Introduction

Patrick: [00:01:21] My guest this week is Chris Cole, founder and managing partner at Artemis Capital Management. Chris' specialty is in long volatility strategies, setting up portfolios, which will benefit from significant change in markets. We discuss how a series of small bets can lead to disproportionately large non-linear payoffs in both life and markets. Having read some of Chris' work, I knew that his thinking would bring a fresh perspective to the show. As metaphors for Chris' philosophy, we discuss what kind of watch he wears, Dennis Rodman, and movies. Please enjoy this conversation with Chris Cole.

Convexity in Daily Life

Hey Chris, this is going to be a lot of fun. Let's see how far down the rabbit hole we can go together today. Maybe a fun way to start would be for you to tell us what a Tikker is.

Chris: [00:02:17] It is a watch that actually counts time backwards to your death. So in many ways some people might find that idea very morbid, but actually, I find it quite life-affirming, because it says you only have a finite amount of linear time in your life. This watch has oftentimes lets you know you better use that to the best possible way.

Patrick: [00:02:46] I ask because we're going to talk a lot about exposure to what we'll call volatility and convexity, which sounds like kind of scary terms, but really it's exposure to change, what happens to you, or your business, or your portfolio when the status quo goes away, and things change considerably. And I think a neat way of understanding how that works, how convexity works, is to talk about a couple of examples from life outside of investing. Maybe you could touch on what some things that we do as human beings, good and bad, that give us positive or negative exposure to change and convexity.

Chris: [00:03:26] Let's go back to the Tikker idea. That's really interesting. For a long time, I wanted a watch that counted time to my theoretical death, as morbid as that might be, and actually these guys Kickstarted one, so I was on the list to get it. But I like to think of human life almost like an option - we have non-linear payoffs, but we're linearly exposed to time. So an option is a financial instrument that you have long convexity, you're long this myriad of different possibilities, but there's a limited amount of time that the payouts can occur in, and as you get closer and closer to the expiration of that option, there is a decay factor. It's much like a human life, so we experience time in a linear fashion, but we experience emotion and happiness non-linearly.

I think, a lot of times life can be analogous to markets, is about how do you take this linear concept of time and extrapolate it into non-linear satisfaction in your daily life? And then, from that, there's actually the idea of long convexity trading as a market strategy that has the same idea in markets.

Patrick: [00:04:45] What would be like a couple, let's say, daily practices or things that we do that would give us positive exposure to, let's say, positive non-linear outcomes, and maybe some that have negative exposure, like maybe eating junk food, or something like that?

Chris: [00:05:00] Yeah. I think, there's a myriad of different examples. Health and time are your most valuable assets. I think in my paper I talk about the idea that Warren Buffett's worth $66 billion, but he's also in his late '80s and I always ask people, would you switch places with Warren Buffet? And, almost nobody says yes to that trade. Everyone says, no. Well, how much do you value your time then? Your time is valued in the billions, and your health is valued in the billions, so how do you maximize both? How do you make sure you're getting the most out of that? It means spending your time in ways that make you happy. It means spending your time around people that make you grow. It's about observing healthy habits. It's about taking small risks that have big payoffs.

This is funny, I mean it's a trite example, but I'm single, and sometimes I'll go out with my friends, and you see someone out there, and someone's afraid to go talk to an attractive or nice girl. I say, "Well, what do you have to lose?" Just a very small linear loss, which might simply be pride, or a small linear amount of time, with the potential exponential gain of maybe meeting the person you'll spend the rest of your life with, or maybe just meeting someone who might be really amazing, that could be even a good friend. That's a perfect example, or a simple example of an exchange of linearity for non-linearity, but we can use even more complex examples. The idea of meditation, exercise, spending time learning to expand your neural connections. It takes a small amount of linear effort to produce massive non-linear gain over longer periods of time. All are great examples.

Making Money from Long Volatility and Convexity

Patrick: [00:06:42] It's a really neat way of thinking about the concept, exposing yourself to huge potential benefits from a series of small investments. And sometimes, you can almost think about this like insurance, where you're paying something, you're investing something - losing something - for the exposure to say a big payoff in the case of, obviously, it would be bad things in insurance, but it also seems as though you can flip that, and we'll get back to the investing side of this too, where you're not actually paying premiums, but you actually enjoy those little small investments. And maybe at first, eating well, or exercising, or meditation, when you change from eating poorly, and being lazy, it's a hard change - it is a payment - but as you continue to do those things, you start to actually enjoy the small investments, and then, who knows what could happen with the big non-linear payoffs?

I think about this podcast as a perfect example of the same idea. It's an investment of an hour, or two hours, every so often with somebody, which is almost always really interesting and enjoyable, and who knows what that could create beyond just a simple conversation. So thank you, that's a great way of framing how exposure to convexity, or volatility, or change is a good thing in your personal life. We can shift now to investing. You mentioned you can do this same thing in a portfolio, so let's start to get into how that works. Maybe start by describing why you want exposure to be long volatility or convexity, and why most investing strategies are actually the opposite of that.

Chris: [00:08:17] I tend to think about the world in terms of, there are so many different investing strategies, but if you were an alien that came down from outer space, and you just simply looked at their return streams, it would tend to fit into one of two camps, either long volatility, long convexity strategies, and short volatility, short convexity strategies. Short convexity strategies have a positive payout usually, and then, large, sometimes exponential declines, occasionally. And then, long convexity strategies are the opposite. You have a small payment, you're trying to stay neutral with small payments, and then, occasional large gains, and I think a lot of people don't realize that if you take things like, not all these asset classes are bad, of course, people have to have exposure to things like credit, and long equity exposure, and value investing.

It's not necessarily a value judgment on short convexity, but these are all strategies that work most of the time, and then they experience really large draw downs when they don't work. And I think very few people are exposed to the opposite and if most people's portfolios tend to be 97% short convexity and maybe 2% to 3%, if that, long convexity, and I think a lot of people found that out the hard way during the financial crisis, or during other risk-off periods. Convexity investing is about finding exposure to small bets that have small negative payouts, or structuring investments to try to have neutral to slightly negative payouts, that have extreme payouts in periods of dislocation or change.

Convexity investing is about finding exposure to small bets that have small negative payouts, or structuring investments to try to have neutral to slightly negative payouts, that have extreme payouts in periods of dislocation or change.

Patrick: [00:09:55] If we go back to defining convexity a little bit as sort of the non-linear payoffs to change, can you expand a little bit more on, let's take value investing as an example, why value investing is actually a short convexity strategy?

Chris: [00:10:12] A valid classic strategy but value investing extracts a equity risk premium, and during large scale declines in markets, value investing is not immune to the crisis that can envelop a market endogenous crisis, and we've seen that in periods 1998, in 1928, in 2008. Now, the irony is that, I would say in many ways, value investing needs these crises because it results in all of this behavioral inefficiency that allows for the value risk premium to be extracted. So oftentimes, value investing does the best after the period of crisis, but we're talking about trying to find investment strategies that actually will do well in a crisis, or during change, but don't cost you that much during other periods of stability. If you take that, you combine that with value investing, you have a very, very powerful combination.

Patrick: [00:11:06] Do you think that the, because so many people will be familiar with the idea that Nassim Taleb's Antifragile is the best popular analog for this idea of being long convexity that, what's his line? The opposite of fragility isn't something that's strong, it's something that actually gets better when there's violence, or change. So, cash might protect you, but you're not going to earn a big positive return by sitting in cash, whereas what you're trying to build is something that earns a significantly large non-linear payoff when things change considerably. Is it fair to say that the 2008 into 2009 period was the kind of period during which you would expect this strategy to do its best?

Chris: [00:11:55] I think that's definitely a period of large scale systemic crisis, is a period that can be very positive for these strategies, but I think that tends to take most of the focus away from other environments that can also be very good. I would argue that the best type of macro investors have elements of convexity built into their process. I once had the opportunity to talk to a legendary macro investor, and of course, I asked him a ton of questions, and he told me that the biggest fallacy about him is that he was right most of the time.

Patrick: [00:12:31] Who was this?

Chris: [00:12:32] He's very private, so I can't really say who it was.

Patrick: [00:12:35] I have to ask.

Chris: [00:12:36] Yeah, he was actually in the original Market Wizards, and he said, the biggest fallacy about him is that he's right most of the time. He says, he is wrong 8 out of 10, 9 out of 10 times. It's just that the one or two times that he's right, it pays for all the other times that he's wrong, and more. So in that concept, he might not be looking for the world to end. The world doesn't have to end for him to make money. He's looking at different ideas, creative concepts about how reality might move, and then he's finding inexpensive ways to structure positions that are possibly exposed to that change. The best global macro investors have always executed that philosophy. The idea there might be a change in a currency peg, or it might be the change in a political regime, but finding a way to express that in an inefficiency, and the way it's priced, and they're positively exposed to that change.

I think, oftentimes, Taleb has done a great service to the concept of the ideas of anti-fragility, and fragility, and black swan, but I think people have many times focused on the core concept of disaster, and it doesn't necessarily need to be a disaster. Change is occurring all around us. It's finding ways to be robust, and profit from that change, whether that's occurring in markets, or in a personal life.

Patrick: [00:13:56] Speaking of Taleb and the idea of black swan. I love your definition, or one definition of a black swan in your paper, which is, "A black swan is when fear turns to horror." Which I think is a neat little heuristic or trick. Is there a positive version of that same idea when something turns to something to define, say a positive black swan?

Chris: [00:14:17] I think a positive black swan is any surprise non-linear benefit. I think, we've seen it where a guy starts a company in his bedroom, and is excited about the potential, and has no idea about how non-linear that growth curve becomes. That's a great commercial example of that. If you look at a Facebook, or even before that, a Dell or an Apple. Another great non-linear example of that in a personal dynamic is just, you might meet thousands of people and one person defines your life. That's non-linearity. Someone might say, that's not a black swan, but everyone might have their own black swan person, who's a game-changer of all the thousands of people you meet. It might be a mentor, it might be a spouse.

So, these things, they don't have to be negative. I think, it's anytime you expect a linear benefit, and you end up getting a non-linear benefit. And that non-linearity in markets is defined simply by profit and by money, but I think, in a personal life, you can define that through a variety of different emotional, or other metrics.

Patrick: [00:15:24] Seems like a mindset that pairs nicely with this is the tinkerer's mindset, sort of trying a lot of different things without really any one goal in mind, not knowing what to expect, and therefore, just trying a lot of different avenues. I'm curious what you think of kind of the current state of the world through this lens of convexity and exposure to different changes? You used a piece of art on the front of your paper. Maybe you can describe it, but the idea is that tremendous peace and stability can exist right on the edge of fragility and volatility. Maybe describe how that idea applies to where we are today in markets with valuations, with the actions of central banks, and so on.

Chris: [00:16:11] There is a control model now where I almost call it a mommy daddy market, where beginning in 2012, central banks began responding to market conditions rather than economic conditions, and that really started with Draghi's, "Whatever it takes" speech, and it's extended all the way to QE3, and then, what we've been seeing in Japan with the ECB, where they will not allow any momentary drawdown in markets before either coming to the rescue with stimulus, or with talking up markets. But this actually creates risk. It doesn't destroy risks. You can't destroy risk. What they've done is they've taken returns from the future, and they've brought them to the present, and they've taken tales from the present, and pushed them into the future.

And, in the paper, The Volatility and the Allegory of the Prisoner's Dilemma, there's this wonderful piece of artwork that Andy Diaz Hope and Laurel Roth did. It's a tapestry actually that actually shows cooperation and competition across time. Two incredible artists out of San Francisco, and it builds up this amalgamation of different human achievements, and conflict in a teetering Tower of Babel reference. It's incredible. The idea of prisoner's dilemma, where you end up in this equilibrium of false peace, and the greatest idea of prisoner's dilemma is actually the arms race. Where you have two sides, they don't trust one another, they build up massive arsenals of weapons that can destroy the world, and this creates a sense of stability, but it's not true stability, because what you've done is you've taken the potential for intermediate risk, or one, or two standard deviation movements, and you've pushed the greater potential for five standard deviation, or 10 standard deviation events.

An example I give in this paper, which is great from a book called Command and Control, which is an amazing and terrifying book - it's one day removed from Halloween. This is the scariest book you'll ever read, and it's all true. A bomber crashed in rural North Carolina, and was carrying two nuclear weapons. If either of them had detonated, it would have been over a hundred times the power of Hiroshima.

Patrick: [00:18:19] What year was was this?

Chris: [00:18:20] This was I think in 1962.

Patrick: [00:18:22] So, heavy cold war.

Chris: [00:18:25] Heavy cold war, yeah. So rural North Carolina, this bomber crashes. The only thing that prevented a massive nuclear disaster in North Carolina was a very simple fail-safe trigger, a very weak fail-safe trigger. But consider that, if that bomb had gone off, it would have spread radioactive debris all over New York city, and Washington D.C. and you could imagine that, if all of a sudden a massive nuclear bomb exploded randomly in North Carolina, that could have well been the start of World War III and the end of the world, by an accident. It's an example that, fortunately, that never happened, and now this book goes through many different accidents but you have a situation where, because of this arms race, we have this false stability, but underneath that is this incredible potential for volatility.

And so, we see this every time people try to suppress smaller volatility. It's true with marriage counsellors. They always say that the people that are most likely to get divorced are the ones that aren't fighting. The ones that aren't fighting at all have the most tension because they've given up on one another. It happens with avalanche prevention on ski slopes. The forest service will blow up different portions of amount, they'll dynamite mountains, to release the avalanche pressure.

Patrick: [00:19:39] It's like a forest fire kind of.

Chris: [00:19:41] And, a forest fire's the same thing. In fact, the Sequoia trees in the great Sequoia Forest, they will not release their seeds until they sense a forest fire. The forest fire clears out the bad trees, and allows healthy trees to then develop, and as a result of that, the forest service, they actually now institute controlled burns. When they tried to do forest fire suppression, it resulted in bigger, and bigger, and bigger fires. Today, what central banks are doing is completely analogous to all of these different factors. They're trying to remove intermediate, and small risks, and at great, great potential of large risks, the largest risk isn't even from markets, it's social. I'm actually worried that democracy will not survive what they're trying to do.

What central banks are doing is completely analogous to all of these different factors. They're trying to remove intermediate, and small risks, at great, great potential of large risks, and the largest risk isn't even from markets, it's social. I'm actually worried that democracy will not survive what they're trying to do.

Patrick: [00:20:26] And, flesh that out more, that's certainly an extreme view. What would happen socially for democracy to be threatened? The concept itself.

Chris: [00:20:37] Well, it's happened. There's a historical precedent for it, and that's why, if you read Devil Take the Hindmost, and you read the work of Niall Ferguson, it's why all these guys, they're not economists, they're historians, and they're sitting there being like, "Whoa, what is going on in the world? What are these central bankers doing?" Why are all the historians criticizing central banks, and the economists are all behind it? Because the historians know, and they've seen this time and time again. You end up having a situation where there is a suppression of volatility, a funneling of money into asset prices, there's a financial crisis, there's massive wealth disparity, and that leads to sometimes a democratic revolution that results in a new regime that causes tremendous issues.

I think, go back and look, I don't think there is a Hitler if there's not a Weimar Republic hyperinflation in the early '20s. In fact, the suspension of constitutional controls that Hitler took advantage of later on were initiated to control the hyperinflation. And then, obviously, there was a tremendous anger by the middle-class in Germany over their declining place in the world, which was misplaced into xenophobia, and racism. Hitler was democratically elected, but he was democratically elected out of this type of horror of an economic disparity.

Patrick: [00:21:58] What's your opinion then on the '20s and The Great Depression? There's another period, I guess, maybe some of these similar issues existed, where there was massive income disparity, wealth disparity, obviously, an enormous market crash, and then, The Great Depression. And there's arguments that there wasn't enough easing, that there shouldn't have been a tightening in that prolonged, or even created what we think of as The Great Depression, but certainly, an existential threat, one with huge social spillover, kind of like what you're talking about, but the U.S. survived, democracy survived. Do you think really that the U.S. could be vulnerable to something like that? Given we have, 1929, and obviously a horrible period, but what do you think of that period as a example of all these ideas we're talking about?

Chris: [00:22:46] There're some people that use the '30s as a... One of the greatest books about this is Lords of Finance, it's about the history of central banking through that period. I think, a lot of people use the late '30s as an example of why we need more stimulus today, and I definitely think there could be more fiscal stimulus today. That's maybe the difference between that period and now, but beyond that, I think, what got us out of The Great Depression is that we won a world war. This seems to be the thing that none of the economists seem to take note of. It really, really helps your economy when, (a) you have an existential threat overseas, and you respond to that through massive production potential, in a massive war, incredible global war, and (b) after that global war, you're the only industrial superpower left standing.

That is a growth model, the effect of World War II on resolving the issues of The Great Depression. I think, there's a disconnect between people who just pretend that World War II didn't happen, and it was all monetary and fiscal policy, and I find that puzzling. I'm not saying that it's crazy to advocate a world war to get us out of the predicament that the global economy is in right now, but I don't think people are being sort of radically honest when they don't admit how much World War II helped us resolve many of the issues stemming from The Great Depression.

Patrick: [00:24:10] You mentioned earlier that you believe that some of what's happened is we've pulled returns from the future into the present, meaning that valuations have gotten higher, interest rates are extremely low, and when you look at most, or certainly, a lot of the places that I think do a nice job of forecasting big asset class future returns, the almost universal answer is that they're going to be a lot lower than historical numbers. So, mid, low single digits on equities, maybe zero real returns on bonds. People seem to be aware that this is happening. Is your point that, that's just not enough, that we should be expecting even much worse than that? And, that valuations and low interest rates are kind of the best current signs of that problem, of that idea of pulling returns forward?

Chris: [00:25:01] I think it's a great sign of that. And now, what happens when you end up having pension systems go belly up the next 10, 20 years? Because, some of these systems have actuarial expected returns of 8%. That's their baseline expectation, so either, (a) there has to be a massive mean reversion in what people can earn, or (b) there has to be cuts in these programs, and then, how do people respond to those cuts who are already politically angry? It presents definitely a unique challenge there, and I think that's the biggest risk. The biggest risk is not a 20% or a 30% decline in markets, the bigger risk is how socially we respond to that. And then, it also means, if you look at someone like China, you have this massive urbanization, and in the event of a global recession, do they have social unrest if they're not able to sustain such a pronounced growth rate?

Sizing Convexity Strategies

Patrick: [00:25:55] There have been a number of very famous mutual fund, hedge fund managers who have positioned their portfolios, some during the crisis and did very well, but have continued to do so since, whose returns have been very bad, so we'll call this group kind of doomsdayers, people who expect very bad things. And so much of investing is timing that, even if those people or their investors are ultimately proven right, and it could be on any timescale, being early is indistinguishable from being wrong. So how do you think about, and of course we have to be, a little bit humble here. We could all be wrong on this kind of negative view of what could happen in the future.

I want to get into how you actually build a portfolio to express this view. So how do you think about that sizing of the position? If you want to be exposed positively, if you want to do well in your portfolio when there's big change, and have a non-linear payoff, how do you get that exposure? How do you size it in your overall portfolio? And, is there a timing component? Can we size up and down that exposure given kind of current conditions in the market?

Chris: [00:27:09] There are a couple of different ideas on how to, and Artemis specializes in trying to find ways to own convexity inexpensively, and carry that, in some instances, even be positive carry. One way that we approach this problem; is you might sell the first movement in markets for carry, and buy the second movement, so you're selling linearity for carry, and you're buying the non-linearity. That makes you negatively exposed to maybe a 5% decline in markets, and very positively and non-linearly exposed to a -10, -20, -30% decline. That philosophy allows you to carry what is essentially insurance at a much, much less expensive cost, and there are a variety of ways to do that with options. That is one concept.

I think, a lot of people drive their energy into, when they think convexity, they think tail risk, and the problem with a lot of tail risk funds is that if you're losing 10% a year, the average tail risk fund is down 40-50% since 2012. And if you're down 50%, you have to make a hundred percent just to be back at even. It's one thing to have convexity, but if it's incredibly costly, then you end up in this hole that you can't come back out of. One idea is to take a small amount of that convexity exposure, and to pair it with beta, or to pair it with value investing, and other forms of traditional carry. Since the carry is actually, or the other traditional investments tend to be linear in nature, you can actually lever those up slightly to pay for the cost of the tail risk. We've seen some people do this, or use this approach.

The approach that Artemis uses, and some of our peers use is, we consider ourselves long volatility, not tail risk. We're trying to create an alpha product, and long volatility, we'll sell volatility where it's expensive, and recycle it into convexity to minimize the cost of carry. You may time your exposure to convexity, ramping it up or down based on developments of markets, which also helps. The difference between tail risk and long volatility is that tail risk is a true insurance policy, whereas long volatility is an active management strategy. Tail risk protects against endogenous and exogenous risk, meaning risk that comes from markets like 2008, and risk that comes externally from markets, like a natural disaster, whereas long volatility tends to focus mostly on endogenous risk, and may or may not fully capture exogenous shocks.

When people come to this idea of carry, I like to say that the long vol hedge fund index, which the CBOE put out, Artemis is a member of that. If you combine that with the S&P 500, since 2005, that's beaten the average hedge fund by 90%, so that combination of volatility exposure, and classic investing techniques can yield tremendous benefits, because if you can carry something in a way that isn't bleeding out 50% over four or five years, it might be bleeding out -2% a year, but then makes you 40% in a year like 2008. That's a very, very powerful combination with traditional strategies.

Patrick: [00:30:21] I've always felt that macro investing is so hard because you need to get two things very right. You need to guess, or accurately forecast with some consistency what's going to happen, but more importantly, you need to position your portfolio in a way that will actually benefit if your forecast comes true, and those are two very hard things to do. Arguably, impossible things to do, or certainly, impossible to identify someone that can do them for you. From an investor's perspective, someone out there listening, let's say, they buy every line of this argument that you want some exposure to long volatility, and that paired with traditional beta exposure you get this really neat combination. How could someone even do this? Obviously, you do this with real money, but from what I understand, the average Joe couldn't access that strategy. Is there a way of doing this, or getting this exposure that's pretty simple, that doesn't require tremendous skill and experience?

Chris: [00:31:18] This is terrible, there's actually a lack of retail products out there. It's very hard for the average guy with $20,000 to invest, to actually execute this. It's one thing if you're a pension system, or a very wealthy family office. Some ideas on this is that, to find combinations of strategies, or managers, or active strategies that are systematically and positively exposed to change, one, there aren't that many long volatility managers out there. The CBOE long volatility hedge fund index has, I think, about nine or 10 managers, Artemis is one of them, but other asset classes that are long volatility, systematic CTAs, have a long volatility component to them. That's an asset class that is available from a retail perspective, and they offer some anti-correlation and convexity.

I think contrarian global macro is another asset class where you might be able to find good managers. There are systematized strategies that can be executed that show that type of anti-correlation. I think the institutions that try to implement, they might actually have a defensive component to their portfolio, which will include long vol tail risk, systematic CTAs, and contrarian global macro that are all considered long convex anti-correlated managers, and will take a combination approach. We always talk about the left side of the return distribution. Everyone's worried about classic losses, 2008. We're forgetting about the right side. It's not trendy to talk about hyperinflation nowadays but I think one of the scenarios that really is quite scary is a destabilization of both stocks and bonds. There's a question, will the global financial system be able to tolerate a 100 or 200 basis point increase in rates over a period of a year without a complete meltdown in both the stock and fixed income complexes, which would be disastrous to the system.

And then, what would governments do to respond to that? I'm a gold bug. I'm a believer in gold. I own gold. I don't own fiat gold. I don't think owning GLD, I think it defeats the purpose of owning gold. I think, you need to own physical gold, and that is a right tail convex asset class, so that combination of these assets, I think, is quite defensive.

Patrick: [00:33:42] What would it take to convince you that you're wrong? There aren't a lot of soft landings in these sorts of things, but is there a combination of, let's say central bank activity, valuations, interest rates, pick your variable, where you would say, okay, the world hasn't ended, maybe this is what called Ray Dalio would call beautiful de-leveraging or something like that. What has to happen for you to say, okay, I don't have the concerns, huge concerns, social, democracy, some of the things we've talked about for you to say I'm wrong, and I need to change my stance.

Chris: [00:34:19] It's a great question, because I ask myself, and my staff that question all the time. What if we're just wrong? It is an existential question if you're a long volatility manager. It's a truly existential question. Is it possible that they can engineer forever an environment where we'll never have another 20% drawdown in markets, where markets can be continuously propped up by central banking? Now, it's interesting because to get the same benefit on bonds as we got in 2008 to now, you go back to early 2008, the German Bund was around 4.5%, the U.S. Treasury was around 4.2%. Today, the Bund has gone all the way negative to flat, U.S. treasuries are around like 1.7%. To get the same convex benefit from fixed income, rates have to go all the way to -3 to -5%. It's crazy, but it's possible.

Can capitalism function? Or are we going to a regime where there's just helicopter money, ultra-low zero rates forever, and that they can gradually release steam, gradually release bit-by-bit any volatility pressure, and centrally plan the global economy, and have this 10 or 15 year soft landing. And then, inflate our way out of our pension problems, and inflate our way out of our debt problems, our global debt problems. An empirical study of history would say that it's never happened before, that they might have names for what they're doing now, like quantitative easing, but that is no different than what John Law did, what the Romans did with coinage. Can it end in a way that is engineered? Sure, it's possible to be wrong, but I think the hurdle for that, the burden of history, the burden of math, would argue heavily in the other direction.

I'm not like Ben Bernanke though. When Ben Bernanke says he's a hundred percent certain that he's correct, that scares me. That really scares me, because I'm never a hundred percent certain that I'm correct, and the smartest people I know are never a hundred percent certain on anything. I am very reasonably certain this will end in some element of vol, whether it's market vol, whether it's social vol, or whether it's war. How that vol is expressed, I'm not entirely certain, but I'll give a less than 1% probability that I'm wrong, and that they'll engineer it.

I am very reasonably certain this will end in some element of vol, whether it's market vol, whether it's social vol, or whether it's war. How that vol is expressed, I'm not entirely certain, but I'll give a less than 1% probability that I'm wrong, and that they'll engineer it.

Patrick: [00:36:34] We talked earlier about black swan being fear versus horror. Some of the things you've just described strike me as normal, to be expected episodes of fear in markets like, in my career, the next three to four decades there's going to be probably multiple 50% plus drawdowns in stocks. There always have been, and that's part of the equation. What I am curious about is the potential for the horror, the 90% drawdown in stocks, or across asset classes. I'm curious if you've thought about the counterbalance of technology, and kind of the exponential growth of technology, and how it's improved our lives, many in non-linear ways, and whether or not that can act as sort of a counterbalance to some of the big problems that could result from the pension systems falling apart.

I'm thinking, basic things like how we produce food, how we get around, how it's getting cheaper and cheaper to do a lot of the basic things in life. And whether or not we can rely on, to some extent, the kind of human ingenuity and technological growth, sort of, productivity growth, if you think about it in GDP terms as a way to grow out of this in a more soft way. Where it's not an engineered growing out of this, but we just grow, and we get better, and we raise interest rates in a normal fashion, and there's the normal 20 bear markets, and that's going to happen. It's not a reason to sell everything, and buy gold. Could that happen? Is technology maybe a reason why you could be wrong?

Chris: [00:38:23] It's a great question. I was actually at a conference. I spoke at a conference in Europe and an individual pulled me aside. He had read the paper Volatility and the Allegory Of the Prisoner's Dilemma, and he said, "Look, I really agree with a lot of what you've mentioned in this paper. However, I disagree with your, I'm from Norway, work for a Norwegian pension system. We're heavy into oil. I disagree with your assertion that the global decline in commodity prices is..." As I put it, there's a decline in real supply and demand, and there's a disconnect between the real, and the surreal economy. I was saying that I would expect that given the decline in commodity prices, whenever we've seen that historically, we've seen a global decline follow. He says, "Well, I think the game might be changing, because technology, and the way that technology has impacted commodity prices, and particularly, shale is a perfect example."

In that sense, though, what we really need to explore is the interplay between the workforce, how that workforce is impacted by new technology, and then, how classic econometric thinking is being impacted by the new technology as well. If you have a situation where tremendous technological advancements, which is actually resulting in deflation, increased productivity growth, if you buy into that argument, all of a sudden you have a huge portion of the population that is systematically underemployed. Now, the question is, how do we deal with that unemployment or underemployment. Are they systematically, no amount of money printing, or no amount of stimulus is going to impact the fact that they don't have the job skills for the modern economy. You have, in some instances, a game changer in this technology, and it's just amplifying.

A substantial number of people make a living driving, and all of a sudden all those people are going to be out of jobs when there's self-driving cars, so you have these policy makers that are responding using old tools to a changing game, and I think it's possible for a bright future to exist through technology change, but not if policy makers are looking to in essence use medicine on yesterday's problems. You can have a situation where you're spending a tremendous amount of money in stimulus, and the tech companies are just buying back their own shares. In the past, you would have a situation where a company would take the ultra low interest rates, invest in a plant, hire a bunch of workers, and then great, it works.

Now, it's a tech company that already has the needed engineers. They issue ultra low rates, or they issue debt, and they buy back their shares. And now, we have a dynamic where share buybacks have eclipsed the operating earnings of the S&P 500. In some instances you have this incredible technological change but you have economic policies that are being applied to cure yesterday's technological regime, and it's causing more dislocations.

In some instances you have this incredible technological change but you have economic policies that are being applied to cure yesterday's technological regime, and it's causing more dislocations.

Patrick: [00:41:14] Obviously, we're veering outside of certainly my circle of competence, thinking about kind of the future of jobs, and whether or not we have something like a universal basic income, or some way of dealing with this loss of jobs due to automation. But it seems like the ideas of supply and demand, and scarcity are hugely important to capitalism - key variables - and that many of the kind of things that we need, which historically, have been scarce, to live, and be happy are, cheaper and cheaper, and easier and easier to access. And that a lot of the things that, I think, you are, I'm sure not hoping for, but worried about might be significantly improved to the extent that you're 1% that you're wrong, which is basically like saying you're certain, is a lot greater than 1%. I certainly hope so.

And so, the idea of being long convexity, long vol is very appealing from a personal standpoint, but it seems like there are a lot of unknowns that could cause that position to be wrong, the long volatility position to be wrong in the future. I'm curious how you believe, and maybe how your investors actually do, size exposure to Artemis, and to this long volatility strategy in the context of a portfolio. Is it 5%? Is it 10%? Is it 20%? Obviously, there's no perfect number. You can only do your best, but how should we think about this? If there's a much greater than 1% chance that you're wrong, what sizing is appropriate? If people want to gain an exposure like through a CTA, or some of the other vehicles that you mentioned earlier?

Chris: [00:43:01] I think one needs to look at the different payouts. What is one hoping to get, and what type of change do you want to be positively exposed to? And, what's the expected payout of that? And then, that informs the sizing decision. For some of our larger clients, they actually can cross-collateralize our exposure, so that's how it's worked, but even in that scenario, it comes down to an idea of, what is your idea of change? Is that a 10% decline in markets? Is it a 20%, or a 50% decline? What are you trying to protect against? Or, is it a 50% increase with tremendous volatility? And then, that informs that decision. It's interesting that the power of non-linearity is by combining the right assets. I use this example of Dennis Rodman, it's a great example.

Patrick: [00:43:46] This was going to be my next question, so perfect.

Chris: [00:43:48] Yeah, it feeds into that. I wrote this paper about Dennis Rodman and portfolio optimization. I think, Yahoo! picked it up, and wrote an article about it, and somehow a lot of the people thought I was recommending that people invest like Dennis Rodman. I was not saying that people should invest like Dennis Rodman, but the concept at the end of the day was that Dennis Rodman was a guy, he's part of the hall of fame, basketball hall of fame, lowest scoring inductee in the basketball hall of fame, and sometimes, people say, "Why is he part of this hall of fame? The guy could barely score outside of five feet." Modern advanced statistics has taken another look at Rodman, and by a lot of metrics, Rodman is actually one of the 20 greatest players ever to play the game of basketball.

Now, if people don't know basketball, Dennis Rodman could not score, but Dennis Rodman was a prolific re-bounder. When other people miss shots, he would go get the rebound, and he was better at this than anyone in history. Rodman secured about 30% of the defensive rebounds, 17% of the offensive rebounds. He was six standard deviations away from the mean in terms of rebounding, and that was a degree of statistical difference that no other player in any other stat had ever achieved. Rodman was much better at rebounding compared to the average player than Michael Jordan was at scoring. Ironically, teams didn't need to guard Dennis Rodman. He couldn't score. He had no jump shot, he was a terrible free throw shooter. He was not an offensive threat. In many ways, on offense, teams were playing four against five.

He was six standard deviations away from the mean in terms of rebounding, and that was a degree of statistical difference that no other player in any other stat had ever achieved. Rodman was much better at rebounding compared to the average player than Michael Jordan was at scoring.

However, something bizarre happened when Rodman was on the floor. By simply putting Rodman, even with a group of mediocre offensive players, it greatly amplified the offensive potential of the team. So Rodman had one of the greatest winds of replacement value and improvements in offensive efficiency when he played. He was a member of multiple championship teams, including two of the greatest teams ever to play the game. He won five championships, and when he went to a good team, he turned that good team great, and he went to even a bad or a mediocre team, he turned that bad or mediocre team good, because he was so good at rebounding, it created so many second chance opportunities that adding him created non-linearities. And this is kind of the idea behind an anti-correlated or convex exposure, be it long volatility, systematic CTAs, or contrarian global macro. It's almost like Dennis Rodman for the portfolio.

You take these anti-correlated asset classes that are long convexity, they rebound the misses for your value stocks, for your fixed income when things are not doing so well, and allow you to have non-linearities through the interplay of correlations in a powerful way. How you size that, it largely depends on that mix of asset classes, but the point is recognizing how powerful that is, and how those asset classes actually outperformed in 2008. When diversification failed, these asset classes, because they're positively exposed to change, did really, really well, and would have been the difference between protecting a portfolio from disaster, and having a good outcome.

Patrick: [00:47:05] Yeah, really interesting analogy, and Nate Silver and his ilk have done some really neat stuff with statistics to look back, and kind of change our opinions of different athletes through time, and I love your paper on Rodman. He's certainly one of the most interesting athletes ever, and that he was so bad at what we most glorify, and yet might be a top 20 player of all time.

Chris: [00:47:30] And, it's like the long vol hedge fund index, and even the tail risk hedge fund index, if you just take 50/50, and just a naive 50/50, and put that with equity beta, we're not talking about any additional value you get from value stocks, or momentum stocks, or other alpha, just take it, and put it with beta, either of those dramatically outperform the average hedge fund since 2005.

Patrick: [00:47:56] How much of that though is just 2008, 2009?

Chris: [00:47:59] Certainly, there's been an under-performance over the last four years, but I would go back, and I would say I spent a lot of time studying financial crises in history. Consider the period of the late '90s, wonderful time for long volatility. Most people don't realize this, but vol averaged over 20 in the period between 1997 and 1999. The market was up 20, 30% every single year, but we had tremendous volatility. There were two 20% draw downs over that time period, and the VIX went up to 38 in '97, and retested 40 multiple times in 1998, and in both those years, the market ended up over 20%. People tend to associate these periods of calamity with just 2008, but you can actually have high volatility and high change coupled with high asset prices, and the late '90s are an example of that. It's similar to also the period of '87, which is not really on most people's radar screens. It's sometimes hard to find options data going back that far but it's another example of a tremendous period of high volatility that was actually contained within a year that, I mean the market dropped 20% in one day, and then, rebounded very, very quickly.

The Interplay of Art and Investing

Patrick: [00:49:09] Can you tell me a bit about your interest in art. Throughout everything you write, you've got these kinds of amazing pieces of artwork that seem to illustrate one of the points that you're trying to make. How did you get so interested in art?

Chris: [00:49:22] In a past life, I actually spent a lot of time focusing on cinematography and film. I actually studied cinematography in college way, way, way before ever touching Wall Street, so truly a past life. I've always been interested in the visual arts but I feel like a lot of times I hate this idea that people segment left brain, right brain, because I think truly some of the investors I admire the most are actually truly creative. Particularly, if you look at the global macro space, someone has to envision a reality that is different than the reality we have today, and understand how to structure instruments to profit from that potential reality shift, and assign probabilities on that. Now, intellectually, I actually don't see that as being that much different than some highly technical artists.

If you look at great filmmakers, they're envisioning a reality that's different, and they're finding ways to make that tangible, and using technology to do it. It's not all that different of a skillset than most people would imagine. Or even you look at Andy Diaz Hope and Laurel Roth, who did the brilliant tapestry, The Allegory of the Prisoner's Dilemma, that we had permission to use for my paper. Andy used to be an engineer at Apple. I think everyone can benefit by working out that side of the brain, and having it cross play between the combination of technical and logical and creative, is a very, very powerful combination.

Patrick: [00:50:54] What movie, given your interest in cinematography best exemplifies kind of this long volatility exposure to change idea that we've been talking about?

Chris: [00:51:04] It's interesting, because at the end of my paper there were two great movies that I love. I think The Road Warrior really is a long volatility film in my-

Patrick: [00:51:14] Awesome movie.

Chris: [00:51:15] ... mind, because you have...

Patrick: [00:51:18] Mad Max.

Chris: [00:51:20] Mad Max is a man who, really, he's lost everything. He really has very little more to lose, very little linear losses, but by putting himself out there in a moment of self-sacrifice, he in essence achieves great non-linear spiritual growth.

Patrick: [00:51:44] I just saw the recent one, which I loved, with Tom Hardy but remind me of kind of the general plot for the original Road Warrior, and kind of how, it was Mel Gibson, right? How Mel Gibson's character exemplifies these things.

Chris: [00:51:57] Yeah, that follows a classic Western. The Road Warrior is a classic Western, where you have a vestige of society with a sheriff who represents society and order. You have savages that will challenge that order, and it takes a man who is part savage, part order to actually successfully navigate, and be the hero. Mad Max is torn. After the apocalypse he's lost his wife, he's lost his child. He is a soulless drifter who has really nothing left to lose, who wanders out in the wasteland, and he's completely selfish. He's only focused on his own survival, but at some point in the movie, he decides to do something selfless. He decides to put himself at risk in a selfless form, and actually protect this civilization, and as a result, he gains back his humanity that he's lost, and, of course, it's an incredible kinetic action film at the same time with classic, Joseph Campbell mythology.

The other one that's really... it actually just came out, Sorcerer, which for a long time they had old reels of it. It was recently re-released. It's a work by Friedkin, a brilliant short volatility story about a bunch of individual outcasts - one was a ex-con who was on the run from the mob, another one was a Lebanese terrorist, another one was a French banker who had conned a bunch of people - and they'd all fled to South America, and they're given a large sum of money to drive a truck full of dynamite and nitroglycerin to blow up a oil fire in the middle of the jungle. So they're driving these gigantic, but rickety trucks with very explosive nitroglycerin through a horrific jungle environment where any misstep could cause the truck to blow up, but they're all doing it for money, and they're all men who are desperate because they got into their predicament by shorting volatility in their lives.

Organized crime is a form of short volatility, short convexity. They find themselves in South America, and now they're just making a bigger short convexity bet in order to try to get out of their predicament, and they never learn, and so that's a classic film that, go check it out. It was recently re-released, and it's a brilliant one as well.

Patrick: [00:54:22] Fantastic. What is the single most memorable day in your career in investing?

Chris: [00:54:29] It's interesting. I'd have to say the day day Lehman went. It's such an easy choice, but that day is particularly interesting, and it's interesting for reasons that I think most people wouldn't think. Most people would say, okay, Artemis exists because of the money that I made over 2008. I've audited very large gains over that period. Although, that pre-existed the Artemis Fund, and I think most people would say, "Oh wow. That's because you made a ton of money that day, because you were a long volatility." I did make good returns that day. I think the real reason is because I put on more risk. Because as it started to develop, that was the beginning of where there was opportunity, so that's the difference in the thinking. It wasn't that I took the gain on that day, it's that I saw, wow, the opportunities are beginning to expand like I've never seen before, now it's time to put on more risk, so it was the beginning of a journey, not the end of one, as most people would imagine.

The other day that was most painful to me was actually the flash crash. Most people would think that would be a wonderful day. It was for about 10 minutes. When you have a hedge position, I learned my big lesson that day, because the market dropped 10% and came right back, and I learned not to change your hedges that day. That was a difficult lesson for me that day, because we were very well positioned for that, made money into the spike, and then, as vol collapsed back down, we had begun to actually adjust some positions, and were caught off guard by the extremity of the moves. What should have been a fantastic day ended up being not as fantastic as a result of an attempt to sort of rebalance into that.

Recommended Habits and Books

Patrick: [00:56:15] What is the kindest thing that anyone's done for you across your career?

Chris: [00:56:21] The kindest? That's interesting. There's a professional or personal context on that one.

Patrick: [00:56:26] You can go either way, open-ended question.

Chris: [00:56:30] I was in a personal relationship, and I really wanted to grow my business, and she wanted something different, and she could have taken a lot more money than she did, but she didn't out of love, and that allowed the business to keep going.

Patrick: [00:56:49] That's something.

Chris: [00:56:50] That is something. That's probably the kindest thing that someone's done.

Patrick: [00:56:54] Pretty amazing. My last and one of my favorite questions is, comes full circle back to what we talked about at the beginning, which is that, outside of investing in a personal sense, the best ways to gain exposure to long volatility, to positively benefit from change is to expose yourself, to make lots of little small investments. I'm curious, what things you feel are most important to do on a daily basis, your kind of daily ritual, daily habits, things that you feel can lead to these kind of non-linear payoffs in your life.

Chris: [00:57:31] Just personally or?

Patrick: [00:57:32] Just daily habits. It could be getting a good night sleep, could be one example.

Chris: [00:57:36] I meditate daily. That's been powerful. I exercise daily, that's powerful. And I try to read something challenging, to be challenged by something I haven't, and it needs to be something outside of the sphere of influence. It's one thing to read market-based things, but if you're just solely in that world, you're not making neural connections, so try to read something, and learn something outside of your direct daily needs.

Patrick: [00:58:07] So, a little deeper on those three because I think there're three powerful things. How do you meditate? What's your preferred exercise methods, one or more, and then, we'll get into a few of your favorite recent books that are outside the investing world. Maybe, we'll start with meditation. What's your method? How do you do it? How long do you do it?

Chris: [00:58:29] I try to meditate about 20 minutes a day. Sometimes that's 10 to 20 minutes, depending on how it works.

Patrick: [00:58:36] It's hard to do it every day.

Chris: [00:58:39] Exercising, I'll try to do a combination of weights, and running, and then some yoga. Last book I read that I really enjoyed was Genius of Birds.

Patrick: [00:58:51] Pretty interesting. What's that one about?

Chris: [00:58:53] It's about the intelligence of birds.

Patrick: [00:58:55] Okay, self explanatory here.

Chris: [00:58:57] Yeah, I was in New Zealand, and I was just transfixed by these, they call them Keas. In New Zealand, birds have developed a niche where most mammals do in other parts of the world, and these Keas are the only alpine parrot, and they have the intelligence of a four to five year old kid. They're known for completely destroying cars. They love to rip the plastic out of cars. They're highly intelligent. They can solve problems, and they're predatorial. I just would watch these birds. I was amazed by them, and then, a friend of mine was reading this book, and she recommended it, and it not only talks about Keas, but it talks about a lot of different, in many instances, forms of intellect that we don't fully understand that they have in senses.

Another book I really enjoyed was, it's called Creativity, it was about Pixar, the history of Pixar. Wonderful book

Patrick: [00:59:55] Ed Catmull, right?

Chris: [00:59:56] Yeah.

Patrick: [00:59:56] Really great.

Chris: [00:59:57] Yeah. Really interesting. It's interesting in that book, he talks a lot about how they encourage lots of little failures. That's an example of convexity in the process. A lot of that book is about encouraging people to take small risks, and fail, and then, learn from those small risks.

In that book, he talks a lot about how they encourage lots of little failures. That's an example of convexity in the process. A lot of that book is about encouraging people to take small risks, and fail, and then, learn from those small risks.

Patrick: [01:00:14] I'm curious, have you ever come across a book called Impro, Improvisation and the Theater?

Chris: [01:00:18] No.

Patrick: [01:00:19] Okay, so...

Chris: [01:00:20] It sounds great though.

Patrick: [01:00:21] It's kind of this cold classic book that, I guess, it's about improvisation. I'm not a theater fan, so when someone recommended this to me, and it was recommended at the same time by my sister, who's a standup comedian, and an engineer, actually, he's been on the show. He used to work at Palantir as a computer science guy, and so, I figured, "Well, that's two pretty interesting sources of recommendation. I better check this out." And, it is all about creativity as well, breaking down like traditional constructs to try to, back your point about why art is useful, trying to kind of teach yourself, or train yourself to think more creatively. Like, I've not recommended that to anyone and not have them come back, and say, "Wow, that was...

Chris: [01:01:08] Impro?

Patrick: [01:01:08] Impro.

Chris: [01:01:09] Impro.

Patrick: [01:01:10] Yeah, I'll put it in the show notes.

Chris: [01:01:11] Do they specialize on, because I've always been amazed at what they do in like Second City in Chicago, and some of the improv, is it sort of that type of-

Patrick: [01:01:19] It is.

Chris: [01:01:19] ... performance-based improv or is it?

Patrick: [01:01:21] It is kind of everything, and this guy, Keith Johnstone, is the author, is I think kind of a hero in probably anyone that went to Second City. My sister was actually at Second City, that's how she heard about this. I don't know that world well, but I'm sure that many people would say this is sort of like a Bible of sorts, and it really is amazing how body language, how guarded we tend to be, how much of what we do is, in interacting with other people, is about displays of social status, and how to kind of engineer that, or reverse it, or tear those barriers down...

Chris: [01:02:01] Interesting.

Patrick: [01:02:02] ... and like stupid little things like military officers are trained to not move their heads when they give commands, because it conveys an authority, and you can see how hard that is if you try it. Try talking for a while without moving your head, it's extremely difficult and awkward, but it does something. It's like a tool that you can use, and so, there's tons of stuff like that in this book, so definitely check that one out.

Chris: [01:02:27] Wow. I definitely will.

Patrick: [01:02:28] Well, this has been an absolute blast. Thank you for doing this. I've certainly learned a ton, and let's keep in touch.

Chris: [01:02:36] Yeah, it was a pleasure to be here.

Created by @domcooke