DANIELLE DIMARTINO BOOTH: So talk about what effect this herding instinct has had on the
way this generation views investing.
CHRISTOPHER COLE: You and I have a very similar writing style.
I love metaphors.
I think visually.
I think I think you do too.
DANIELLE DIMARTINO BOOTH: Yours are better.
CHRISTOPHER COLE: Yours are-- they're very good.
But in that 2017 paper, I think I wanted to use the idea of an Ouroboros, this concept
of a snake devouring its own tail.
And what this was a metaphor for-- what is now about $3 trillion in equity markets alone.
This is just equity markets, US equity markets.
The number is much larger if you expand that across asset classes.
But of strategies that use volatility as an input for taking risk, but also seek to generate
excess yield, either through selling volatility or through the assumption of stability.
So in this number, you have implicit and explicit short volatility strategies.
And I think there's a lot of confusion as to what this means.
Explicit short volatility strategies are strategies that they will sell derivatives, so they'll
sell options.
DANIELLE DIMARTINO BOOTH: So the easiest would be selling the VIX.
CHRISTOPHER COLE: Selling the VIX, that's right.
So this paper came out prior to the XIV blow up, and it talked about how the VIX ETPs were
likely to have significant problems.
But that's a very small component of that short volatility trade.
A much larger component of the short vol trade are strategies that replicate the risk parameters
of short volatility trades but may not actually be shorting volatility.
So strategies like this might be things like volatility targeting funds or some elements
of risk parity, for example.
DANIELLE DIMARTINO BOOTH: Risk parity is still something we don't hear a lot about, even
though it's massive.
CHRISTOPHER COLE: Yes, yeah.
And indeed, the framework there is-- this could be anything between literally shorting
vol-- literally shorting volatility, what I'll call short gamma or being short trend--
and we could talk a little bit more about that-- short correlations, short interest
rates.
These are risk factors of a portfolio of short options that various financial engineering
strategies will replicate, maybe not all of them, but certain aspects of them.
That doesn't mean all these strategies are bad.
It just means that they are formulated to a world where interest rates are dropping,
assets are mean reverting, and that volatility is quite low.
And guess what has happened the last 40 years?
We are at generational lows in volatility across asset classes.
Asset trending-- I think this is something most people don't realize that, actually,
assets, equity for example, used to trend higher and lower.
You can measure that through something called autocorrelation.
All that means is that if today was down, it is likely that tomorrow will be up and
vice versa.
DANIELLE DIMARTINO BOOTH: Buy the dip.
CHRISTOPHER COLE: Buy the dip, that's right.
So the assets for the greater part of a lifetime were autocorrelated in the sense that higher
prices resulted in higher prices, and lower prices resulted in lower prices.
That autocorrelation peaked right when Nixon delinked the dollar versus gold, or the US
dollar versus gold.
And we have underwent a multi-decade decrease in autocorrelations.
And now, we're at really peak mean reversion markets.
So a lot of strategies make the assumption that mean reversion is implicit to asset price
behavior.
That's definitely not always the case.
So to that point, one of the strategies we actually tested was buy the dip.
How would buy the dip perform going back 90 years?
This is very interesting.
Buying the dip, you don't think of it as a short volatility, strategy but it is short
gamma, what's short that autocorrelation effect.
Well, buy the dip has performed incredibly well over the last 10 years, and really over
the last 20 years, as central banks have been very reactive to market stress.
DANIELLE DIMARTINO BOOTH: That's an understatement.
CHRISTOPHER COLE: Right?
Well, it's very interesting.
If you go back and you test buy the dip over 90 years, that strategy goes bankrupt three
times.
DANIELLE DIMARTINO BOOTH: Bankrupt's a big word.
CHRISTOPHER COLE: Flat out loses all of its money three times over a 90 year history.
It is only really in the last 10 years where it's compounded at about 10% a year where
we've seen that outperformance.
DANIELLE DIMARTINO BOOTH: I think that might-- let's see.
Is that the quantitative easing era?
CHRISTOPHER COLE: I think so.
It's not a coincidence.
Yes, not a coincidence at all.