Here’s a great interview with Tobias speaking to Christopher Cole of Artemis Capital Management.

Chris Cole is a 39-year-old hedge fund manager from Texas who uses volatility to provide “crisis alpha.”

Cole runs Artemis Capital, a hedge fund that seeks to outperform in a stock market crash–to “generate opportunity from chaos,” as Chris describes it.

Cole launched Artemis Vega fund with $1m and has now attracted nearly $350m of investors’ cash.

In this interview, Cole provides some great insights into:

• How To Use Volatility To Hedge Your Portfolio
• How To Capture Crisis Alpha
• Why Most Investors Think They’re Diversified But They’re Actually Not
• How To Predict When Market Volatility ‘Bushfires’ Are Primed For A Spark
• As The Market Becomes More Passive, Volatility Will Amplify, And Market Instability Will Amplify
• When Good Ideas In Investing Become Dominant, They Become Destabilizing

You can watch the entire interview here:

(Source: YouTube)

Full Transcript:

– Mate, you look awesome.

– Yeah.

– You ready?

– I think I’m ready, yeah.

– Yo.

– Ah!

– Ah!

– [Narrator] Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquirers Funds or affiliates. For more information, visit AcquirersFunds.com.

– Yo.

– Ah!

– [Singer] Ah!

– Hi, I’m Tobias Carlisle and this is The Acquirers Podcast. My guest today is Chris Cole of Artemis Capital Management. Chris is a very old friend of mine. He’s one of the first people that I met when I moved to the States. He runs a firm that has a very unusual strategy. He uses volatility to provide crisis alpha, and we’re gonna explore what those things mean. He literally meditates on risk, so we’re gonna learn a little bit about his meditations and the result of those meditations which is these widely read, brilliant abstract pieces on investing and the stock market. Chris, welcome.

– It’s great to be here, Toby. It’s a lot of fun.

– Volatility is a really abstract concept just for people who aren’t investing in volatility all the time. I mean, it took me two years of Carlisle -you explaining it to me before I could understand and we’re now nine years later. What is a simple explanation for people who aren’t in the sector?

What is Volatility?

– Well, volatility is just simply change. If you look at what Artemis tries to do, we make money from change. We wanna turn change into opportunity. Change can be on two sides of the equation. You can have tremendous, turbulent, left-tail change, that’s periods like 2008, and that is really damaging to your portfolio, or you can have periods of time where there’s tremendous change to the upside, where there’s a lot of volatility and shifting to the upside. It’s right-tail. We try to profit from both of these different regimes. Certainly, in one case, the left tail can be quite damaging to many institutional individual portfolios, so we try to turn that into an advantage to people where in the event that there is a significant shift in markets, significant shift in regimes in either direction, we wanna be able to turn that into opportunity for our clients so that their livelihood and their institutional portfolios and their spending is not impacted by turbulence in markets.

– You describe yourself as a provider of crisis alpha, which is a tail-risk strategy or akin to tail risk but somewhat differentiated from it. Can you explain what that is and how it’s differentiated?

– Most people’s portfolio, I have a different philosophy on the world than most mainstream, than what’s taught in most mainstream finance books. What you’re taught in business school, for example, is that you want a nice diversified portfolio and that diversification is going to provide benefits to you over time. I think that was really proven to be false in the 2008 recession when everything went down together. The problem at the end of the day is that most, people think they have this diversified portfolio of different asset classes, but really, in a crisis, they find out that their diversified portfolio is just 98% levered to long GDP.

The way I like to phrase this is that there’s really only two asset classes. There’s short volatility and there’s long volatility. Most people’s portfolio requires stability, requires some sort of expectation of mean reversion to make money. It’s along the overall growth in the economy and the expectation that that growth continues. When you end up seeing some sort of deviation from the recent past, that could be either a massive deflationary environment or a massive inflationary environment, most people’s portfolio is ill-equipped to handle that. That’s the long-volatility asset classes. Most people, 98% of what they have in their portfolio is only exposed to long GDP, only exposed to stability. It’s only short volatility. What we seek is that crisis alpha component, is the being benefiting from change, benefiting from sort of regime change. That regime change could be something as extreme as a depression or it could be something as extreme as a kind of extreme inflationary, markets go up 100 or 200%, and inflation’s up as well, kind of what was experienced in Germany in the 1920s. Both are examples of extreme left- and right-wing change. We want positive exposure to that, and that’s what I would define as crisis alpha.

– People typically associate high-volatility regimes with crashes but we have, even in the U.S., we’ve seen high volatility with a market advancing very rapidly in the early 1990s. You say, and this is one of the things that I find most interesting, that I think the thing that most people are afraid of is a gigantic crash, but the thing that they often miss is that hyperinflation or a very high inflation, unusually high inflation, is another possibility and volatility can help in a scenario like that.

Hyperinflation

– Yeah, it’s a fantastic example. Now, one of the issues is that people say hyperinflation. People get this crazy idea of gold bugs and Germany and Zimbabwe. But there’s other less extreme examples of periods where you have extreme volatility and extreme right-tail movement. A great example is the late 1990s in the U.S. You’re in the throes of the dot-com bubble. Everyone was chasing these dot-com stocks, NASDAQ was going crazy. The stock market went up 100% between 1997 and the end of 1999, and volatility averaged over 25 for that period. That’s amazing.

To put that in perspective, you know, to put that in perspective, that’s nearly twice the amount of volatility that we’ve experienced in the recent past. And during that period, you had regimes of the market would jump up dramatically and then collapse 20% as well and then go up another 50%. So, this is extreme volatility with extreme movement towards the right tail.

Another recent example was China. In the lead-up to their crash in 2015 was a period of extreme right-tail vol. So, everyone’s oftentimes very afraid of the left tail, but they oftentimes forget the impact of how volatility can coincide with, particularly, periods of extreme speculative tops in asset markets, usually incentivized by irresponsible central banking. These are two elements of the volatility puzzle. I think the right tail is something that oftentimes gets forgotten or ignored by people who view volatility as a potential investment.

– You’ve been running Artemis in its current form since about 2012.

– Mm-hmm.

Alpha Strategy

– Before then, you had a slightly different strategy which was to try to implement, as more of an alpha-type strategy, try to generate returns uncorrelated to the market by trading volatility. How have you used those skills and built them into the current form of Artemis and the way that you trade volatility?

– There hasn’t actually been that much, there’s been an evolution of my strategies and an advancement of my strategies over time, but I think the philosophy’s always been very consistent. I think the difference is that the period of 2007 to about 2011 represent an incredible period of time to profit from change in markets, particularly the period of ’07 to ’09. The same strategies as applied today have less of return simply because there’s less change. But if we reentered that type of extreme-volatility environment, you would get amplification of those returns that is true alpha. So, the benefit of volatility investing, if you’re gonna invest in a volatility fund, the game plan, the alpha is not, the expectation of alpha is not something that occurs in a consistent day-by-day basis. The idea is to hold the volatility fund through a business cycle, because you’re going to enter into seasons of volatility just like there are seasons in nature, and you wanna capture the transitions between these seasons. I originally was a derivatives structurer at Merrill Lynch and Bank of America, what became Bank of America. In my spare time, I developed a strategy trading the then fledgling market for VIX futures and VIX options. To put this in perspective, if we go back to 2006, 2007, I was running with probably about $200,000 of just personal money and, at times, I was 20% of the trading volume in the back of VIX futures. If anyone knows about trading now, that’s quite funny ’cause that market has expanded quite a bit.

But I was able to make large asymmetric gains in the period between ’07 and 2009 through these types of volatility and profiting from change strategies. What’s really interesting is that there was a profit from the regime shift up in vol, which was incredibly massive, one of the largest jumps in volatility since 1987, but also, a profiting from the regime shift down in volatility. I think that’s what sometimes people forget. That provided the seed capital for Artemis. It really took until about 2012 to begin launching an institutional vehicle. As you know, we would, you know, some of the viewers probably don’t know this, but Toby and I would get coffee every day and we had beachfront apartments in Santa Monica, and I was running my little firm out of a beachfront apartment. Now, we have nine employees and a board of advisors in downtown Austin, so it’s expanded quite a bit since then, but they were very humble beginnings and very exciting beginnings back then. So, it’s been a fantastic journey.

– And it’s a great testament to the robustness of your strategy that you’ve survived through what has been a very difficult time for volatility, because there’s been not a great, you haven’t really had that gigantic volatility event. Presumably, that’s coming at some stage, you’re not necessarily predicting it but you’re, that’s the nature of markets, that that season comes eventually.

– You know, it’s so interesting because you’re in L.A., so it’s always 70 all the time, but, you know, as you know, I grew up in Michigan, and so, if you look at the temperatures in Michigan, they’ll fluctuate anywhere from, I think it was negative 25 just acouple of weeks ago when that arctic blast came down, and then it can go up to about 103 in the summertime. The average temperature’s about 60 degrees, and that average temperature, predictably, occurs at the end of September, as you transition from summer to fall, and of course in the spring.

So, I want you to imagine that, imagine that you’re in Michigan, you’re hanging out, it’s August, September, the temperature drops from 90 all the way down to 60 degrees, and then you run around screaming to everyone, oh my goodness, it’s 60 degrees out! This is incredible. What’s happening? This is unprecedented. This is incredible. And, of course, everyone in Michigan would look at you like, um, what’s this crazy L.A. guy doing, right? He’s never… You do know it can get a lot colder.

Well, what’s really interesting is last year, we had this uptick in volatility from a truly generational low point in vol. 2017 was one of the lowest volatility years in a hundred years of data. So, you’re in the throes of summer, and volatility went up a bit in 2018, and the media goes crazy. You have all these people saying, oh my goodness, volatility’s exploding and there’s all this expansion of volatility. So, if you look at the average of where volatility’s, if you look at where volatility averages, it’s about 20.

And if you look at the rolling one-year average where vol was last year, it barely ticked above 17. So, we didn’t even get over an entire year to where average is. To put this in perspective, volatility went above 20 and stayed above 20 for six years between 1997 and 2004. It was above 20 for close to five years in the great financial crisis. It was above 20 for another five years in the period of ’87 to about 1990, during that recession.

So, everyone’s running around, screaming about high volatility, it is analogous to, you know, screaming about how cold it is when it reaches 65 degrees in Ann Arbor, Michigan, where I’m from. The difference here is that seasons in markets last around the debt cycle, they last about three to four years. Seasons in nature last about three to four months. We have been, due to central banks, in a substantially prolonged period of summer. That’s what’s been unusual. But the volatility we experienced last year is actually just below average.

– So, the average is a little bit misleading simply because you have those enormous spikes. It’s a little bit like the old joke about the guy who’s got his feet in the oven and his head in the refrigerator and he says, on average, I feel pretty good.

– You’re 100% right on that. But even if you adjust for that asymmetry, even if you adjust for that asymmetry, there’s nothing particularly unusual about 2018.

– Right.

– In a full sense.

How to Make Judgements

– Your strategy is not at all about predicting volatility events, and we’ve discussed at various times when I’ve said, do you think that this is, is this the big one? It might surprise people who, you sound like a bearish guy, but you’ve often been quite, your view is, in many of those instances, it wasn’t, and it’s been borne out every single time. What sort of inputs, or how are you making those judgments?

– It is interesting, I should clarify. We have some models that are arbitrage-based and the legacy models that are on Artemis have been arbitrage-based in the sense that, and what that means is that, you know, if someone comes to you and says, you drive a lot, you live in L.A., what if I give you car insurance for the next week and I’ll pay you a dollar to own car insurance? Would that be interesting to you? But only for the next week.

And you’d probably be like, sure! You’re like, oh, here’s a dollar, and you get car insurance. There are some times in markets where you can structure positions where you’re paid to own insurance against extreme outcomes. You’re actually paid to own that. A lot of our strategies have been based around taking advantage of that.

As time has evolved, we’ve been applying new strategies that use data science in many ways to have a predictive edge. In this sense, we look at, I like to use another Los Angeles analogy, you know, the fires in Malibu. You can never predict the spark that causes a forest fire, but what you can do is, if you wanna look at forest fires, you look at underlying conditions that lead to them. So, you know, things like dry heat, high winds, these are all underlying conditions. And when those underlying conditions are in place, if a spark does emerge, it’s likely to transform into a forest fire.

Well, we’ll use data science and a lot of domain expertise combined with new analytical techniques in order to scan markets for various macro factors that have a pattern mashed onto previous periods of financial stress, and then we’ll use that to price and size options. That’s been, I think, a very effective method, particularly over the last year.

What are underlying conditions that lead to volatility fires in the market? These would be things like breakdowns in FX and carry trades. They’d be things like changes in different cross-asset correlations. One that was particularly relevant last year was divergence in the movement of interest rates and different equity prices. Any one of these things may be not enough, but when multiple of them are happening at the same time, based in a prediction, in a predictive algorithm, then you can use that to buy insurance effectively ahead of a volatility fire.

View in the Short Term

– It sort of begs the question a little bit, what do you see right now at mid- to late February 2019? What’s your view in the short term?

– It’s interesting. My personal view on the long term and what our models show right now is actually a pretty benign environment for volatility. And if anything, the risks are more, and I say risk, risk is an opportunity, are more skewed towards markets exploding upwards than downwards at this particular juncture. But that’s a short-term view. And when I mean short-term, I mean really the next week to two weeks. I think from a personal standpoint and in looking at it from a macro standpoint, certainly the, what central banks have, the about-face that central banks have done and what Powell has done certainly has caused a huge run-up in markets this year. I think the S&P nearly has a Sharpe ratio of five this year.

If we think about, it’s crazy, it’s amazing actually, because all of a sudden, the world’s ending in December, and then they decide not to raise rates, you know, 25 or 50 basis points, and then all of a sudden, everything’s good again. In the short term, this can work, but if you look longer-term, it’s not a lack of central bank stimulus sometimes that causes big crises. It’s a build-up of speculative debt and leverage. Right now, the build-up in debt and leverage is at historic proportions. Corporate debt-to-GDP is about 47%. It’s never been greater. And so, even though in the short term, you can have the stimulus injection, I think in the long term, the market cannot be continuously sustained by companies issuing debt and buying back shares and continuous debt expansion. At some point, there is a limit to that. I think if you study previous periods of crisis, you’ll see that same pattern. It’s oftentimes not been, it’s not been a fact of a lack of stimulus that has caused an economic slowdown, but oftentimes a build-up of debt that becomes unsustainable in any type of basic business cycle pullback.

– You’re an incredibly creative, analytical guy, which is an unusual sort of combination to find in one person, combined with that phenomenal work ethic of yours, you’ve produced these incredible think pieces, for want of a better word. I’ve loved reading them when they’ve come out. I’ve often found that the best way to read them is jet-lagged or after a glass or two of wine. I swallow the whole thing in one go. Your most recent one is a riff on the David Foster Wallace, What is Water? So, what is water in this context?

-You know, it’s funny because I wonder how much of these… I actually really miss the old days of going down for coffee and sometimes on aFriday night, going for wine. Imagine how many of these ideas have been tested onyou before they’ve come out or how much I’ve, and vice versa, how much I’ve absorbed from your wisdom and your worldview. Either quite consciously or subconsciously, you’ve been a coauthor on many of these pieces.

For people who don’t know, Toby’s the first guy that I would run ideas through and one of the most valuable minds in terms of being able to think abstractly about these things. There’s a wonderful kind of parable that was talked about in that commencement speech. If someone has not listened to it, I think just take 20 minutes of your life. It’s sort of a life-changing speech. He talks about the concept of two fish, swimming, and they’re swimming along and they come across an older fish, and the older fish goes to the younger fish and he says, well, how’s the water over there? The two young fish are like, what’s water?

In many ways, we exist in a world of abstraction and the medium becomes our reality, so much so that we don’t even see the medium. This metathinking experiment can be taken very broadly. But I think one of the key things that, one of the key things for me to understanding volatility, and then understanding that the market crashed the way it did in ’08, and be able to hold volatility through that, was this realization that money didn’t really exist. It exists, it’s a medium that is important and that we derive our livelihood from, so it exists in that sense, but it really is only a human thought abstraction, and that if people lose faith in money, it ceases to matter. There’s many historical examples of that.

The same thing could be said across numerous different institutions and things we take for granted. Democracy only works because we have a collective belief in it. A government only works because we have a collective belief in it. If that collective belief vanishes, the medium vanishes. So, in that sense, we have to imagine ourselves as fish swimming in water, and real volatility is not necessarily a, the true volatility is a situation not where there is turbulence in, or waves, that’s one form of volatility. True volatility is actually understanding that the medium itself can be taken away or can evaporate, where all of a sudden you’re a fish outside of water, gasping for air.

I think in my latest, the piece from last June, the discussion around that was the fact that we’re actually seeing a significant degradation in liquidity in the stock market, which is absolutely scary, in that sense. I think people talk about the volatility event in February and they talk about the VIX spiking up and what happened to the VIX ATP is, sure, that’s alarming, but I think what’s more alarming is that you could, on February 5th, have put an order in for just $30 million worth of E-minis and moved the whole market. You had people who, fund managers who had been in business trading futures and options for 25 years who say they couldn’t believe how bad the liquidity got in what was a relatively small move in markets.

I think this is one of the big risk factors that people are not really thinking very much about, is that you have these ETFs that are backed by a liquid underlying. You have, in many instances, some of the ETF providers are almost acting like shadow banks in this role, in this liquidity mismatch. You have companies buying back their shares at record paces, a trillion dollars of share buybacks, and, in a very literal sense, the stock market volume is back to where it was in periods, the late ’90s.

So, the stock market is actually self-cannibalizing. As a result of that, you also have regulatory rules that have inhibited other players in stepping forward to provide liquidity and the high-frequency players are kinda like shadow market makers. They’re there most of the time, but when there’s a crisis, they step back, and it provides this artificial kind of trust so that there is this liquidity that seems to be there until it’s not. When you’re looking at this confluence of events combined with accessible leverage in the global economy right now, this is an interesting scenario where we may actually see significant disruptions in the very medium of the market itself, which could leave investors gasping for air when the water, the water, very medium that we use to transact, evaporates.

Liquidity

– There have been crashes in the past and the nature of a crash is that a lot of liquidity disappears. Is this a new phenomenon? Why is this something that’s on your radar now?

– Certainly, liquidity drying up is not a new phenomenon. I think what is a new phenomenon are many of these, the fact that many of the new regulatory rules and the fact that the ETF landscape and the fact that now the, another thing that I did not mention initially here is also the fact that most investors are now passive. We’ve crossed the 50% barrier where most people are now passive. So, we take for granted that these instruments and we take for granted this liquidity but in many ways it’s phantom because, and a lot of these structures have not been tested in a real crisis or in a situation where central banks aren’t providing ample liquidity.

This is not an end-of-the-world scenario. I’m not pointing out, I’m not trying to sit there and say that the whole stock market’s gonna collapse tomorrow and that you should run and go get gold and guns. That’s not what I’m saying. These are risks and we’re pointing out risks. When liquidity dries up the way it did on a 4% down-move in markets, that’s something, I think, if you’re an institutional investor or even someone, an individual investor, should take notice or be aware of and understand that there are different strategies, long-volatility is one of them, but other strategies that benefit from change that may be good diversifiers to protect against that type of liquidity risk in this type of regime. The past investing situation is something that’s really interesting topic to talk about as well but we can get into that a little bit later or, I didn’t mean to interrupt your question.

– No, no. That was where I was going. I was just going to ask you about, there have been a proliferation of ETFs that have, and the attraction to them is that they’re so liquid and trade through the day and the underlying trades through the day but it’s easy to see that there might be a mismatch between those two things. That was what I was going to ask you. I mean, specifically in volatility, there have been, volatility ETFs seem to be, I mean, short-volatility ETFs in particular, because they have that return stream that basically they make a little return every day, pretty consistently, until Taleb’s turkey farmer comes and chops off their head and we’ve seen that recently with VXX exploding.

– I’m really glad you brought up the XIV debacle, which I don’t think is… after XIV blew up, as you know, that’s something that I, something that we had talked about since 2012, I think,

– Right.

– and I had written publicly about a lot. I think Artemis had warned about the potential of that going back many, many years. So, when it finally blew up, I told a friend of mine, thank God, now we can stop talking about this. But I think what’s interesting about the XIV, and for people who aren’t familiar, you had a situation where you have product that rebalanced in these underlying VIX futures, and people, it became very popular because it was a short-volatility product that made money from the roll-down in VIX futures. The problem was, is that it, in many ways, came to dominate.

It became a major part of the ecosystem in VIX to the point where actually it was imposing a self-reflexivity on the futures and the VIX itself. So, as something that Artemis had warned and we had warned through the years, it was very possible to get into the cycle where as volatility rose, this particular product had to exit out many of its positions to the point that that would then cause volatility to rise even more in a self-reinforcing spiral that would cause a massive, massive collapse of the entire product. And, of course, that came to bear. Many people were trading this product. It had a 3/10 Sharpe ratio until it went almost to zero. You had many people who lost their entire life savings as a result of it, many brokers embarrassed by it.

That’s the story there. I think what happened with XIV, it is possible, it is possible for that to be a microcosm that could occur in many other types of ETFs that have a liquid underlyings in the wrong type of systemic market crash. Certainly, you could be in a spiral where you have a, you have an ETF product that’s particularly liquid, people are selling out of that product, and then you have an underlying asset that is less liquid, in some cases doesn’t even have the same-day settlement as the underlying liquid ETF, and then it becomes a self-reinforcing spiral. It might not be as dramatic as what happened with XIV, but XIV is an interesting proxy or a extreme proxy for what could occur in different asset classes or different styles of ETFs in the wrong type of environment.

That’s something to keep in mind. It goes into something with the ETF frenzy and the passive investing frenzy. This year, according to Bernstein Research and J.P. Morgan, over 50% of the market’s gonna be passive. I have to give credit where credit’s due. This thesis did not come from me but Mike Green who, it’s his thesis, he came to me to,in many ways, act as a sanity check. He said, “Chris, can you independently test “this thesis of mine?”

He said, “The first part of my thesis “is that the more the market goes passive, “the higher volatility should be.” I said, okay, even though, I’ll test that but that makes intuitive sense to me. It absolutely makes intuitive sense to me because naturally, if you have no incremental, if everyone’s buying and there’s no incremental, if everyone goes passive, each incremental buyer causes the market to gap up, and each incremental seller will cause the market to gap down, so if, hypothetically, you had a market that was 99% passive, volatility should expand dramatically. This made intuitive sense to me.

The second part of his thesis initially did not make intuitive sense to me. Active managers across the spectrum have been criticized for underperforming passive index funds. Of course, the people who put this out there don’t talk about the fact that index funds have actually had one of the most historic Sharpe ratios in history, going back over 200 years, but let’s just ignore that fact ’cause obviously things don’t mean-revert. I’m being sarcastic obviously. You look at it and say, okay. The tremendous amount of criticism of active managers underperforming passive investments and institutions and pension systems wanna go fire all their active managers and go to these passive products.

Well, Green’s theory stated that the more the market becomes passive, the more the market is dominated by passive investors, actually, the less alpha will be available to active managers, but the more unstable the market will become. So, Mike Green sent me this theory, he works for Thiel Macro, and he said, “Can you help me, “like, run your own simulations and let me know.” And I said, you know, I agree with the first part about the higher vol. I don’t know, intuitively, the second part doesn’t make sense to me. So then, I created a simulation that looked at just a simulated market environment that shifted the percentage of passive to active investors. And sure enough, what I found is that he was absolutely correct.

The more the market is dominated by passive investors, when you begin going over a level of 50%, go 55%, 60%, when you start jumping over that level and really the sweet spot’s about 45% passive, so the further you go away from 45%, the less excess alpha is available to the active manager. Also, the same thing happens on the other tail. In a market that’s entirely dominated by active investors, there’s less alpha as well. But I found this fascinating and I was trying to understand why and I came up with this basic analogy. This runs counterintuitive, right? You’d think that if everything

– Very.

– is passive, you’d think that active investors should be having a field day. So, let’s imagine this. Maybe this goes back to some of our old days, having wine down on the beach in Santa Monica and talking markets. Let’s imagine that we go out and I get just incredibly drunk. I get crazy drunk. I am a passive investor. At this point, I’m passive. I’m wandering wherever, aimlessly, right, aimlessly in whatever direction. But you are my friend and you’re an active manager. Your job is to direct me home. So, when I go too far to the left, you bring me back, when I go too far to the right, you bring me back and you’re helping me get home even though I’m a stumbling drunk. Well, this is what active investors do. When things become too undervalued, they buy.

When they become too overvalued, they sell. They’re volatility stabilizers and they’re helping to find value in markets, the same way that a sober man is helping to get a drunk man home along an alpine path. This works out wonderfully and you are compensated for your efforts. Now, let’s imagine an alternate situation happens. The passive investing, the passive drunk becomes so dominant, so large, that all of a sudden, I’m not, I’m 5’10, 180, I am now 20 feet tall and I weigh 500 pounds. I am a giant and I am drunk out of my mind and you are trying to pull me back to the right path. But you can’t, I’m too big. I’m too strong. I’m stumbling drunk but you can’t correct it. This is what happens when passive investors dominate the marketplace.

They are a large stumbling drunk that’s just going to roll in whatever direction, and the active manager’s become too inconsequential to correct their valuations. So, in either direction, depending on the prevailing mood in the economy, you’re either gonna have wild fluctuations to the upside, or you’re gonna have wild fluctuations to the downside, whatever the prevailing dominant dynamic is. So, according to this theory, as the market, according to Green’s theory, as the market becomes more and more passive, volatility will amplify and market instability will amplify but the volatility could be right- or left-tail, we’re not saying volatility means a crash, we’re saying it could be right- or left-tail, but inevitably it makes the market highly unstable.

So, you know, Vanguard and what they call the Bogleheads, the people who are the efficient markets people, they preach the gospel of efficient markets in the temple of passive investing, but what you can prove, analytically and quantitatively, is that when the, and that’s not a bad idea, when there’s a balance, but when the market becomes dominated by passive, ironically, it becomes, the passive investing drives market instability and market risk. So, like I say, this could be, if we see this trend continue, we should see a trend towards either right- or left-tail vol. I’m not saying the world’s gonna end, I’m not bringing out my sickle and saying that everything’s gonna collapse, but it should lead into a period of enhanced high vol on either tail.

– There could be a crack-up boom is what you’re saying as well. It could be an event where the, we have a late-1990s-type scenario.

– Easily, yeah. Or a crack-up boom followed by a crash. It is impossible to predict because a lot of it is driven by what, you know, if central banks want to print more money and then there’s speculative fervor, you could have a massive crack-up boom, or you could have a collapse in the event that people are not able to service their extraordinary debt obligations. Either way, I think what we are going to see in the next 10 years, particularly if these trends continue, is an amplification in volatility. What I’m saying is that you can make money on change, on playing either tail, and that when we see these trends coming, we see these trends coming, what looks best in the rear-view mirror are short-volatility trades that have made money from mean reversion. And if you’re in an institutional portfolio, those look very attractive because they have fantastic three-year Sharpe ratios or four-year Sharpe ratios. But this next regime is very likely to benefit strategies and active managers that focus on change, but change can be involatility or regime shifts, but that change could be on either tail of the distribution. It’s important not to fixate on just one.

Passive Investing

– Let me just go back a little bit to the analogy of the drunk and the explosion in passive investing. Passive investing simply means that a strategy tracks an index. Indexes aren’t necessarily S&P-500-style market, cap-weighted index, which I think is what you’re talking about because in that style of index, if something becomes overvalued, more money flows into it. It becomes bigger so that the companies that are the biggest and the most overvalued attract the most money, which is why any strategy that’s sort of even an equal-weight strategy has historically done, has outperformed that market-weight strategy because an equal-weight strategy looks a little bit more like a value-investing-type strategy, it just pays less for earnings and assets and so on.

My intuition about active investors in that kind of environment is that that’s a good environment for them because, you know, let’s say that I’m not your friend on the way home from the bar when you’re stumbling drunk and let’s say I wanna pick your pocket which is kind of what active investors are trying to do when those movements occur, I’m not necessarily wanting to short the very biggest but I might wanna buy the very smallest, and to the extent that they don’t attract capital and they stay undervalued, from my perspective, that’s a good thing. I’m interested to know, I’m sort of challenging the assumptions a little bit, what is the nature of the passive, in one instance, and why don’t active investors benefit from them?

– The concept at the end of the day is that absolutely, absolutely, there should be some correction in that. But what’ll happen over long periods of time is that the active investors are just not big enough to cause a correction and correctly value. If you identify something as being misvalued, let’s just say you decide to buy a Princess Diana Beanie Baby in 1999 for $2,000 or $45,000, but if money keeps, now that’s obviously, you could sit back and say that’s absurd, actually, that’s not a good example. Let me take a step back. Let’s just go back to what businesses you can actually value, something that has cashflow. Something’s undervalued. It’s wonderful that it’s undervalued but unless there’s some sort of a realization of that undervaluation, you can’t monetize your correct understanding of the world in that.

Or if something is overvalued but money keeps flowing into that, then it remains overvalued and if there’s not enough active investors to self-correct it, you end up running through problems. I talked to one individual who was a sector specialist. He was an absolute, I can’t say who he is, but he’s a very well-respected hedge fund manager who runs a boutique firm that he does short selling in a specific sector, and he has a fantastic track record. He was lamenting how difficult it’s been to short sell some of these stocks. You’d have situations where the stocks would, there’d be outright fraud in a particular stock and it would keep going up. He had never seen this in his entire career. He felt that the indexation, and some of these stocks that he was trying to short were indexes, he felt like the indexation was actually a key factor in driving this, that money flows were pouring in to these ETFs that were just allocating to these stocks because they had a certain level of liquidity, and that was propping them up regardless of any understanding of the fundamentals. He’s the smart guy trying to pick out the overvalued stock but he’s not able to realize his gains because the dumb money keeps flowing in en masse. That’s part of the problem. If that drunkard is so big, there’s just no way to self-correct it, until he falls off a cliff anddies.

– I have some sympathy for the view because you can certainly see, last year, for example, I think that the market cap-weighted S&P 500 outperformed its equal weight counterpart and that has been, that has occurred more frequently over the last few years. That’s an unusual thing, that’s an unusual event. Certainly, over the last few years, S&P 500, the strongest one, or the U.S. stock market’s just long-only market cap-weighted some of the strongest performers in the world and any hedging or any global exposure outside of that has led to underperformance of that. I sometimes wonder whether this is a, and you may be saying that this is, it’s the fact that we’ve now tipped over that key point at 45% of the market becoming passive, because it’s something that, I certainly remember there were articles in the late 1990s, in 1999, talking about, there were companies that didn’t even get picked up by the Russell 2000 so there were, some Russell 2000-ists that is, in the largest 2,000, it’s the smallest 2,000 of the largest 2,000, so the smallest companies are quite small that fall outside that, and they said the market for these companies is gone.

There’s no bid for them anymore because so much money’s focused in the indexes. The authors of that article posited the only way that these companies would find returns was in takeovers and going private. As a fundamental value investor, that excites me a little bit that you would find these incredibly cheap companies and could foment change and create some sort of, create some sort of event that would drive some returns there. But that is a concern, perhaps, that there is that tipping point. Do you have any idea why 45% is a magic number or 50% is the magic number?

– It was interesting ’cause I ran a simulation, I developed my own simulation that looked at active and passive agents and created a simulated market, and then looked at that evolving over time. I actually presented that in that June paper, I think. I did that work and I came up with that approximate level. Actually, in my paper, it was about 60%, but I assumed that the active-to-passive level remains consistent throughout. If you actually adjust where active managers are fired for passive, then the level begins to shift down, which is interesting.

Mike Green did a similar analysis and came up with practically the same numbers. That’s what was so fascinating about it. We’re coming from two independent, both of us were programming our own simulated environments to try to test this theory, and both came out with approximately the same, slightly different but very similar levels. Why is there that level? I think it’s just like anything else. There’s an equilibrium that is matched and when you have a system on the edge of healthy equilibrium, when you tip over that equilibrium, it’s enough to destabilize. And figuring out where exactly that tipping point is is a science in and of itself. Now, we’ve run these models or simulated models, it’s very difficult to then apply that directly to the global economy because there’s many more variables that come into play, but it certainly is something interesting to at least prove, on a theoretical toy model basis, that there’s validity to the theory.

But I think, everyone talks about passive investing as market efficiency, and this goes to what you’re talking about with the Russell and also with the market capitalization-weighted, what it actually is is a form of momentum investing. It’s a form of liquidity momentum investing when it becomes the dominant form. We’re not talking about the Bogle passive investing back in the ’90s when it was kind of a revolutionary, throughout the ’80s and ’90s, it was a revolutionary concept in being adopted. But finance has this wonderful way, and this is something that Jim Grant has very eloquently said, it takes a good idea, puts it to the extreme, and then that good idea, what initially starts out as a good idea, becomes a very dangerous thing when it’s taken outside of the middle path and becomes the dominant thesis. In 1987, everyone blames portfolio insurance. There’s nothing wrong with portfolio insurance when you have one or two guys doing it. When it’s done en masse by every major institution, it becomes a massive source ofinstability.

– Right, so each individual actor could be doing what is rational, but aggregated it becomes an irrational behavior that leads to adverse consequences in the market.

– That’s right, yeah. I was trying to explain this. In 2000, I think it was in 2016, or actually early 2017, there was a debate that we had with actually the guy who, who essentially created XIV and was the CIO of XIV. He was saying you guys just hate risk, you don’t like risk, you’re afraid. But no, no, this isn’t about risk. Taking risks and taking risk premium is not a bad thing. It’s a good thing, right, it’s a good thing. It’s when you systematically apply something nonstop that it becomes a bad thing. And then I said, well, it’s like this. I’m a single guy, I go out, and I see a cute girl and I ask for her phone number.

That’s taking a risk. Maybe she goes, she gives me her number and we go on a nice dinner date together. Well, maybe she says no, thank you. And that’s okay and I go on. Now, imagine if I systematically took that risk and kept asking her number again and again and again. That’s called stalking and it’s not a good thing. That’s bad, right? So, systematically applying risk in a non-thoughtful way, you take a good idea and you turn something into something very, very dangerous. Unfortunately, I think in this world of financial engineering, we become so enthralled with harvesting risk premium that we lose common sense. And good ideas, when they become dominant, become destabilizing. Finance is littered with it. I mean, everything from portfolio insurance to mortgage-backed securities. The list goes on and on and on.

– Look, I think that’s a perfect place to end at. Chris, thanks so much for giving me the time. I certainly appreciate it and I hope the listeners have learned something today.

– Yeah, thank you. I really enjoy it. Just like having a, just like old times, actually.

– I look forward to another one in the not-too-distant future.

– Absolutely. It will be a lot of fun. We’ll see you soon. Have a great one, Toby.

– Perfect, thank you.

– Bye-bye.

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