Hello and welcome to another episode of the OddLots podcast. I'm Tracy Aloway

and I'm Joe Weisenthal.

Joe, I've been reflecting on this year. It's been a busy year. Yeah, go on.

In fact, we're recording this. We're on yet another trip.

I know.

We're in Huntington Beach for this year's Future Proof Conference, which is

always a fun time.

An event I always enjoy, but we have been on the road a lot.

We have.

And I feel like the entire year is starting to feel very surreal for me. It feels just very different to prior years for many different reasons. But I was also thinking one of those reasons is because it seems harder and harder to do portfolio construction nowadays.

And I know that sounds really weird given that like markets are still at record highs and everything seems to be going reasonably well even though we had that terrible jobs number. But if I think back to the big leg down that we saw this year, it seemed really scary because basically everything sold off at once, right?

You know what I really like? I like how you started this with this philosophical thing. It's like we're out on the road and all this

and then I was like, how do I protect my portfolio?

and reflecting and the surality of the times and now we bring it around to portfolio construction but no there's true and there's two a couple things going on so one is the sort of like cross asset class moves the other thing is and it's very related to that I mean it's the flip side of this which is correlation breakdown and then there is still this other element that I think is at play where at least like

I would say there's two more things which is that one within US assets the winners are still the winners right especially a lot of these big tech names so you haven't gotten the sort secular

and people have been talking about overvaluations for ages,

forever.

And then the fact that, you know, you're not getting paid much to take on volatility risk or volatility measures are still very low. So there's a lot of difficult unintuitive things going on

and I don't even know what a tail risk hedge actually looks like at this point because I would have thought like well obviously maybe you diversify into longduration bonds or something like that but then in April when we had the big sell-off long duration did not do that well either. So, it kind of has me scratching my head about if you were worried about stuff both literally and figuratively perhaps blowing up at this point in time. What would you be doing? Like what does a tail risk hedge actually look like nowadays?

You like buy gold? That's already a record high. So, yeah, it's confusing.

Yes. Okay. So, on that note, I'm very happy to say we actually have the perfect guest to talk about tail risk insurance and just tail risks in general. someone who's been working on Wall Street for a really, really long time and has a very storied career. Lots of stories involving big names that you and I would definitely recognize. We're going to be speaking with Veneer Benali. He is of course the founder of a longtail alpha and again has worked at many, many firms previously. We'll get into all of that. Veneer, thank you so much for coming on Hot Thoughts.

Thank you for having me.

So I should just go ahead and ask you to give a sort of fiveinut summary of your career because it is kind of amazing. But the important thing is you didn't start out as a trader. You started out as a mathematician.

Yep. I started out as a theoretical physicist. I was finishing my PhD at Harvard and this is 1991. The recession had just hit. I didn't know what a recession was. I wanted to be a professor. But my job evaporated because I was going to go work at the super colliders the superconducting super collider that got cancelled by Congress 1990s.

I had a postoc lined up in France and one I think it was in Texas in Austin

and I got a call out of Wall Street out of Goldman. They were looking for quants like me to work on options trading or options model building rather I should say. So I went and interviewed mostly because it was a free trip to New York.

So I went there, got interviewed by an elderly gentleman who was taking notes saying doesn't know any finance. Full disclosure, I knew no finance. I had no interest in it. It was Fisher Black who was interviewing me.

Oh wow.

I decided, you know, Black Scholes fame. Little did I know when I turned that job down from Goldman, I took another job at City Bank trading derivatives cuz in my mind it was a sabbatical. I was going to do this for about 6 months to a year and then go back to physics.

Mh. Well, little did I know that my whole life would become basically very deeply connected with option trading. So, that's what I've been doing. And we'll talk a lot more about Taylor sketching in a second.

Wait, I got to ask why did you decide to turn down Goldman given that Fischer Black himself was doing the interview and you chose to go to City at that time?

Well, one was a research job at Goldman and the job at city was actually trading derivatives and uh since trading was so far away from what I knew and this was really supposed to be a vacation for me for about a year like sound like a good thing to do or fun thing to do rather.

Did you ever feel like I'm always so curious about stories from the early days of physicists going to Wall Street was there a period where you felt like it was a bit bene I mean you call it kind of a vacation job. Did it feel intellectually beneath you for a while and then did it eventually become sort of genuinely intellectually satisfying in the way that maybe you had anticipated an academic career to become?

So interesting. So the modeling certainly at those days seemed a little too naive. So for instance, I'll give you an example. Very first trade that we did large trade I was bank at the time and it was an interest rate cap on yen interest rates linked to the dollar yen. So it was basically a two-factor option called a hybrid option. And it turned out that as a physicist I was very easy. It was very easy for me and I was very able to write a Monte Carlo to write this knockout cap. But for the finance people it was kind of tough. So the math was very easy.

But I also learned that trading is not just math. Trading is a lot of behavioral stuff and so on. And that I just obviously had to learn. And I have some great stories of stuff that I did really badly back in 199094.

Tell us the story about something you did badly.

Well, to 1994, if you remember, you know, 1993, the Fed had eased and rates were quite low and everybody was long the front end of the yield curve and buying EUR dollar futures contracts.

Wait, didn't a town around here go bankrupt?

Yes. Yes. Yes. We'll get to that. Exactly. So, February of 1994, the Fed raised rates by 25. And then very surprisingly April 18th of that year they did an intermeating increase and at that time bond market really sold off quite a bit and I just did what human beings do which is bet on mean reversion. And so I tried to buy the bond market and tried to buy the bond market again and again and again until I realized that there's something called trend following and exit and I think the bond market sold off a good 15 20 points and finally I recouped it all but it was a brutal few months of literally getting my face ripped off.

So one other thing I'm curious about the sort of early days of quants but what exactly was the pitch to scientists whether they're you know mathematicians or physics guys when these big banks or big trading firms are trying to recruit back then because you know like quant was in the I know we had 1987 by then but it was still relatively in the early days so I'm really curious like what they told you about what you would be doing.

So in the from the modeling side it's pretty straightforward right the black shields equation and stochastic calculus stoastic finance is basically what's called the heat equation or the diffusion equation in physics and that's something that every physicist learns when they're in early graduate school. It's like solving a partial differential equation. So the math is exactly identical the math of finance. And maybe that's a problem actually in in retrospect now that having done this for 30 years and 30 plus years and survived maybe that's a problem because the beauty can somehow hide the frictions that are underneath it.

From the trading side when I first started trading I think it was very simply being mathematically sharp and quick uh and being able to answer quizzes just made interviewers feel like they were getting smart people on the desk that they could train, right? The blank canvas so to speak.

Yeah. So once people on these desks got armed with PhD physicists and understanding of like Brownian motion and stuff like that, did that change how the actual markets traded from your perspective? Like sort of pre and post that did assets conform more to as models anticipated because of the model effect on them like what was your observation of actual existing market behavior pre and post the physics revolution?

Oh, absolutely. And this is a very important question because if you fast forward to 2018, the big XIV debacle and the Volmageddon and a lot of things that happen now and actually fundamentally what we do now, what I do now is related to this fact that there's a very tight feedback loop between models and markets and models.

So give you a very simple example, right? If you have an option that you've sold to somebody and you have to manage the risk, of course, when you sell the option, you're getting a volatility premium. That's why you sell it. You're getting an insurance premium, so to speak. But then to manage the position you have to delta hedge.

But delta hedging means that you have to buy and sell the underlying asset and some higher order Greeks as well. Gamma, Vega, theta that you've all read about. But delta hedging requires people to be able to buy and sell so that they are the seller. The market maker is locally flat of course.

So the market maker that's what you do and that's how you earn your keep earn your fees so to speak. The problem is that there's an idealization in mathematics or mathematical finance that you can do this at an unlimited size and size doesn't matter but it matters. Liquidity is actually not there. The basic assumption of black shores is that you can continuously trade with almost zero transactions costs.

Well, that's just not true in real markets. As a matter of fact, in the last maybe two years even, you've seen liquidity in the E- mini futures contracts, which are possibly the I would say the zeroth order hedging instrument for the equity markets go down relative to the high levels frequently go down to maybe 120th or 150th of it level. So people just can't get out.

So what happens is that people sell options then they start delta hedging. Delta hedging results in the options market reacting to the delta then results in new hedges coming in. So this feedback loop gets tighter and tighter and tighter until something breaks. And when something breaks and the bot shut down, which is today's environment,

you actually have no liquidity. And that's when you get these crashes like Liberation Day on April 2nd.

Volageddon was definitely one of the more weirder events in markets because everyone could see what was going to happen when the VIX curve actually inverted. like you could see that all these products were going to go absolutely belly up and no one no one seemed to react to it until it was like much too late.

That reminds me. So, one of the reasons that we are interviewing you here in Huntington Beach is because you used to work at Pimco with Bill Gross. And the last time we spoke to Bill Gross, I think was actually at Huntington Beach two years ago. And one of the things we spoke to him about was volatility selling.

And Bill kind of became the poster child for a little bit of volatility selling at least in the bond market in the sort of like guess it would have been 2015 around then, mid sort of 2010s area. I'm really curious who's selling V now and how has it changed over the course of your career?

Yeah, so great uh little side point there. So Bill and I've been great friends as a matter of fact I went to Pimco because I heard Bill speak at a talk when he was advertising in book back in 2000 and Bill's an amazing genius, great investor. And one of the best compliments I got recently, I was communicating with him and he said, "I have your paper at the top of my reading list." And I said, "Which paper, Bill?" and he said this paper that I wrote with Larry Harris on the volatility selling ecosystem that basically you grew up before 2018.

So yes, so Bill actually in in a sense invented this whole idea of selling volatility in fixed income especially through buying mortgages or explicit selling of straddles and strangles. And what we realized and again I was head of analytics at Pimco. over the last over 15 years or so I was there I got to see and help him manage the quantitative risks of those portfolios.

We ended up educating a lot of our clients at that time about volatility selling harvesting vault premiums and so on which did end up adding quite a bit of as Bill calls it structural alpha to the PIMCO portfolios and you know 20 30 40 basis points every year.

What happened is that everybody got educated and it became part of the academic lore and everybody realized it. There was a lot of crowding and it's a little bit like selling insurance right so when you find that one insurance policy selling works then you say why don't become multi-line insurance provider so you start selling insurance policy on everything and so what has happened now over my career it have gone from institutional selling where first it was hedge funds then it was large sophisticated mutual funds like pimco who could actually still fit it inside of the mutual fund complex because selling naked options is not really allowed unless you cash back it,

right?

And then over time it has now gone to all the do-it-yourselfers. So all the wealth offices and family offices and large endowments and this whole area what's uh which is now called alternative risk premiums is based on this idea

that you can go and sell volatility in various forms explicit forms or implicit forms to generate income. So everybody's doing it.

Yeah, that's the answer. everyone even more people are doing. So when we see alternative risk premia it's basically a wall selling overlay is that it

yeah I mean you can make it more or less sophisticated I mean it's a little bit naive to say it's only wall selling but wall selling is a very important component of it and there were some great papers by people from AQR who took every asset class so equities bonds credit foreign exchange and then also sliced it down in various types of strategy style and quality and momentum and so on they made like a 16x6 matrix and then they recreated did this what I consider to be more sophisticated sounding

ball selling but it really is false selling and what people do just to to be very clear is it's not just ball selling they also layer on other things like trend following on top of it

to create a counterbalance to the ball selling because trend following is naturally a ball liking or ball long ball type of strategy

going back to I hadn't realized that about the declining or the collapsing liquidity within the e- mini futures but is there some sort of I don't know law of thermodynamics or something I don't know if that's the term or that's the analogy in markets where such that when some instrument becomes the hedging instrument of choice, the more popular that gets, the less capacity there is for liquidity in that instrument. Is that sort of what's going on here?

Yeah. So, in this case, the e- mini futures contract are basically a speculation vehicle. They're a cash equization vehicle. So, they serve a lot of different purposes. But I think the biggest thing that's going on here

is that starting maybe about 10 years ago and somewhat surreptitiously, the market morphed from human market makers. So, when I started trading, it was human market makers. I still remember when I was, you know, in the 1990s, Tommy Baldwin on the pit of the CBOT floor, Chicago border trade floor, you know, you would do a trade and Tommy Baldwin and he was legendary. Obviously, he would lift his hand up and the market would stop and turn and go the other way. Human humans could do that.

Yeah, what has happened surficially or you know very strangely over the last 15 or 10 years maybe is that the human beings have sort of left this market making area and 90 plus% is being made by bots and what bots know very well self-s survival is extremely important to them is as soon as they see a liquidity title wave coming tsunami coming at them they just get out of the way the liquidity just becomes very episodic and Muhammad Alaran used to call it latent illquidity which is just the fixture of the markets today. It looks liquid

and when you don't need it, it's there but if you need it, it's not there.

So how do you actually deal with that as a trader?

Yeah. So as a trader, so this comes back to the role of options fundamentally, right? So what do options I mean in the world of quantitative finance, you can take an option, you can replicate it by doing delta hedging and so on. Basically looking at the partial derivatives of an option pricing equation or you can say I'll just buy the option. So an option is a contractual agreement between you and the option provider.

So if there's ill liquidity and you believe this is a fixture of the environment that we're going to live in, then there is no other way than to actually have a contractual agreement with somebody

where you're delegating the uh illquidity risk to them and so you are buying it when the premium is cheaper. But trying to delta hedge it yourself is like literally trying to you know put an elephant through the eye of a needle. There's just people just cannot work out. I mean, I just can't

I just can't imagine the market collectively trying to get through that needle these days.

There is just nothing there. Let's talk about April for a second and maybe that period like between April 2nd and April 9th because that was a a market event for sure and it was also a real economic event with many things going on that weren't just lines on a chart etc. and we know what sort of happened there with the tariffs and then the reversal of some of the tariffs and what so forth.

Since then, we've seen some of these correlation breakdowns that some of our previous guests have talked about. From your perspective, you know, whether it's April 2nd through April 9th or April 2nd through now, what happened then such that maybe some maybe is it a new regime? What changed in that month? Yeah

though I think one of the things that is going on is we are slowly undergoing a regime shift and I like to always paint this picture and I'll come to your question right after I give you this big macro picture from the 60s to the 80s 60s to the mid 80s you had this period of rising inflation rising volatility noncredible central banks and stuff was kind of breaking and people were behind the curve.

then you had the bulker increase of interest rates starting in the 1980s and until the maybe late 20s 2020 call it 2021 on covid was an accelerant you got negative yields and falling volatility credible central banks and so on and I think we've actually turned the corner again so starting in 202021 I think we are probably going to look more like the 60s to 80 than 1987 to 2020.

now having put that backdrop you know in in front of us I think the issue really comes back to yes there is a regime shift both in terms of people's response function and how quickly things happen. So one data point that I can relay is since I started trading is in the past when crisis were would happen even including the GFC which I lived through and you know did fairly well it used to take months maybe weeks for things to correct and you had time to plan and time to execute.

Then Volmageddon maybe took a few days. 2020 COVID it maybe happened in you know few days to few hours and then starting this year it feels like things are actually happening on an hourly to maybe minute basis. For instance in April when the you know big crash happened and the correction happened all the action including some of our trading happened in the pre- pre pre-market. So the markets had not even opened up and if you needed to do something you had to do it during the night session because that's where all the action was.

So I think that's one fixture what's going on right now is that stuff is happening much faster and it does feel like the balance is tilted in the favor of more automated trading rather than human-driven trading.

Let me ask a philosophical question about tail risk projection, which is whenever there's a blow up, we suddenly get all these stories about tail risk funds that have done phenomenally well out of last month's chaos or whatever it might be. And then no one talks about them for like the next three years.

You don't know how they're bleeding you dry during those other months, right?

That's right. Um until we get another blow up and then the cycle repeats itself. In your mind, what is the purpose of tail risk protection? Yeah,

this is very simple and I've been trying to do this. This is actually one of my mission since I started our firm is not just managing the risk but also trying to educate people on what the purpose is. The purpose is very similar to insurance and not everybody needs it. If you don't live in California earthquake prone zone or in Florida hurricane prone zone, you don't need the insurance.

But if you're going to run a large equityheavy portfolio, and by the way, equities have demonstrated over the last 100 years and maybe going forward are the one way to create long-term wealth because people go to work. The first thing I learned when I was at City Bank from my boss told me was just look at log GDP versus log S&P. The charts are aligned. Basically, if people work, the market goes up.

So, what that means is that you need to be invested in the stock market. And the more you invest in the stock market, the more likely it is that you're going to make higher compounded returns over time. But also, you will suffer big draw downs. And one of the biggest problems with people's behavioral function is that when the markets collapse, they forget their plans and they liquidate. Right?

So what tail risk fundamentally does, it's not a fund that you should look in isolation and say, is this fund a good performer or not? Just like you would not go back home and say, "Well, what the what was the total return on my home insurance policy?"

Right? It's just a positive negative 100%. Right? Every single year. So, would you quit buying insurance? You won't because home insurance or car insurance is not an investment. It is the cost of doing business. So that's the context in which one should think about tail risk hedging is it allows you to first protect yourself from yourself in the bad events and then secondly when the markets are down

the value of those hedges going up allows you to buy assets on the sheep which results in compounded growth.

Why hasn't Wall Street created an instrument where you could sell away your liquidity to protect you from yourself automatically? I'm going to invest in this fund and I cannot sell until the year60.

Isn't that called lockups?

But do those funds actually exist? Could I buy that? And then there's two things that intuitively seem that A you protect yourself from yourself. B, you diversify automatically by the fact that you're across time and then C presumably that would be more stable for securities lending and collect the little instrument. Has Wall Street created a fund that one can't get out of?

I think like Tracy just mentioned uh hedge funds like to have lockups and and this

I just I should just be able to buy an ETF that I can't sell.

Yeah. Uh I think the if you can get over the regulators I think that we are living in a world where Marktomarket daily NAV etc for ETFs and full transparency is required. But I do think I mean one one very sophisticated institutional investor who was a client of ours actually said I would pay you more if you sold me a product that actually had a longer lock.

because this is a question I have about portfolios and diversification in general and it goes back to the point that you made about how stocks have done very well and the expectation is that as long as the economy grows stocks will continue to do well for a while 6040 was a craze right and this was a good portfolio of your treasuries and your stocks balance out.

but why should like what is the case for diversification let's say setting aside the behavioral fact that people sell at the lows What is the case for diversification when there is this asset class that does so well over time?

Yeah, so this is great. So if you could guarantee that this asset class would keep growing always then you would 100% be on stock only.

Now what bonds traditionally used to do was they provided you with income that when the stock market wasn't doing well at least you wouldn't go completely broke because you would have some yield.

But I think it got taken to an extreme right. I mean the greatest example and I wrote a whole book on this topic is is the European Central Bank followed the Japanese central bank and then they started buying at negative yields and they convinced all the indexers to keep buying bonds with them. Right? I mean think about this. You were buying bonds meaning you were lending somebody money and you were paying them interest

and at that point diversification is an insult. I mean you don't want to buy a negatively yielding bond along with stocks because it does nothing for you. And we're living the consequences of it today because the bond market over the last five or seven or 10 years even has had absolutely dismal zero returns.

Joe, do you think people who want positive yielding bonds are entitled still? That was your position for a whole year.

I still think that I still don't think anyone is entitled to yield.

No, I don't. If you want to take the risk, go get it. But the sort of moral demands that the government must provide you yield for what? For not spending and doing anything. Give me a break. Joe Joe spent a good year making fun of yield bugs as you call them.

I don't It's great. Go out, collect your yield. I'm I'm happy for you, but don't pretend that it's some sort of moral insult that the government isn't providing you risk-free yield. That is my only That is my only stamp.

That's I would argue the US government's most important role. Anyway, let's go back for a second. So, it's not just the insurance idea. you touched on this, but it's also the idea that like you can get a massive windfall when there's a market crash and then you can use that money to actually go on a buying spree at a time when markets are cheap and everyone else is, you know, short on cash and they can't do the same. How do you actually deploy that into practice and how do you scale for instance an expected windfall against the type of assets that you could potentially buy?

Yeah, I think this this is where the first principles thinking becomes really important. So you have to look at every portfolio is different, right? So one of the other mistakes I think people make is they think you can just pick up a finance 101 book and say every portfolio is identical. It's all risk neutral and everybody is exactly the same. It's just not the case. Public fund that has a 40% or 50% funded ratio is very different than a 90% or a you know bank that's 120% fully funded. Right? So everybody has different needs.

The first thing that you do is you look at the underlying portfolio's posture. How much loss can you take? look at the systemic risk shocks that they can actually withstand. So you run a shock, you run a full distribution analysis and figure out what is the outcome under which they will be under so much distress or so much duress that they might end up having to liquidate assets. And there are actually quite a few like that right now where if the stock market went down 20%. And privates went down about 20%.

In order to raise liquidity for distribution, they would have to actually sell seed corn, right? So it's really really bad. So that's an existential risk that you want to quantify. So the first thing that you do is you figure out what that risk is. A full distribution of outcomes and then you look at the instrument set that's out there in the marketplace starting from the most reliable and surprisingly enough like Joe mentioned already the cheapest one which is equity option volatility. M

you can buy those put options but people who are not willing to pay a lot of continuous premium you can do more sophisticated tricks where you can buy indirect hedges for instance credit default swaps today the CDX index if you don't see the charts it's actually tighter than it was pre the GFC it's the tightest it's ever been

because people are buying it for cosmetic yield reasons so there are a lot of derivative inst cosmetic yield simply means that the total yield if you look at the yield of a corporate bond today.

It is basically treasury yield plus some spreads. So the treasury yields are at call it 4 and a half 4%.

But the spreads are actually very tight only 50 basis points on the CDX. So you're getting a 5% 6% yield

which in the context of where we were 3 years ago looks like an issue. You are taking much risk.

Okay, keep going.

Yeah, it's a cosmetic yield. Your decorated yield. So to me the yield is not justified by the risks that are underlyed. So there's various instruments that you can use and create a portfolio of these types of hedges.

Is tailor risk hedging like insurance from a business from a structure of how people buy it? Is it like insurance where people sort of reload every year in a sort of okay start of the new year what is the tail risk I want to put on etc or something that renews and they have to keep paying a fee or is it just sort of something that can be set it and forget it a permanent allocation that sort of the tail risk hedge like talk to us about the business of selling a tail risk hedge

yeah so definitely so it goes up to the highest level where this becomes part of where you guys started portfolio construction it's an asset allocation decision Yeah,

it's not a trade. So the context has to be that if the agents are all lined up, meaning boards and trustees and so on, they think of this decision as protecting the portfolio, making a more robust portfolio as part of the DNA and the tail becomes part of the how you rebalance your portfolio over the long term. Okay. So that's how you set up the strategic portfolio. But then to your point, every year, yes, you have to renew this policy. You re have to recommmit premiums. Now you can preund for the next 5 years if you wanted to

but because options decay

in order to have this reliable hedge you sort of have to uh buy new options.

Yes.

What would be the worst kind of tail risk hedging in your view? Is it you know too expensive or does it not actually work when there is a big market crash? Like what is the ultimate sin of a tail risk strategy?

Ultimate sin absolutely is the one which promises to work but doesn't work. Right. So a lot of people try to reduce your cost by creating synthetic strategies, right? I already mentioned futures markets aren't very deep when you need them, but there's a lot of strategies which actually use a futures replication strategy

like the 1987 crash also purported to do. And those strategies typically don't work. And so there's many that promise and they look like they are cheaper and they don't cost any bleed but they also do not deliver which again going back to April 2nd the only thing that worked during that April 2nd to April 8th period was reliable hedging using index options nothing duration didn't work trend following didn't work a lot of other altruis premium strategies didn't work

so that is the cardinal sin you just do not do not have the luxury to go to the constituent and your clients or whoever's bought it and said, you know, we were trying to be too smart and oops, it didn't work.

Yeah. As you mentioned that to even talk about buying a tail risk hedge, you have to sort of understand is what is the existential risk for the fund and different funds have different flavors of existential risk depending on how funded they are. And so obviously an entity that's 120% funded is going to have very different risk scenarios than one that's 40% funded.

But you said something interesting which is that and I've been thinking about this a lot in a different context which is how levered is the financial system or the real economy to an ongoing rise in the stock market? How important is that? And at what point does even a sideways stock market, let alone a decline become risky for something that could break? And you know, we used to think credit is the thing that breaks. But I wonder if it's in the stock area thing now where you really get the problem if the equity values don't go up. Tell us more about what you said about what happens to various types of economically important players. If the stock market one day stops going up for uh sustained period of time,

I think you have a big problem, right? So, so not only is the stock the whole system 401ks and public pensions, they're all levered up to the stock market because that's the only way you can get to your 7 12 or 8% actual yield. So, if the stock market doesn't keep going up and keep delivering those kind of returns, it's very hard to get to that point.

Maybe if inflation rises, at least again cosmetically, maybe the long bond gets up to 7% or 8%. And everybody can just lock it in and immunize and you're there.

But in real terms, you're not going to have the income that you need 30 years from now to retire.

I'm fine. I have a zer mortgage. So I I have I have a mortgage that's locked in from that one period of time.

Yeah, exactly. So the system is very levered. And then corporate credit clearly is very very concentrated. We all read about payings and so on. But corporate credit based on the merrenton model again that connects equities to corporate credit spreads is also leveraged the stock market.

that the stock market suddenly had a big sell-off, corporate credits widen out, which is the real problem, right? Because if corporate credit widens out and the cost of borrowing goes up for all the corporations, maybe not the fang stocks, but the 493 other stocks, then how does the system produce? Because our whole system is based on borrowing. And I don't think very many companies in the US can function if your cost of operating your business was 10% a year.

Okay. Okay. Well, on that note, we would be remiss to have a tail risk person here and not ask what's the big risk that you see on the horizon in let's just say the short to medium term.

I think for me the biggest risk right now is uh what people have been talking about is you know the so-called and I call it so-called the Fed independence paradigm shift because I don't believe the Fed was ever really fully independent but now it's coming to the four that the fiscal and monetary authorities are actually one.

So what happens in the aftermath if the Fed actually becomes part of the central government, the fiscal authorities, I think at that point all bets are off because that's the one anchor that everybody whether uh realistically or not has held on to. But if interest rates can change just based on the need to finance something that totally upside downs the financial system. So to me that's the single biggest risk right now. So would that materialize into an inflationary risk for instance and then would you be focused on what you can do to offset that?

Yeah, inflationary risk and I think one of the best option trades again this is not a direct option. So going back to what you were asking before you don't always just have to pay premium the yield curve steepener where you buy the short end of the yield curve and you sell the long end of the yield curve. Today you can do it through using swaps and all that for essentially zero net carry.

So here's an option very similar to shorting the negatively bond market in Europe a few years ago where if you put a yield curve steepener on

either in a hyperinflationary maybe not hyper but a lot high inflationary scenario or in an aggressive Fed cut the yield curve steepens. So yes, so that environment is an environment in which the curve steepener could work. And yes, my zeroth order prior forecast would be that if we lose explicit independence of the Fed, the yield curve actually steepens a lot more.

Something I'm interested in. So, you know, you were talking about the recent eras and the the 60s and 80s and things may have gotten a little unglued and then the Vulkar era and then the postcoid era and now this question about whether what's left of Fed independence is at risk. You know, you're a physicist and or a lot of people in your space are mathematicians. Is there a limit to how much you can sort of math it out so to speak? because a lot of these questions are external to mathematics and so how do you think about the limits of quantitative analysis when we're dealing with things like will the political system allow the Federal Reserve to remain independent?

Yeah, I think a lot of it is actually non-quantitative and what I've learned even though I come from a quantitative background, it's not the math itself, but it's the sequence of logical arguments that you can make to get to a conclusion. Right? So for instance, we knew even before fancy mathematics was discovered uh you know lrangeians and so on that gravity exists. Gravity's existence has been known before maybe math was invented but gravity has been there

and so I think there's some central laws of finance which will still continue to exist uh regardless of the mathematical modeling of them and you know the bill gross when I used to work with him he used to say some things we can take for granted I'm paraphrasing it but the steepness of the yield curve the fact that the yield curve needs to be upward sloped for the financial system to function because people lend money in order to get something in turn. Those are not mathematical devices. Those are really just the way the capitalist system works.

So I think you can take the quantitative modeling to its own limit. But there are certain things that have happened in our system where we're at a point now where gravity so to speak of the financial markets are going to have to take over.

But presumably also if you can't predict the politics because it's very difficult especially nowadays. If you can't predict the politics then maybe right sizing your positions becomes more important. And so the maths actually becomes one way of dealing with the very uncertainty non-mmathematical element of what's going on.

Yeah. Exactly. And I think to take that point one step further. So correlation has been the greatest gift since the 19 mid 80s to to 2020. Right. So you got stocks and bonds just say 6040. Stocks went up, bonds went up and they were diversifying which is what a beautiful place to be in. Right. It

sounds nice.

So so that was a freebie. And again this goes back to financial gravity so to speak that state of affairs that free lunch should not exist. So I think we might be entering a phase where stocks and bonds maybe are actually not diversifying and you have to look at other things. Gold of course as you mentioned maybe Bitcoin who knows but I think the fact that reliable insurance or portfolio protection is so available today using the options market to me would be the place where I would look.

When you look at the long end of the yield curve today in the US, is there an element in which these concerns about the loss of Fed independence are being priced in right now? If suddenly you could snap your finger and know for a fact that the Fed will operate as it has been for the last 20 years, for the next 20 years, would there be a change? Is there some margin that concern there?

You know what? I don't know if the Fed is going to be a committed inflation fighter as well as it has been in the past. Therefore, I'm demanding extra yield today.

No, not yet. I don't think so. Maybe a slight amount of premium has gone up. But one of the most striking features of the system is that if you look at the Treasury yields, look at the 30-year bond today is 470. But you look at the 30-year interest rate swap, it's trading at, believe it or not, 389, right? So, it's almost 85 basis points under the US Treasury.

Now, you ask, why would somebody take the uh swap market at a lower yield? And I've been trading swaps since its inception back in the 1990s. Swap spreads are negative 85. And that goes back to the receiving of interest rate swaps to hedge liabilities by a lot of large institutions. So they have certainly not priced in inflationary effects into the swap market.

But at some point this has to also equiliiberate. So in my view it has not been priced in. Maybe it's too early to price in because maybe the Fed does not lose its independence and you know rises as phoenix from the ashes. But uh I'm a little bit pessimistic about it.

Just going back to your storied career on Wall Street for a second, how good were you at playing Liars Poker?

I was actually pretty good. I uh think I mean I learned it after I joined Solomon Brothers was a good group of people and I think the first year maybe I lost a bit but I think in the third year that I was there I won it and I was actually uh I think the one who took the biggest spot and I also my boss gave me his uh 18 ft fishing boat but he was buying a new one as part of the settlement that I knew.

Yeah in lie of cash. He was like here take my own.

Well cash plus the boat I think. So yeah

that's a really big pot.

That was a big pot. Yeah. At that point, we used to spend after the trading day was over. Every day we would print out randomized liars poker sheets. Uh, usually about 24 or 30 of them, and we'd play about 30 30 rounds every day.

Wait, Liars poker sheets. I thought you played with actual cash.

Yeah. So, actual cash you play with dollar bills, but uh, you know, if you're playing 24 rounds, there are not enough dollar bills flying around.

I never thought of that.

Yeah. So, you randomize based on how the dollar bill numbers are generated. Yeah.

Is there going to be a future in finance for a young physics student or a math nerd in high school today? You know, people worry about this with AI and so forth, but a young person who's quantitatively minded. Do you feel confident that there will be a role for them in finance in the future?

Absolutely. I think finance has existed from the very very beginning because it's based on the two fundamental emotions, right? Greed and fear, right? So as long as there's greed and fear and there's smart people around uh and again going back to math and physics it's not so much that the toolkit itself is teaching you anything special. It's just it teaches you think in a discipline logical fashion

and I think with tools like what we're seeing with AI and so on and coding becoming completely democratized. I think the ability to ask important questions rigorously becomes even more important. So I think it's going to be even better than it's been.

Veneer that was absolutely fantastic. Thank you so much for spending time with us at Huntington Beach at the Future Proof Conference and that was great.

Yeah, thank you so much. That was fantastic. Thanks for having me.

Joe, that was really fun. We should have an back and just do like stories from Wall Street in the 1990s episode. We could do that.

I love the stories. We could do a lot more on the stories and I'm also interested in like basically you know the philosophy of portfolio construction. I mean obviously there's the math of portfolio construction but I do have a certain dissatisfaction with many conversations about portfolio construction including this

in what sense?

Well diversified stocks have almost always gone up. Has every insurance I mean I guess another question that I could could have asked is has every insurance contract on the stock market essentially so far been a waste in human history because the stock market is at all-time highs. I have I have questions about that.

The counterpoint to that is, and I've I've come to realize this as I get older in my life and in my portfolio, is there is something nice about like waking up during a sell-off and going like, "Oh, shoot. My 401k has been absolutely decimated today." But if I look at, you know, some other position or some other tail risk hedge that I have, like that's actually up a little bit and it's offset some of the pain. And if I actually had to cash out of my portfolio on that day because of whatever I had to make a mortgage payment or whatever, then I would have some extra cash to spare.

And you could get an extra return by having that extra cash available to you to then go into the market and buy stuff on the cheap.

I think that we really should have an odd lots ETF that is advertises its illquidity that you can't sell this. If you need cash now, this is not the instrument for you. If you are putting your money in this, don't expect to see it again for 30 years. But the plus side is it will keep you from making bad, irrational decisions on a day when everything is red.

I mean, there's there's a value in that. There's a value in that. And there's also a value in being able to, you know, sleep at night a little easier because you have different positions. But anyway, should we leave it there?

Let's leave it there.

All right. This has been another episode of the Odd Thoughts podcast. I'm Tracy Aloway. You can follow me at Tracy Aloway.

And I'm Jill Weisel. You can follow me at the stalwart. Follow our guest Veneer Bonsali. He's at LongTail Alpha. Follow our producers Carmen Rodriguez at Carmen Arman Dashel Bennett at Dashbot and Kalebrooks at Kalebrooks.

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