Long Volatility: The Critical Piece Missing in Portfolios (w/ Danielle DiMartino-Booth & Chris Cole)
DANIELLE DIMARTINO BOOTH: Talk about one way that you would play volatility long. Or if there is no way, one way, how do you-- you said 20% long volatility. How do you do that? CHRISTOPHER COLE: Now, I take a very broad definition of what long volatility is. So let's start out with specifics. I actually went back and I tested using very defensible assumptions. What different traditional explicit volatility strategies, how they would have performed over periods like the Great Depression, over the 1970s. So for example, it's very popular to do covered calls. People will own stock and they'll sell calls against that. Large pensions do that as well. Some people will do tail risk catching. They'll buy put options-- various strategies. So I tested all of these strategies using very realistic assumptions going back to the 1920s. And those assumptions are laid held in very high detail in my paper. So one of things I found, just to start out with-- short volatility strategies, which in equity markets, currently there's upwards of about $200 billion of these strategies, are very popular, have performed extremely well since the '80s. These mean reversion short vol strategies, pretty much every single one of them showed complete annihilation of capital over 90 years. And I would say that based on very defensible assumptions that people should not only avoid these strategies, but also institutions that robotically and systematically apply them. And I believe there is a place for these strategies if they're used tactically. Using human discretion, say, this asset has overpriced volatility. We're going to sell it as part of a trade. That's very different than what a lot of institutions are doing, which is they are constantly systematically selling volatility for excess yield. And this includes even collateralized short vol strategies. So most people have come back and said, well what about something like a covered call strategy? Why would that show impairment of capital. And well, let's take a look at that. In the 1930s, the stock market dropped 80%. Now, if you were selling calls on the way down, you would have done a little bit better than someone who was just holding the stock. But then, we had the deflationary left tail. Then you have the right tail, where they do the 1932 Banking Act, and they devalue. Lower rates-- devalue, and also, devaluation versus gold. At that point, you had a 70% rally that occurred over a month and a half. So imagine that you're selling calls, earning a little bit of money. But you're holding that against stock. And you're losing all the way down. You lose 70% of your capital that way. And then, you're selling calls into a 70% rally that occurs over a month and a half. And that wasn't the only rally. There was another rally that occurred in the '30s, that over 80% over four months. And that was the Roosevelt devaluation versus gold. DANIELLE DIMARTINO BOOTH: Hard to pivot in that short period of time. CHRISTOPHER COLE: That's right. DANIELLE DIMARTINO BOOTH: That's your point. CHRISTOPHER COLE: So these are political risks. You have deflation. And then, you all of a sudden have a political shift that causes reflation, either through monetary or fiscal policy. And if one thinks they can predict that, they're wrong. There's just no way unless you're psychic. So with that same understanding how shortfall performed, we can look at how longfall has performed. Long volatility, truly buying a straddle, buying puts and calls, would have been positive carry for decades. It would have made money in giving you diversification over the 1930s all the way through the '40s, and also would have given you income in the 1970s. So to this point, one of the things we've advised is something we call active long vol, which is this idea that you forego the first movement in volatility. You're not looking to protect against exogenous risks. But when the market moves a little bit, you catch the momentum of volatility. And this is how we modeled it. It is an attempt to model systematically what active long volatility managers seek to do, which is provide portfolio insurance type of protection for lower cost security. But there's other long volatility strategies or countertrend strategies that are also really effective. Commodity trending is an example of a strategy that can be very effective. Commodity trend has not been very popular in recent years, but was particularly effective in the 1970s during that inflationary period and was effective in the 1930s. And then finally, gold, is a long-- I would say a long volatility asset because it plays off of that fiat devaluation that occurs. DANIELLE DIMARTINO BOOTH: Of course. CHRISTOPHER COLE: So in this sense, by having parts of the portfolio, all of these asset classes, all of these asset classes are countertrend to equities and are uncorrelated to bonds. They show no correlation to equity and bonds. So to the same point, instead of chasing excess yield, what people need to be doing, particularly the large institutions need to be positioning portfolios boldly in asset classes that are non-correlated to stocks and bonds, preparing for a period of secular change. Danielle, the numbers are amazing. The numbers are amazing. In my portfolio, the replication portfolio going back 90 years that we show in the paper, you're able to achieve consistent performance above the 7.25% pension return target that is consistent through every generational cycle. DANIELLE DIMARTINO BOOTH: And that's how pensions should be invested for the long haul. CHRISTOPHER COLE: That's right. DANIELLE DIMARTINO BOOTH: Absolutely. We're going to go in the weeds, and then we're going to pull back out. Describe the evolution of cross-asset volatility. There used to be an order of things-- FX, rates, equity. Has that been destroyed in this era of all-- you name it-- VIX, move, every gauge of volatility is at a record low. CHRISTOPHER COLE: That's right. Actually, equity vol, US equity vol is actually relatively expensive comparative to other-- comparative to like currency vol, for example, which is truly at all-time lows right now. DANIELLE DIMARTINO BOOTH: And that's a massive market that nobody ever talks about. CHRISTOPHER COLE: I think one of the things that's really-- we talk about the short volatility trade. And I say, OK, it's close to $3 trillion in equity markets right now. The portfolio insurance was only 2% of US equity markets, but in 1987. And that, now, these short volatility strategies of all of their styles are now closer to 10% of the market. That same trade is being replicated across multiple different asset classes. so we're seeing it replicated across multiple different asset classes.