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