(Ep.26) The Acquirers Podcast: Benn Eifert – Volatility Research, Institutional Options And Volatility

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In this episode of The Acquirer’s Podcast Tobias chats with Benn Eifert. He is a Stanford undergrad, Cal PhD, and CIO at QVR Advisors. QVR is a boutique SEC-registered investment advisor managing quantitatively-driven, options-and volatility-focused strategies across absolute return, risk premium and hedging needs. During the interview Benn provided some great insights into:

– Why I Launched QVR
– What Was It Like Working For The Chief Economies Of The World Bank
– How Can Investors Discover Opportunities Using Absolute Return Trading Strategies
– The Most Demand For Hedging Happens After The Event That You Should Have Hedged
– Investors Can Generate Additional Alpha Using A Call Over-Writing Program
– Understanding Price Changes In The Derivatives Markets
– One Major Source Of Tail-Risk Protection Can Be Achieved Through Put Selling Structures
– How To Use Indexing To Access Liquidity In The Option Markets
– In Single-Names, The Toxicity Risk Of Flow Is Higher Because People Lift You On Those Nickel Calls
– What Is The Impact Of The Japanese and Europeans Buying Structured Notes

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Full Transcript

Tobias Carlisle: This is The Acquirers Podcast. My special guest today is Benn Eifert. He’s a Stanford undergrad, Cal PhD. We’re going to talk about his firm, Quantitative Volatility Research, right after this.

Automated: 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.

Tobias Carlisle: Hi Benn, how are you?

Benn Eifert: I’m well, Toby. Great to talk to you. Been a while.

Tobias Carlisle: Likewise. We were introduced by Chris Cole a number of years ago. I think that that’s likely because you’re a volatility guys just like Chris, but you have a slightly different approach to Chris’s. Where Chris is crisis [selfer 00:01:15], you’re not offering one single thing. You’re hedge for some clients, you offer alpha for others. Is that a fair description of QVR?

Benn Eifert: Yeah. I think the way that the world has evolved now versus say 10 or 15 years ago, the institutional allocator community is a lot more sophisticated, has a lot more involvement in a wider variety of types of strategies and types of instruments and types of securities. I think the types of folks that we talk to, they know what’s in their portfolios, they know what risk factors they think they’re exposed to. They have some idea.

Benn Eifert: What they’re really looking for isn’t just someone to manage some more of their money. It’s, “What can I put in my portfolio that makes it a better portfolio from an overall risk-ward perspective?” Depending on the allocator, that might be any number of different things.

Benn Eifert: I think our idea is really how can we bring our skill set and our infrastructure in the options and volatility markets to bear, to solve the types of problems that institutional allocators have. I think one major area that we’ve always been involved in is different types of relative value or absolute return, trading in that space, but that we also speak with a lot of folks about more tail-risk hedging types of needs and with other folks about more alternative data, if you want to use that loaded term, or yield generation types of needs for folks that need to invest and make some money. There’s a wide variety of types of things that we do.

Tobias Carlisle: You could be approached with a question as open-ended as, “What can you do for us?” Or do they come to you and say, “We have this very specific need to hedge this problem. How would we do it with volatility?”

Benn Eifert: Yeah. It can be anywhere along that spectrum. Often, the way a conversation might go is you’ll get introduced to a pension fund manager, for example, that is looking at the world and thinking, “Gosh, we’re allowing a whole lot of equities and we have to be in what makes sense, but I’m pretty worried about the medium-term outlook for X, Y, and Z reasons.”

Benn Eifert: Gosh, I remember back in 2008 when my firm had to fire sell equities with SMP650 because we didn’t have the cash to pay benefits. What can I do in the current market environment that doesn’t cost me too much, that will give me some protection against that type of environment? Here’s what my portfolio looks like. It has this kind of global asset allocation characteristics. That might be one type of way that a conversation might evolve.

Tobias Carlisle: When you’re expressing those traits for them, you’re doing it purely through options? Or are you doing that options and futures? How does the trade get expressed in practical terms?

Benn Eifert: Yeah, so depends on what type of exposure. Often, it’ll be options. We might, for relatively simple tail risk-hedging type of trades, which we were going along that example, you might not need the futures. Usually futures would be something more involved in dynamic hedging of an option position. For a simple, static, tail-risk allocation you might not need that.

Benn Eifert: There might be some list of equity options, there might be, depending on again the set of needs, there might be listed options in other asset classes like treasury bond futures, for example, or treasury bond options. There might in some cases be some over-the-counter derivatives, that meet other kinds of needs, things called variant swaps for example, that are just a pure play exposure to volatility and tail-risk.

Tobias Carlisle: You find that there’s sufficient liquidity in the options, enlisted options, even in single names, to put those treads on?

Benn Eifert: Liquidity in, I would make a couple of distinctions of what we mean. On primarily what we do, we’re more index-focused than we are single-name focused. I think typically, the types of risks that a large institution is worried about from a tail-risk perspective in particular, are usually broad macro events. They’re not usually specifically trying to hedge individual equity exposures that they have, or if they do, that’s again just a very specific thing. We tend to live more in index, region, sector type of exposures.

Benn Eifert: Liquidity in general in the option markets, I think index has in our view, certainly volumes have increased and increased and increased very steadily every year for the last many years in index. Whereas, that wouldn’t be the case really in single-name options. In a single-name, option volumes have somewhat stagnated or at least grown not nearly as quickly as index. There’s a variety of reasons for that.

Tobias Carlisle: What are those reasons?

Benn Eifert: You have to think of ultimately the primary market makers in options are going to be the broker dealers and also the major electronic option market makers like Citadel and like Walleye, and various other folks. Those folks are trying to solve a pretty specific risk-management problem when they’re doing business, which is they want to do less of volume with some edge in that they’re making bids and offers and people are paying them some spread that covers some of the risk that they get into a position that moves against them.

Benn Eifert: In single-names, the toxicity risk of flow is higher because people lift you on those nickel calls, on some funny company right before earnings, and just a symmetry of information is a much worse problem for a dealer. In the I would say 10 or 15 years ago banks and other organizations involved in market making were just making money hand over fist in everything that they were doing. When things are going that well, you can be aggressive across a variety of business lines that maybe aren’t as profitable for you, and just as part of an overall business. I think that’s why banks were more aggressive say even in 2008 or 2007 on some single-name related things.

Benn Eifert: Whereas index, you don’t have nearly the same asymmetric information problem, right? S&P options, for the most part, there really aren’t events in special situations of a very, very major variety. Obviously, there’s fed releases and there’s certain kinds of discrete moments when information becomes available that someone might’ve gotten a hold of. It’s just a much smaller adverse selection problem for market makers. I think that’s what’s really bifurcated the liquidity there.

Tobias Carlisle: I think since the 2007, ’09 crash, a lot of folks have been very nervous about the market. For some reason that seems to have lingered a lot longer than the dot com crash. It’s my impression that it’s been expensive to hedge for much of the last decade. How can you hedge more cheaply, or how can you put that crisis off a tail hedge and do it in a more cost-effective way?

Benn Eifert: Yeah, absolutely. I think a couple of things. Generally, options and volatility and tail-risk became extremely expensive in the immediate wake of the crisis, as you point out. Unfortunately, the behavioral reality of these things is that the most demand for hedging happens after the event that you should have hedged, right? You know all the reasons why that is, better than I do.

Benn Eifert: From 2009, ’10, ’11, ’12, there was a persistent, very high risk premium in general across the options landscape, especially in index, which again was the go-to hedge. If you’re nervous, you go buy S&P options. That was driven by again broad-based demand for hedging. Lots of big, institutional investors put systematic tail-risk hedging programs in place where they just said, “We’re willing to burn 1% a year, or 2% a year as a hedge budget to go try to protect the downside.”

Benn Eifert: The cumulative effect of course of everybody going and buying protection and everybody being scared to sell it is that it becomes way too expensive. A lot of those programs lost money very quickly for several years and obviously didn’t turn out to be good values for the folks that were running them. You started to see a lot of those large-scale institutional hedging programs start to die off say 2013, 2014, 2015.

Benn Eifert: Many of those same institutions then over time replaced those programs not explicitly, but with option-selling programs for yield generation. Typically, different types of options, more towards the front of the short term options and things. In general, there’s been much, much less demand for protection portfolios over the last, call it five years, than there was in the five years after the crisis.

Benn Eifert: There’s to some extent this significant crisis hangover, as you point out. I think that in option markets anyway, that’s I would argue mostly gone away. Generally speaking, you always expect there to be some risk premium in option markets, the same way there are in any markets, right, unless things are incredibly distorted, you should have a positive expected return to determine equities, and on credit you should have a negative expected return on buying volatility and hedges. That’s still certainly true, but we think much, much less than it was for a time.

Benn Eifert: Now that said, to more specifically to your point, where do you find relatively affordable tail-risk protection? Of course all prices aren’t created equal. The first question you have to ask yourself is well, if it’s going to be relatively inexpensive, you have to somebody who’s selling it to you. If you’re having to go out and pay someone to manufacture it at a high cost themself, it’s going to be different.

Benn Eifert: One major source of supply of tail protection that’s available in the post-2008 environment and particularly the last five years, if you think of retail structured product investors, it’s a concept that for U.S. investors isn’t as top of mind. I think typical U.S. investors and retail investors, they buy stocks and they buy bonds and now they buy ETFs and mutual funds and so forth.

Benn Eifert: Globally, especially in Europe and Asia, retail investors predominantly do other types of things. They go to their local branch of BMP Paribas and they buy a structured note that might be a four-year note that gives them an 8 or a 10% coupon in exchange for in the current environment, typically in exchange for taking some equity market downside risk.

Benn Eifert: Actually I’ll back up a second. In the old days, the more typical thing that European folks used to buy were principal-protected notes. Think of in a world where interest rates are 5 or 6%, you as a bank can offer to a customer a principal-protected investment in equities, say in just an index, for example, by taking their $100, locking it up for four or five years, buying them some long term call options, and then buying them some zero coupon bonds. Enough to give them their money back if stocks go down. That’s called a principal-protected note.

Benn Eifert: Those type of investments were very popular for a long time. That works when interest rates are sufficient to buy as your coupon bond and make that all work out. What replaced that in the wake of 2008 slowly as interest rates went down and stayed down, and long term interest rates went down so you couldn’t really generate that kind of yield anymore, was put selling types of structures.

Benn Eifert: You can’t get yield by taking interest rate exposure, you have to get yield by selling puts, and so the typical structures involved in that marketplace now might be the investor, again puts of $100. They get a 10% coupon yield every year unless at some point the equity market that’s referenced in the note is down 30%, upon which the investor just gets put into those equities at that price. They take some bad left-tail equity risk in exchange for getting a coupon on the up side.

Benn Eifert: In doing that, the retail investor who’s buying that note is effectively selling long term deep out of the money tail protection, and the bank is buying it. Then the bank isn’t in the business of just holding onto that. The bank then recycles that into the markets through typically selling long term down side puts as a hedge.

Benn Eifert: Those are very big businesses globally, hundreds of billions of dollars of issuance of those types of products a year that effectively involve retail investors selling you tail-risk insurance on the S&P, on the Euro stocks, on the {mee kay 00:00:15:14], on the HSCEI. The major big global indices are all very popular. There’s all kinds of structures and products, but that gives you an answer to the question, “Well gosh, who’s going to sell me some nice tail protection?”

Tobias Carlisle: Basically, Japanese investors first, I guess, and then more recently European investors are starved for yield in the way that they provide with that yield, you sell some puts out far enough that you hope that they’re not struck. Then you get this yield in the interim. Are the Japanese notes, are they called Eurodashi notes? Is that the…

Benn Eifert: Yeah, so Eurodashi notes are the typical name in Japan. In there’s products are also very popular in Korea. There’s a huge market in Korea that’s linked to all manner of other global indices, and then European investors, as well. I think the Japanese structured note market in the Eurodashis is one of the oldest and best developed.

Benn Eifert: Similarly to your point, Japanese rates have been low for a long time, actually. Japan had its major bubble and then bust in the early ’90s, and it has really been in sort of a stagnation deflation environment ever since. That’s provided the impetus for the development of these markets.

Tobias Carlisle: I have two thoughts about that. One is that do you think that the Japanese buyers of these notes understand the risk that the note carries with it?

Benn Eifert: I think typically they understand the basic notion that if the markets are very bad, they’re going to lose some money. These notes are often quite complex, actually. I think the complexities of the notes are often probably lost.

Benn Eifert: In many cases, for examples, the notes will be linked not just to one index, but to the worst performing of a basket of three indices. They might also have some features about how the notes get called back to the issuer if the market’s up a certain amount. They turn into actually very complicated derivative products that you need fancy wants to think about how to price and so forth.

Benn Eifert: Really, I think generally my view would be that retail investors probably wd be better served trying to do simpler things, that they understood a bit better. The basic allure is that it’s hard to find anything that’s going to give you an optical 8 or 10% yield anywhere in the world. I think people compare that type of product to the type of really gnarly credit you have to buy these days to get an 8 or 10% yield and [crosstalk 00:17:50] this seems better, right? It’s large cap equity risk. It’s not some near bankrupt company.

Tobias Carlisle: I don’t mind it behaviorally though, if you’re forced to buy down 30%, it’s probably not a bad place to be, to be buying equities. That’s the tail hedging, and that’s where you can at least find some liquidity and you can find some better pricing. On the alpha side, what sort of strategies do you implement to try and generate returns?

Benn Eifert: Everything I think starts from the same basic thought process, which is derivatives markets exist not because there are guys like us who want to go find some sneaky trades to do to try to generate some alpha. Derivatives markets exist because there are end-users of derivatives that are trying to achieve some objective. Most of those, so for example, those retail investors buying the structured products and effectively selling puts are an example of that, they’re an end-user of derivatives.

Benn Eifert: Pension funds, pension funds who are buying down side protection to hedge are an end-user of derivatives and these days, pension funds who are selling short-term options, for example, in the context of call overwriting, overwriting calls over their existing equity portfolio, are end-users of derivatives.

Benn Eifert: An absolute return investment process in derivatives would typically just start with asking the question, “Where are there big imbalances in the market, either temporarily or rather persistent, where some end-user or some large group of end-users are doing something in very big size because it achieves one of their objectives, but that’s too large relative to the market, or that’s congesting a particular part of the market?”

Benn Eifert: An example in the last several years is I started to allude to call-over writing and cash secured put selling, typically relatively short-data in index options has become very, very popular among large institutional investors. These types of strategies, so for example you take a $100 billion pension fund that has $60 billion of equity exposure. That investor is going to say, “Look, if stocks are up 30% this year, I’m going to be doing great. What can I do that path-diversifies me a bit so that if stocks are flat, I do a little bit better?”

Benn Eifert: Well one thing I could do is I own $60 billion of equities. Maybe I sell $10 billion of call options against those equities. Then that investor will do slightly less well if the market goes up 30% but look, he’s going to be fine. If the market’s flat he’s probably going to harvest some yield from selling those options. [crosstalk 00:20:54]

Tobias Carlisle: Just so I can simplify, so they’re basically selling some strike above 30 on the call so that on the basis that 30% is a great yield for anybody, anything above that’s just being greedy. We’re much more likely to have returns below that so we can get some yield by selling those strikes that are up further. Is that the approach?

Benn Eifert: Yeah, that’s the basic idea. It typically wouldn’t be one year, 30% up side strikes. Typically it would be every month they might sell $10 billion of 2 or 3% out of the money strikes, but then do that every month. Roll that type of position every month.

Benn Eifert: Some months are going to be flat months, and they’ll just collect the premium that they sold. Some months are going to be up 5% and then they’ll lose a bit of money on that particular month on the options that they sold. Some months will be down months in the equity market, and they’ll make a little money.

Benn Eifert: Their bet is that over the course of a year, selling those modestly out of the money strikes every month, they’re going to harvest some, they’re going to net collect some premium. Or at least if the market is up huge, they will have given back some money on that program, but their underlying equity exposure is very large, much larger typically than they are overriding.

Benn Eifert: It’s a way to transfer some returns from a scenario path where the market’s up a lot, to a scenario path where the market is flat and choppy, or maybe even down small or something like that. These types of programs are very popular.

Benn Eifert: Also, if you’re to look at a 30-year back test of the performance or these types of strategies, they look very, very good largely because short-term options for a long time were really quite expensive. I think our view is that what you’ve then seen happen is these strategies to grow in popularity to such an extent, now a pretty significant portion of the large-scale institutional investor community has some type of call overwriting program for example. It might be 40% of pensions.

Benn Eifert: The size of those, and most folks are doing something very similar, so typically they’ll sell relatively near the money slightly up side, one-month options. Everybody’s doing the same thing in very big size. What that typically does is it changes the price and changes the forward looking expected performance relative to that 30-year back test that you did in the first place.

Benn Eifert: What folks like us, when we’re looking at absolute return strategies, we think okay, most likely we are supposed to actually be buyers of that over-sold part of the options market, and we’re probably supposed to think about what else we can sell against it to hedge, so that we have a hedged position where we’re buying something cheap and selling something expensive.

Benn Eifert: Then you have to go do a bunch of work and figure out well how would you actually do that, and what would make the most sense, and what type of a portfolio are you going to have and so forth. The starting point is almost always where is there some kind of dynamic in the market that’s involving some large-scale behavior by end-users of derivatives that’s making something too cheap, or something too expensive. Then how do you structure a strategy around that.

Tobias Carlisle: How are you making the assessment that it’s too cheap or too expensive?

Benn Eifert: With options, typically what you’re looking at is when you trade relatively short-term options, those options you can normalize their price in some sense into what we call an implied volatility. As we typically and volatility traders and market-makers don’t retain directional exposure to options. If we were to buy a call option, we would sell equity against it to be neutral to the equity market.

Benn Eifert: If you were to compare that implied volatility or normalized price, the level of volatility that would just defy the current dollar market price of options to expectations of the actual realized volatility that you’re going to see in the market, that tells you something about how cheap or expensive those options are.

Benn Eifert: If you were to look 10, 20, 30 years ago, typical levels of implied volatility for short-term options were much higher relative to the likely level of realized volatility that was going to occur. That premium was much higher than it is in the last several years.

Tobias Carlisle: That’s why the end-users have put those trades on, because they’re trying to harvest that, and now that that’s been suppressed, it creates an opportunity for you. You’re trying not to be directional to the equity. Are you trying to be neutral to the volatility? Are you somewhat directional to the volatility?

Benn Eifert: We always have some type of volatility exposure. In this case, we’re not only in an absolute return mandate anyway, we’re not only buying those options and then hoping for volatility to emerge. What we’re doing is looking elsewhere for example, slightly longer term options where there’s more of a balance between buying and selling and supply and demand, and where the profitability is driven also by things like what does the term structure of implied volatility look like? Is it much higher for somewhat longer term options, and how does that work, and being able to structure a portfolio which for both shorter term and longer term options.

Tobias Carlisle: Do those occur because there’s some event? There’s some political event? Sometimes there’s volatility around presidential elections or there’s volatility around macroeconomic events globally. Is that what creates the unusual shapes in the term structure?

Benn Eifert: There is event pricing in the term structure. You’ll always notice the options expiring immediately after some well-defined, known catalyst like a fed meeting, for example, will trade at some premium. In general, the shape of the level of implied volatility for options with different amount of time to maturity and a different stripe price, so down side puts versus up side calls, really is always determined by supply and demand, so who is buying what, and who is selling what.

Benn Eifert: Typically, when markets are relatively quiet and volatility is low, usually the term structure of implied volatility, which just means what is the level of implied volatility for one-month options, two-month options, three-month options, what is the shape of that relationship. Typically it’s upward sloping.

Benn Eifert: The notion is look, I mean if things are quiet right now, in a year or two who knows? All kinds of things can happen. If you want to take, if you’re going to sell a one-year option to someone you’re obviously taking some risk that things change and the world gets more volatile and so typically in a quiet environment, that would trade at a premium to a short-term option. Supply and demand really is what determines all of those parameters.

Tobias Carlisle: Just to step back slightly, you have an undergrad in economics, and then your PhD from Cal. What was your PhD in?

Benn Eifert: It was also in economics, actually.

Tobias Carlisle: Then you went and worked in an emerging markets economist for the World Bank?

Benn Eifert: That’s right, yeah. I worked for the Chief Economies of the World Bank. Initially, mostly focused on sub-Sahara in Africa, and then some work on Latin America and India, across a variety of different things. Yeah, so emerging markets macro.

Tobias Carlisle: How do you then transition from, I don’t imagine there’s an enormous amount of math in something like that, into something that’s heavily math-driven. That’s an unusual step.

Benn Eifert: Yeah, and actually I realized I just got… I think we did the timing slightly wrong. I worked for the World Bank in between undergraduate and grad school, and so in grad school, I did some emerging markets macro work. Actually my thesis was in that area, but over time started working more and more on finance.

Benn Eifert: Graduate school in a technical discipline is like anything else. You can do a wide variety of different types of things and acquire a wide variety of different types of skills. In my case, applied statistics and applied math is sort of the core of it. Finance, or quantitative finance is sort of a field of that.

Benn Eifert: You learn how to write code, and you learn how to program computers, and you learn how to do statistics and so forth. You get a job and you learn what you’ve got to do. Yeah, from there I worked actually at a hedge fund for a while, while I was in grad school, but my first real job was on the Wells Fargo prop desk after grad school.

Tobias Carlisle: What were you doing on the desk?

Benn Eifert: I was a quant. I was the main quant and then I hired a few people and ran a small quantine at Wells Fargo. Then we did that business spun out and became a hedge fund. Eventually I started picking up some responsibility for derivatives trades that were outside the core wheelhouse of the business so that that business was primarily focused on corporate securities.

Benn Eifert: Things like convertible bond arbitrage, capital structure arbitrage, trading secured debt versus unsecured debt. I started doing some of the, for example, currency derivatives, so more macro-oriented volatilities trading, primarily from a portfolio hedging perspective initially. Then we did build out more of a pure play derivatives relative value and volatility trading piece of that event business, of [Sequila 00:31:37].

Tobias Carlisle: You’re a lecture at Hass, at Berkeley-Haas at some stage? They have a quant finance school, is that what you were doing there?

Benn Eifert: Yeah, so they have a master’s in financial engineering program, which is a great program. I taught in that program as part of graduate school for several years. Then subsequently, at least for a few years, I’m not… It’s a very tough time, competition for time. Teaching is great and I really enjoy it, and it is actually useful from a business perspective because there’s not really a better way to recruit than to have continued direct exposure to students as opposed to you interview somebody a few times. You’re primarily often testing whether they’re good at interviewing. It is a big time demand, so I’m not currently teaching.

Tobias Carlisle: Then you launched QVR in 2016?

Benn Eifert: It would’ve been 2016 I was working on it, so I was on garden leave all of 2016 and building a lot of the core infrastructure. We did launch the business in 2017.

Tobias Carlisle: Your clients tend to be large institutions, for the most part, who approach you with a specific problem, and it could be hedging or it could be the alpha generation.

Tobias Carlisle: Could we talk a little bit more about the… I heard your conversation with Corey. You were discussing some interesting… One interesting trade anyway, that was trading volatility of energy companies in large cap versus small cap. Can you just walk us through that?

Benn Eifert: Sure. I think this is an absolute return trade example. The type of thing that would come up in the context of some of our strategy sleeves in relative value trading. I think the example that I gave was there are obviously many participants in ETF option markets. One major use case, I think I gave the example, again, of overwriting, right?

Benn Eifert: I think I gave the example, what happens when there’s a large fund manager who, for example, owns a lot of equities in small cap energy and decides to do some large-scale overwriting, sell a whole bunch of call options?

Benn Eifert: Typically what we would see is we would see the prices of options on those small cap energy names. Or I think I’d maybe give the example of the ETF, maybe XOP, NEMPTF, see those prices fall significantly relative to where they were previously and relative also to the prices of options on large cap energy names, or XLE, for example.

Benn Eifert: You’d probably also see that nothing really appeared to change in the dynamics of realized volatility in those sectors. It wasn’t that suddenly the XLE name, the large cap names became a lot more volatile relative to the small cap names.

Benn Eifert: We might see direct evidence that those trades happened, probably you would see, if they were done and listed, you’d probably actually see the transactions occur and you’d hear that they occurred. Typically, we have a variety of models for thinking about this, but one thing we might end up doing is buying those options on the small cap energy names that were heavily sold by the overwriter, down to a significantly cheaper price. We might hedge by selling the options on the large cap names, and then be in a relative value trade position.

Benn Eifert: That again is the result of a more temporary point in time demand by end-users, in this case an owner of the equities who was willing to sell off the up side above some point and did it in such large size that he depressed the relative price.

Tobias Carlisle: It’s somewhat opportunistic when you’re finding these trades. How do you screen for them, or how do you hunt for them?

Benn Eifert: I mean that type of thing would be something where, as a business in this space, you obviously have the full data history on all of these types of things. Where are the options on all the different major liquid sectors trading, and you have models that very quickly observe the price changes and all the other signals associated with that, and would be highlighting that to you, right?

Benn Eifert: It’s opportunistic in a sense, but really you could manage that type of a strategy nearly completely systematically if you so chose in that you’re monitoring many, many, many different relationships like that continually and have signals that are triggering when significant changes in price happen, but don’t have any clear justification in underlying price dynamics.

Tobias Carlisle: That’s fine. Next question, is it enough that the trade seems to you to be mispriced, so do you need to find out, do you need to understand why?

Benn Eifert: We like to understand why. At a minimum, we like to validate to ourselves that there is not a really good reason why this price is changing. In derivatives markets, typically large price changes either happen because something underlying a structural is changing and the price change is justified, or because there’s some large transactions that just, there’s a big buyer or a big seller, and they’re changing the price. We would like to be involved in the latter and not in the former.

Benn Eifert: Obviously, one example, in that particular example the thing that you would be worried about would be if there was some… I mean in that example it’s hard to think of, but in some fundamental reason why the small cap energy names were going to be really quiet for the next month, or something. Whether there would be something regulatory. I don’t have a great immediate example off the top of my head.

Benn Eifert: A similar thing that’s I think a better example, and it gets a bit wonky but if you think back to Japan in 2012, 2013, remember the Japanese equity market had been dead for a long time at very depressed levels and very quiet. One market price change that people started to notice was that the price of call options, up side call options in the [Nee kay 00:38:19] was starting to go up a lot relative to the price of down side put options.

Benn Eifert: In some sense, people who were buying options were doing so in a very bullish way for the market, if you want to think of it that way. It was the type of thing where if you were just running some historical data analysis through some statistical models and coming up with a judgment thereof, you would’ve said, “Gosh, this is a really big price change that we don’t,” really, to an extent that you don’t really ever see it before, and this is silly, and you’re supposed to do some kind of trade that involves betting on meaner version, selling those call options and buying the put options and doing some kind of hedge.

Benn Eifert: The key thing to understand it was Abe was putting in place a bunch of new large-scale programs involving huge new central bank easing and structural reform, and the marketplace was getting really focused on the possibility that the Japanese economy would be revitalized and the equity market would go on a big tear, and that is really what you saw was a violent, highly volatile rally in the Japanese equity market.

Benn Eifert: If you had just naively looked at market prices going up in these calls and down in these puts and said that this is silly, it’s some kind of statistic collaboration, you’re supposed to trade against that, which some folks did, you really got run over, right? I think from our perspective, we’re always most interested in, again, price dislocations coming from end-users and flow. We want to be able to validate from a defensive perspective that there’s no big macro regime change that’s driving what appears to be a change in prices. If there is, we probably just don’t want to be involved. We might have a view on [ebinomics 00:40:10] or not, but we know that there are smart macro traders who are making those bets and our job is not to bet against them.

Tobias Carlisle: There’s a similar, similar event with [Varmigettin 00:40:23] in February, 2018.

Benn Eifert: Yeah, I mean in February 2018, I mean the lead up to that of course was that retail investors largely first discovered VIX products in volatility markets, call it back in 2011, 2012. I think again, those markets are somewhat complex.

Benn Eifert: Retail investors really liked buying volatility through those products because it was very easy to do. It became extremely over priced in that product, and folks didn’t really understand why they were using money. If I bought a VIX and VIX was 15 and VIX is still 15, why am I losing money? They didn’t necessarily understand that they were buying futures, and futures at the term structure and so forth.

Benn Eifert: After several years of losing money doing this, the retail investment crowd discovered that they could just short the same products instead of buying them, and actually new ETFs were created that did that under the hood and allowed them to just buy an ETF, which is effectively shorting VIX products.

Benn Eifert: Those investments did very well for a period of time but became too large for the market. Volatility when down and down and down and the risk premium embedded in those products went down and down and down, and that culminated in Volmigetten, as you said, in February 2018.

Benn Eifert: One market price change that folks observed ahead of that was that options on VIX products, particularly up side call options, were becoming very expensive in the sense of just the price was rising because clearly people were buying them, again to relatively unusually high levels, but really the justification for that was that this possible event, this major short squeeze in the VIX complex and the unwinding of some of those ETMs was looking very plausible and looking potentially like it could happen in a relatively short period of time.

Benn Eifert: Certainly, selling those optically expensive VIX calls would not have worked out very well for you. Again, so understanding the landscape, understanding the risk characteristics that are out there in the world is really important, not just seeing a time series chart of some index and thinking it’s too high.

Tobias Carlisle: Investors seem to have been chastened in the aftermath of XIV failing and so on, but do you see any emerging changes to the volatility term structure, or do you see anything out there that’s skewing the market for volatility?

Benn Eifert: You know certainly not. I don’t see anything equivalent to the VIX complex in late 2017, early 2018 where you really felt like there was a ticking time bomb to some extent, where you didn’t know the timing but you figured it was highly probably that there would be a bad event at some point.

Benn Eifert: Generally speaking, our view is that there’s, again, very heavy selling of short term index options via call overwriting and put underwriting by large institutions, probably to the point that’s significantly depressed expected returns that those folks think they’re getting, relative to historical benchmarks.

Benn Eifert: That’s not a blowup risk, that’s very different, right? These are large, deep-pocketed institutional investors overriding calls against some proportion of their equity portfolio, right? They can under-perform their expectations, but there’s no sense in which this is some kind of blowup risk.

Benn Eifert: The only other, there is some risk. We talked a little bit about retail-structured products and how there’s some supply of tail risk coming out of that. There is some risk in that landscape, just in the sense that those structured products are typically again relatively complex. Banks issue them and hedge them and the hedging of complex products is usually a complicated and error-prone and risky business.

Benn Eifert: There are scenarios where the equity market is down 30 or 35% over three to six months and that space generates some pretty big, unexpected blowups for banks, but we saw that to some extent in China in 2015 where if you recall in summer of 2015, Chinese equities almost doubled over the summer in a big bubble, and there were all of these videos of vegetable peddlers on the street with their laptops, doing their trading.

Benn Eifert: Then those prices subsequently fell about 50% and it did cause a big squeeze in those longer term options associated with structured products. There were some big losses in the market. Again, this stuff is I think relatively contained to specific pockets of the market that don’t have… None of it is systemic risk or anything of that variety. I think that most of it is some folks that could lose some money in the wrong scenarios.

Tobias Carlisle: What about the structured notes that the Japanese and Europeans are buying? What sort of behavior does that create if they knock in down 35% or if they kind of kick in?

Benn Eifert: Yeah, exactly. That’s what I was alluding to. The trick is that those notes, we talked about the investors effectively selling put options. It’s a bit trickier than that. They’re technically selling something which is called a knock-in put option, in the sense that really the investors only get put into the stocks if once the stocks are down, let’s say 30%, for example, and then they’re just long stocks and there’s no more option associated with that.

Benn Eifert: What that means is that the banks who are issuing and creating these notes, initially when they issue the note they’ll do some kind of hedging. Typically they’ll sell a long term, out of the money put, but if the market goes all the way down there and those notes start to knock in, the bank still has that put that they’re short that they sold, but there’s no option anymore that they’re long, right? Just the retail, it was converted into a stock exposure.

Benn Eifert: That’s a tricky type of risk to manage. For the banks, what it means is that at some point, as the equity markets go down and down and down, banks suddenly start getting short volatility. They’re getting net short options because they used to own a long option, which they sold a vanilla put against, but they don’t have that option anymore.

Benn Eifert: That creates some potential short-squeeze dynamics where this is happening to all the banks at more or less the same time, and they’re all having to go and buy back two-year options, three-year options, exactly at the wrong time when the market’s down 30%. That’s the risk.

Tobias Carlisle: On a day-to-day basis, you’re just running your models, trying to find something that’s slightly mispriced, trying to understand why that is the case and then trying to find a way to trade that for clients. Is that what happens?

Benn Eifert: Yeah, I mean there’s going to be a variety of types of strategies, right? In absolute return land, some things that we’re doing, the mispricings are slower moving, and the day-to-day work is more about maintaining the risk exposures that you want as the world moves… As prices move around, and so forth. We’re rolling some options from one maturity to another, or taking profits someplace and increasing exposure some other place.

Benn Eifert: Some things as you mentioned, like in the example of that, the small cap versus large cap energy, volatility exposure, that might be something where new mispricings, or new seeming mispricings pop up relatively quickly, and we want to try to assess them and see whether we’re going to put on a trade or not.

Benn Eifert: Generally speaking, it’s an investment process that’s built on different strategy sleeve building blocks, which each have their own logic and their own infrastructure around them for providing the information that you need to make decisions, and make the fine-tuning adjustments to that portfolio on a day-to-day basis.

Benn Eifert: Similarly, a tail-risk hedging program is typically more going to be, usually things aren’t changing dramatically on a day-to-day basis, right? You have some longer term oriented exposures. At some point you might start rolling some of those exposures to longer dated instruments once you’ve owned them for some number of months or so forth. The exercise is on a day-to-day basis, is typically more incremental.

Tobias Carlisle: Are you allowed to tread a PA?

Benn Eifert: We are allowed to. I’m too busy to be too involved in a PA, but yes, in principle, subject to the standard restrictions.

Tobias Carlisle: Is there an internal hedge fund or an internal way for you to pull your investments?

Benn Eifert: There’s not, in principle. There are firms that do that. I think our view is it is somewhat tricky running an internal prop allocation together with client allocations. You can do it, but you have to, of course, worry about all the documentation of and trade splits and allocations, and making sure that you’re not doing things that you shouldn’t be. Our view is that it’s not necessarily worth it.

Tobias Carlisle: How do you invest your own money?

Benn Eifert: Well I’m a small business owner. Most of my money is just right there in the business, supporting the activities of what we need. Then the part that’s not, is very just long term, is sort of how the way you would want your dad to manage his money.

Tobias Carlisle: Very vanilla.

Benn Eifert: Very vanilla, very long term oriented, and try not to look too often. Try to rebalance it when you’re supposed to.

Tobias Carlisle: That’s great. Benn, we’re coming up on time. If folks want to get in contact with you, what’s the best way to do that?

Benn Eifert: Sure, you can look at our website, QVRadvisors.com. I think there’s a contact form on there that works. I think my email address is Benn@QVRadvisors.com, if anyone wants to reach out, too.

Tobias Carlisle: You’re on Twitter?

Benn Eifert: I am on Twitter. You can follow me on Twitter @bennpeifert. Fair warning, though. I think 95% of my Twitter content is comments on what savagery my three and a half year old son is up to lately, or things of that variety. What music is on in the office, but you’re welcome to check it out.

Tobias Carlisle: I think there was a good tweet today, it was about whether you’re… With the broken headphones, whether you could just pump it off.

Benn Eifert: That’s right, well yeah. Yesterday, markets have been very quiet, as you know, and so the office banter starts to kick up, the distractions start to elevate.

Tobias Carlisle: Everybody’s gone on vacation.

Benn Eifert: That’s right.

Tobias Carlisle: That’s great. Thanks very much for spending some time with us, Benn, off at QVR.

Benn Eifert: Absolutely, Toby. It was a lot of fun. Thanks for having me.

Tobias Carlisle: My pleasure.

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