either in a hyper-inflationary, 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 steepener could work.

• 42:59Speaker 07

  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.

• 43:08Joe Weisenthal?

  Something I'm interested in, so you know, you were talking about the recent eras and 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. 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?

• 43:47Speaker 07

  Yeah, I think a lot of it is actually non-quantitative. And what I've learned, even though I come from a quantitative background, it's 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, you know, 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

• 44:30Speaker 07

  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're at a point now where gravity, so to speak, of the financial markets is going to have to take over.

• 44:53Tracy 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.

• 45:12Speaker 07

  Yeah, exactly. And I think to take that point one step further, so correlation has been the greatest gift since the nineteen, mid eighties to 2020, right? So you've got stocks and bonds, just say it's 6040. Stocks went up, bonds went up, and they were diversifying, which is what a beautiful place to be in, right?

• 45:27Tracy Alloway?

  That sounds nice, yeah.

• 45:28Speaker 07

  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.

• 45:57Joe 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.

• 46:28Speaker 07

  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, if you 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, right? 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,

• 47:13Speaker 07

  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.

• 47:27Tracy Alloway?

  Just going back to your storied career on Wall Street for a second, how good were you at playing liar's poker?

• 47:33Speaker 07

  I was actually pretty good. I think, I mean, I learned it after I joined Solomon 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 spot. And I also, my boss gave me his

• 47:52Speaker 07

  Eighteen foot fishing boat, but he was buying a new one as part of the settlement. Wow.

• 47:57Tracy Alloway?

  In lieu of cash. He was like, here, take my.

• 47:59Speaker 07

  Well, cash plus the boat.

• 48:00Joe Weisenthal?

  Wow. That's a really big pot.

• 48:03Speaker 07

  That was a big pot, yeah, at that point. We used to spend after the trading day was over, every day, we would print out randomized liar's poker sheets, usually about twenty-four or thirty of them, and we'd play about thirty rounds every day.

• 48:15Tracy Alloway?

  Wait, liar's poker sheets? I thought you played with actual cash.

• 48:18Speaker 07

  Yeah, it's actual cash. You play with dollar bills.

• 48:20Tracy Alloway?

  Yeah.

• 48:21Speaker 07

  But, you know, if you're playing twenty-four rounds, there are not enough dollar bills lying around.

• 48:25Tracy Alloway?

  I never thought of that.

• 48:26Speaker 07

  Yeah, so you randomize based on how the dollar bill numbers are generated, yeah.

• 48:30Joe Weisenthal?

  Is there going to be a future in finance for a young physics student or a math nerd in high school today? You know, 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?

• 48:47Speaker 07

  Absolutely. I think finance has existed from the very, very beginning because it's based on the two fundamental emotions, right?

• 48:53Joe Weisenthal?

  Fear and greed.

• 48:54Speaker 07

  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 that it teaches you to 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.

• 49:21Tracy Alloway?

  Veneer, 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.

• 49:29Joe Weisenthal?

  Yeah, thank you so much. That was fantastic.

• 49:30Speaker 07

  Thanks for having me.

• 49:45Tracy Alloway?

  Joe, that was really fun. We should have Veneer back and just do like stories from Wall Street in the 1990s episode. Let's just do that.

• 49:51Joe Weisenthal?

  I love the stories. We could do a lot more on the stories. And I'm also interested in like, basically, you know, 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.

• 50:08Tracy Alloway?

  In what sense?

• 50:09Joe Weisenthal?

  Well, diversified 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, I have questions about that.

• 50:24Tracy Alloway?

  But the counterpoint to that is, and I've, 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.

• 51:04Joe 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.

• 51:22Tracy Alloway?

  I mean, there's, 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?

• 51:33Joe Weisenthal?

  Let's leave it there.

• 51:34Tracy Alloway?

  All right. This has been another episode of the Odd Lots Podcast. I'm Tracy Alockway. You can follow me at Tracy Alockway.

• 51:39Joe Weisenthal?

  And I'm Joe Weisenthal. You can follow me at TheStalwart. Follow our guest, Vaneer Bonsali. He's at Long Tail Alpha. Follow our producers, Carmen Rodriguez at Carmen Armin, Dashal Bennett at Dashbot, and Cale Brooks at CaleBrooks. 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/oddlots.

• 52:04Tracy Alloway?

  And if you enjoy Odd Lots, 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.

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