In this episode, we sit down again with one of the OGs of VIX futures trading & options, Brett Nelson, CEO of Certeza Asset Management, and discuss their new mutual fund — Convex Core and how it relates to their Macro Vega hedge fund strategy. Join us to hear how the mutual fund aims to participate when the market is up, exploit opportunities when things get bumpy, and then protect heavily when the market is down. Brett explains why Convex Core isn’t just an overlay strategy and how utilizing changes in Vega & Gamma can help protect you in a rough market. We talk about the Geometric Loss Problem, Certeza’s three regimes of Volatility, their equity component, dialing through options, looking for the mathematical structure in the market, the rebalancing premium, and the importance of educating Advisors/Investors on volatility as an asset class. Finally, we ask Brett’s opinions on some well-known relative value or Volatility arbitrage trades, asking when they work and when they don’t. And rounding things out is a discussion on the two new VIX ETF products coming out, and Brett’s thoughts on Delta Hedging Market Makers, just how critical “flow” is, and what the next disruption event could look like.

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Convex (CNVEX) to the Core with Certeza’s Brett Nelson

 

Jeff Malec  2:27
Happy Thursday everyone actually we’re recording on a Friday but so be it. You’ll probably listen to this on a Thursday. But we’re happy to have back on the show today Brett Nelson, the founder and CEO of Certeza asset management and now Certeza fund advisors which we’ll get to in a second but Brad is one of the oh geez VIX futures trading and options starting personally as far back as oh four and professionally back to 2012. I’ve been on here at our CME we’ve had investors in those programs for the better part of five to seven years before VA was cool. So welcome, Brett. Brett. How’s it feel to be in the cool kid space these days?

Brett Nelson  2:53
Really cool kids face Yeah, it’s been a it’s been really fun. It’s really nice and super excited to be here today, Jeff.

Jeff Malec  3:00
Right when you first started, VIX like nobody really cared, right?

Brett Nelson  3:05
Yeah, no one really knew. No one really knew the VIX was even tradable when I started trading it so

Jeff Malec  3:09
right. And technically it is right technically, it’s not a real thing.

Brett Nelson  3:14
That’s kind of vapor we always say VIX is vapor right? But

Jeff Malec  3:19
I like it. And we did a pod before which we’ll put in the show notes talking through your background. As one commenter put out online spending way too much time talking about Utah skiing. So we’ll skip over that. Except Just tell me what’s it looking like? For this winter? It’s going to be a good ski winter.

Brett Nelson  3:37
Oh, man. I hope so. We could use it. Yeah.

Jeff Malec  3:40
Are they any snow? Yeah.

Brett Nelson  3:41
Now what we just got cold as of yesterday, so we’ll say hi.

Jeff Malec  3:45
And your reminders where you are? You’re north of Salt Lake,

Brett Nelson  3:49
north of Salt Lake, about 90 miles north.

Jeff Malec  3:52
And was it Ogden? Logan actually so lonely and Amanda, you got it. Logan, Utah. Hedge Fund capital.

Brett Nelson  3:59
Yeah, mountain town hedge fund capital.

Jeff Malec  4:03
Um, so yeah, it’s worth noting that our last time we did actually in person right in a studio there in Salt Lake. Which must have been like a week before. COVID got really bad, right?

Brett Nelson  4:18
It was just barely. It was not well, it was a week before the market effectively crashed but market was already dropping seriously, because COVID was becoming a thing. So we were it was it was right before everything locked down. Yeah, I

Jeff Malec  4:30
remember that was it was a Sunday night, right? And I came into the studio and you were in the corner with your with a laptop on a Sunday night and I’m like, what’s going on?

Brett Nelson  4:38
Yeah, Asian hours were opening on I knew that it was gonna be big because COVID had just become a thing. And the market was just absolutely tanking in Asia.

Jeff Malec  4:47
Yeah, that’s right. When we stupidly didn’t talk anything about that on the pot. So shame on me. But uh, yeah, I’m just surprised that we were like, things seem so normal then we’re like, oh, there’s thing and the other markets going down. But at least me personally, I wasn’t thinking like this is going to affect the US in such a big way. Well, you

Brett Nelson  5:07
weren’t thinking this is going to be the single biggest VIX event in the history of Yes, I’m talking to the VIX guy. Right.

Jeff Malec  5:14
Exactly right. missed opportunity.

What’s new, I know it’s new. I teased it in the intro there. But what’s new is you’ve launched a mutual fund. So tell us a little bit about how that differs from your head friend strat, macro Vega, and what the impetus behind all that was on let you roll with it. Sure.

Brett Nelson  5:43
Yeah, the macro Vega is purely a VIX statistical arbitrage program, it’s meant to be completely non correlated to anything pure alpha driven, you know, the mutual fund is called convex core ticker co n dx, we took a dramatic shift with this structure to bring our expertise into the public equity world, you know, getting it into the hands of advisors, and retail and everything like that. Whereas, you know, the, the hedge fund and managed account space and alternatives is a little bit more exclusive and a little bit more geared toward sophisticated investors. And the mutual fund is not the same strategy, we didn’t simply just convert our big strategy over, we took our learnings from the volatility space, and we actually applied them to the equity markets. So large cap equities. And we created what, what we think is an optimized experience for the investor in terms of how to participate in the markets in the equity market, specifically, while not being so prone to the downside. So we’ve got significant downside protection in the form of our learnings in the in both the volatility space and in options, which is where my background is, as well as full participation in the upside of the equity markets. So that’s really the goal there. It’s not to be uncorrelated, it’s to participate when the market is going up. And then exploit the opportunities when things get bumpy and protect heavily when the market is going down.

Jeff Malec  7:11
I love it and the So would you consider like an overlay strategy, or similar to have some people do overlays with options? But good? Yeah.

Brett Nelson  7:24
I mean, it’s a good question, because that’s one of the things that led to it was that we had a lot of people saying, hey, you’re VIX experts, and we love what you’re doing. And it’s Can you overlay it with my equities? And I always joke with them and say, Yes, I can give me full control of your equities. And I’ll do that, yeah. And they’d say, yeah, I’m not giving you control of the equity book, I just want you to do that the hedge component, and I would look at them and say, I can’t do that optimally, I would really like to bring the equity exposure and the volatility exposure together into a perfectly united package. And that’s effectively what this is. So it’s, it’s not an overlay, people are still using our VIX product as an overlay or an addition to, and this mutual fund is actually meant to be kind of someone’s core holdings in terms of a lot of people take that core satellite approach where they’ll say, we’ve got this core equity, and then we, we satellite it with a bunch of alternatives, which is, you know, the space that you and I are very familiar with. And we said, Hey, you can still use our macro mega product for your satellite component, because it’s non correlated. And you can still use other longball products for protection, everything. But we want to come in and actually fulfill that core equity, we want to kind of replace this what we think is kind of a flawed mentality around buy and hold equity, that passive component, we think it should be done better.

Jeff Malec  8:41
So dig into that a little bit, if you will, what, what’s flawed about it?

Brett Nelson  8:46
Well, you know, let me give a little bit of an example. If I came to you in the space that we operate in and said, Hey, gentlemen, got this fantastic opportunity for you. It produces about 6% a year over decades, and it has a Sharpe ratio of about point three or point four, and the biggest peak to trough drawdown was only about 53%. You would look at me and say, well, that’s not a good opportunity at all. That’s a terrible opportunity. And I would say that that’s exactly what spiders buy and hold passive is, that’s exactly what it is. And so, when we studied into it, we said it’s not that the good years, inequities aren’t good enough, it’s the bad years are catastrophic. So the point was to say, can you actually build kind of a mathematically based program using expertise and options and volatility to say we’re going to participate in the good years which is whatever he wants and get rid of those just absolutely catastrophic circumstances.

Jeff Malec  9:45
How does that compare with like, I feel like the same thing is being sold to retail that but as a buffered note, or as the JPMorgan hedged equity of some of those structures, right? If I, hey, we want to give you upside participation. participation and kind of cap your downside with these options structures? So compare and contrast with some of those structures.

Brett Nelson  10:08
Yeah, so first I’ll talk about kind of you mentioned, one of the gorillas in the room is the 500 pound gorilla is is that JPMorgan hedged equity fund, and a lot of people are familiar with it. And so are we. The issue with that is, that’s the traditional approach to hedged equity, I’m going to give you basically muted exposure to the market. So preferentially a better risk adjusted profile, which I think they actually do versus passive equity. But for example, if the markets up 10, you’re going to be up six, if the markets down 10, you’ll only be down five, or four and a half. So the risk adjusted profile is probably better. But nonetheless, it’s still muted. And so the the question is, can you actually get that downside protection and still fully participate in the upside? Do you have to give up half or 40% of the upside? That’s one of the big questions. We don’t think so. And then, in terms of, you know, the other the other concepts of what hedged equity is, right? It’s, it’s to say, Okay, um, we can, we can say, what are the best ways to, to protect structured notes? Okay, let’s, let’s say, what is the structure note, a lot of the structured notes are structured like, we will protect against, for example, a, well 15% 20% downside, maybe even 30% downside, depending on the note, and then they’ll say, where there’s this sneaky little knockin and then, right. So you as the investor, feel like you’re perfectly protected against all these circumstances until it gets really, really bad. And then you’re going to take the entirety of the loss,

Jeff Malec  11:54
right, you get protected against the first 10% loss and realize everything after that, which seems backwards.

Brett Nelson  12:01
And we say we said that’s exactly backwards, because people don’t inherently care about a five or a 10% fluctuation in the market. That’s what equities do. That’s the risk premium market, right? So well allow them to just participate in the 510 percent down, it’s when you get to 20%. A lot of people are probably familiar with what we call the geometric loss problem, right? The geometric loss problem is, if I lose 10% of my portfolio, it only takes 11% to get back to break, even if I lose 50%, it takes 100% to get back breaking, but right? It’s a geometric problem. And so we say, why would you protect someone against the area that is easy to recover from, and then make them endure all the pain from the thing that’s hard to come back from, that just doesn’t make any sense at all right. And so we do the exact opposite, our approach is to say, you participate, you, you may or may not participate in the first little bit, and you participate in kind of the five to 10% zone, and then we start hedging things off heavily. Or I should say, our hedges start to protect you, once it starts to get hairy at 15 20%. That’s where we come in very strongly.

Jeff Malec  13:12
Which seems more the model of the bigger players write up the pensions and whatnot. And maybe yes, more retail is done. But to that point, that’s made kind of further out of the money options. Very expensive, relatively right. So there’s the skew. And there’s lots been written on like, there’s so much demand for these tail options, that there’s somewhat overpriced. So how do you? How do you solve for that? Or are you solving for that? Or what are your thoughts that

Brett Nelson  13:38
we actually discovered, you don’t really have to solve for it? Because functionally, that’s not where the it’s not where really the money is made in the market. In simple terms, you need to have protection on we all know that you can’t buy insurance on a burning house, right? So you can’t really come in as the house is on fire and say I’m going to protect this, right? It has to be there. But it doesn’t really have to constitute that much of the portfolio. Because we’re not really talking about the problem comes in when you take the mindset of something like the JPMorgan hedged equity, when you say I’m going to protect you against all loss. So if the markets down to you’re only going to be down one, or if the markets down five, you’re going to be down three, if you take that mindset, insurance, or downside protection becomes incredibly expensive, right? If you ditch that mindset and say, protection really only needs to protect the catastrophe, right? Then in then the protection or the hedges or the insurance, whatever you want to call them, actually become quite cheap. And they can be on all the time and that’s not really they’re not really robbing a bunch of return from the portfolio. And then you also come in you realize what we do. What we know about the markets is that the opportunity for extra gains or excess gains is actually due to volatility. It’s not due to the duration of the market, right? And so if you know how to exploit volatility, then you don’t really care so much how much the catastrophic hedges are costing you.

Jeff Malec  15:12
So in more mathematical terms, would that be your focus more on being long Vega then? Long skew or long gamma? I guess.

Brett Nelson  15:23
Yeah, I would say the more accurate way to phrase it is that we exploit the, the changes in Vega and gamma, right? Because the opportunity is one that and you know this because, you know, we kind of mentioned it before we started a little bit in just casual talk. The opportunities come when the market gets bumpier, not when there’s no volatility, when everything’s calm, and the market is just grinding higher. That’s there’s no opportunity for excess performance there. Right. It’s a where you come in and actually exploit the market inefficiencies is when things get bumpy. And that’s manifested in terms of to your point, Vega, and gamma.

Jeff Malec  16:01
I feel like people realize that on an intuitive level, and like March 2020 thing of like, everyone’s freaking out, they’re buying, they’re buying the insurance as the house is burning, right? From a ball seller kind of standpoint, that’s easy to be like, Oh, yeah, I’m happy to sell VIX at 80. There’s no way it’s going to stay at 80. Yeah. But you’re kind of saying from the flip side to right, if there’s maybe in layman’s terms, that from 40 to 80, is some opportunity in that.

Brett Nelson  16:28
Yeah. And, and, you know, I’ve mentioned this before, but there’s, there’s essentially three categories of the of essentially volatility, or let’s call them three regimes. You know, a lot of people talk about two regimes, high volatility, low volatility. But let’s, let’s actually break them down a little bit a little bit differently, and say, it’s actually not high and low volatility. It’s like the base state, which is a grinding Common Market, right, usually grinding somewhat upward. And when we’re talking about equities, that’s the base state, categorized by low

Jeff Malec  17:01
volatility, right, Jan, through August this year.

Brett Nelson  17:05
Yeah. Or even talk about in lengthy periods, 2013 2014 2017, the entire year, things like that. That’s the base state of the market, right? There’s not opportunity for volatility exploitation there. The interesting part is that we know during that category, to get technical, that there is a volatility risk premium. So the market is almost always slightly over pricing volatility during that base state. So this is where you’ll start to see in the vol market, you’ll start to see premium sellers. absolutely killing everyone, right. And to the point of you hear about this iron condor trade that is becoming so popular with retail, and they’re just massive Condor sellers out there for those who know what the Condor is. And they’re trying to exploit the base state of the market. But it performs incredibly poorly outside of the base state of the market, which is, which is just the grind. Right? Yeah. And then you’ve got effectively the next state is, is not straight into catastrophic, you know, kind of moonshot volatility, it’s really more this, you might call it a high volatility regime. But the state is one of a more choppy market, right? And that’s where volatility arbitrage is really where you want to be, right? You’ve got opportunity in in the fluctuation of volatility over time. Okay. And then you’ve got the third state, which is what you might call the momentum state, right? And we would say this is categorized by divergence. So if I said, volatility, or the VIX, for example, is typically a convergent instrument. So it likes to, if it goes high, it wants to come back down and revert to that kind of base level of high teens or mid teens. In the divergence state or the momentum state. We’re talking about, for example, on March 2020, or October 2008. type scenario. Volatility actually becomes divergent in that it becomes a momentum trade, which is contrary to its convergent nature, right? It’s not hurting anymore. It’s not mean reverting, it’s the exact opposite. It becomes momentum. It’s a breakout trade. And in that state, there is no telling how high the limit or how high the ceiling would get, right. Those who are familiar with ETFs in the big space, you know, they were familiar with the idea that Oh, yeah, some of the big CTS could double like in February 2018 event, but then what we saw on March 2020, is that some of them that had only ever doubled before or two and a half x kind of upward movement went six at tire instantly, right? And that’s that momentum divergence we’re talking about where everyone loses their mind and will take fire insurance on whatever burning city is on fire, right? At any cost,

Jeff Malec  20:01
I think there’s even more technical reasons that have become, which we’ll talk about later. Like, then it becomes market makers needing to doubt the head and just becomes a self fulfilling thing causing liquidity cascade where one thing leads to another and all this momentum pushes in that same direction. Exactly. It’s interesting. And speaking of Hofstede, they talked about JP hedged equity program the other day, and I think it was Rodrigo. On that pod resolve riff said it’s, if you map it with the 60%, S&P 40% cash, it’s nearly an identical curve. So really, really all they’re doing is giving you 60% stock exposure, which is you could do that on your own, but go ahead and put your 18 billion over there.

Brett Nelson  20:49
The interesting thing is that the people who run it, they don’t claim that it’s anything. Well, yeah, they got most of the time that I hear that I hear comments coming from them, they actually admit that it’s terribly unsophisticated. You know, it’s, it’s not particularly sophisticated at all. And it’s not trying to be simplicity sales.

Jeff Malec  21:05
Um, so coming back to things, you had a great term in there, but it passed over my head, I misunderstood what you said something about a convexity or something. Did you say that word convexity? I may remember, it was like, do we get equity exposure convexity or something?

Brett Nelson  21:27
But there is there is no, the reason that we call our fun convex core actually plays on our data, our idea of convexity, because, you know, when we talk about using volatility, a lot of people use volatility to protect a portfolio, the idea there is convexity, right? Because if you’re if you don’t have heavy convexity, in other words, something that is increasing it and it’s, it’s the difference between velocity and acceleration in your car, right? Your speed is your velocity, but your acceleration is saying, Are you going faster each moment than you were the moment before convexity is that I’m going increasingly large. And when we talk about using volatility, we have to use convexity. Because if you didn’t have heavier skip convexity, you’re paying an absolute fortune to protect yourself to use volatility, right? So would you want something is that it’s relatively cheap to you, if not sometimes free to you to use, that is going to increase in value as the market, you know, starts to drop or, or starts to run lower. And that’s that convexity we were talking about. And any user of volatility or VIX or even the option side, the Vega in the options has to know what that convexity is, and how to exploit it to prevent themselves from just bleeding to death as they tried to protect the portfolio.

Jeff Malec  22:46
The IRS did a little skydiving back in my younger years. And that one guy explained, he’s like, you don’t lose your stomach because you’re going 150 miles an hour, right this way in the plane, and then you just switch direction of the velocity. So there’s no acceleration, it’s just a switch of the of the direction of the velocity.

Brett Nelson  23:06
And I did that, too. And the only time your stomach jumps is the moment that you exit the plane slightly. And then after that, that brief moment there is that like,

Jeff Malec  23:16
you’re floating. And then coming back for a second, just touch on the equity component of all that. So we’ve got the vol piece. It’s going to kick into that convexity. I still might argue that everyone wants that convexity so badly that that’s why that it’s overpriced, because everyone wants that convexity. But your models are saying that doesn’t quite matter as much.

Brett Nelson  23:40
It would be nice if it was lower priced. Yeah. Right. But that doesn’t mean that we don’t need it, or we’re not willing to have it just because it’s slightly overpriced.

Jeff Malec  23:50
And if it remains overpriced, I guess, right? Well, it’s only a huge problem if it’s overpriced, and now it’s right price the next day, or the next month, right? Yeah. Because

Brett Nelson  24:00
you’d lose some of that or and and by being slightly overpriced, you’re losing some of giving away some of the convexity you should otherwise have.

Jeff Malec  24:07
Right. But right, maybe it’s 10 to one convexity, maybe you have 10 to 1.2 convexity or something. Yeah, something

Brett Nelson  24:14
it’s not it’s not that it’s not too dramatic. It’s not too dramatic to overcome. It’s what I was getting at is it’s not the primary return driver or the thing that would ruin a strategy.

Jeff Malec  24:25
Right? It’s not it’s not cutting that convexity in half or even by God.

So under the equity piece, are you doing just an index single names? what’s the what’s the beta portion look like? Now we

Brett Nelson  24:44
focus on S&P 500 because we want to representative broad based index that is that we like to stay away from idiosyncratic risk. Others like to build models around whether or not they can choose the best basket of stocks. We don’t like to mess around with that. We’re mathematicians by nature. We’re not stock pickers. Right. So we look for the mathematical structure of the market. And the and the easiest way to do that with the broadest, I said the highest liquidity with the greatest capacity for scale is the S&P 500. Right. So we basically position our exposure to the S&P 500 itself and tie ourselves to that.

Jeff Malec  25:22
And that via owning the ETF, owning futures, a little

Brett Nelson  25:26
bit of options on primarily are options on either the ETF, the S&P, the SPX index, the cash index itself, or the futures got all virtually

Jeff Malec  25:38
interchangeable. Got it? And that’s just that’s how it works in your models or you have, how would it alternate between those flavors?

 

Brett Nelson  25:47
Mainly, it’s just basically granularity, okay? mathematically, they’re, they’re pretty much interchangeable. A lot of people might argue, for example, the spiders has dividends where they don’t, people just need to understand that that’s all priced in that if it wasn’t, there would be an ARB in the market. So and since we’re not all sitting here becoming rich off of that ARB, it doesn’t matter. It’s really a question of how large Do you want the contracts to be the largest of the SPX. half as big or the E mini and then a 10th of the size of the SPX are the spy ETF options.

Jeff Malec  26:19
Got it. But I guess what, why options instead of outright owning the deltas or the

Brett Nelson  26:26
it’s interesting, because that question has been asked a lot as to why certain why larger banks haven’t been able to do what we’ve been able to do. And one of those, one of the answers to that question is that there are sometimes handcuffs put on someone. So for example, if I must own the underlying, right, in order to express my opinion, I’m slightly restricted as to how much exposure I can have, especially if there’s some, for example, some type of tax consequence. So I can’t pare back my exposure to equities, because it would be a taxable event if I did, for example, or I can’t get above an exposure of 100%. Good times. So because I can’t fluctuate my exposure to the underlying if I own it, I can’t properly position my exposure for whatever the conditions of the market are. So we express it through options, because mathematically, we can tailor very specifically exactly what mathematical profile is being rewarded the best at the time, it’s like that it’s the old Warren Buffett thing, right? You want to value something, you want to make sure you’re getting about a value for your risk dollar, right? If something is overpriced for a unit of risk, don’t buy as much of it or don’t buy any of it. And if it’s under priced, or you’re getting over compensated per unit of risk, take more of it. And that’s the way it works with options. But with options, we can just dial it in so precisely that we know exactly what the experience is going to be when the market moves.

Jeff Malec  27:59
But then that helps you probably pair up with the vol on the on the downside as well. Little more.

Brett Nelson  28:05
So when things get bumpy, we can we can adjust our exposure in terms of for example, the quantity of contracts for buying and selling to exploit or in, in our technical speak to arbitrage the volatility complex as it’s doing it. And the nice thing about the options too is if I was doing it with the underlying I would have to go out and try to try to use something like either VIX futures or VIX options or something like that, in order to exploit my underlying equities, but since I’m already using the underlying the options on the equities to express my opinion on the equities themselves, the volatility components built into them so that I can just explain it directly.

Jeff Malec  28:47
To questions so what was it like? So you guys, did this whole mutual fund? recommend it? Is it a bear was it a lots of lawyers, lots of

Brett Nelson  28:58
for those in that for those in the private world in the hedge fund and commodity pool space, and especially in the managed account space that haven’t ventured into mutual funds, if you want to get ready, it’s, it’s so much more onerous to start a mutual fund. And so much more costly. And even the ongoing The, the operational cost of the mutual fund is just many times higher than either a hedge fund or a private fund of any kind or a managed account. And so there’s definite hurdles to trying to get into the mutual fund world and so many competitors but then at the same time, you and I both seen kind of this opportunity to bring hedge funds slash alt programs and models into the mutual fund space for a group that didn’t know they had access to them. And that was really the driver there.

Jeff Malec  29:55
Right and when you have outright people like JP Morgan, who are admitting This isn’t the most sophisticated thing to be like, Okay, this, we are trying to bring you a very sophisticated thing. It seems like there’s definitely a market for that. Which I’m always asking like, do you feel like this is the best time ever to be a rich dentist investor, right? Like you can trade for free on Robin Hood, you can get access to a hedge fund pros like yourself via mutual funds, you can have inverse or levered ETFs. Like, it’s probably the most you can shoot your foot off. But also, you know, you have the most tools in the toolbox probably at any time ever.

Brett Nelson  30:31
Yeah, no one. I mean, it’s evolving right now because you and I in the space that we’re in, you know that, you know, RCM brings more and more, what you would say, what used to be kind of Nietzsche all strategies into mainstream, that’s kind of a focus that you guys really like to like to pursue. And that’s what’s creating the moment we have now is because we have what have been dubbed liquid vaults or hedge fund strats and type inside of a mutual fund. People don’t really understand that it is the best time to be like a retail high net worth or something like that you have through traditional means you have access to strategies, you never know one, but the ultra, ultra high net worth family office or fund to fund space ever had access to.

Jeff Malec  31:21
So along those lines, oh, this is complex stuff, you got to educate the investors or educate the advisors? How do you go about getting them to understand, you know, what it is that’s going on behind the curtain? Yeah, so

Brett Nelson  31:35
one of the things you have to realize, too, is that, while your followers will be, you know, pretty, pretty, you know, understanding and, and more sophisticated of the type of things we’ve been talking about here, you know, VIX and volatility and derivatives and options and, and delta and gamma, and Vega, and things like that. A lot of that in, especially in the traditional ra world, it’s just not going to go over well, you have, you have a portion of our eyes that are highly sophisticated. And then you have a larger portion that are just not particularly sophisticated and don’t care to be. And then you have kind of a middle range that would really like to be more sophisticated. But they these all these kind of liquid vaults and more accessible vaults for their clients haven’t been around long enough for them to really get the education. So we do a lot in terms of trying to first bring it down into the, you know, the nomenclature and the vocabulary they’re used to so for example, the convex core mutual fund that we talked about, whereas you I would talk to you about Yeah, it’s it’s a volatility arbitrage mask strategy masquerading as an equity strategy, right? Yeah. But, but to them, the part that they care about is that it’s a hedged equity strategy, just like the JPMorgan, but more sophisticated and more optimized, right. And so we look at it, we say, we’re not going to go to them and say, hey, we’ve got this, this fantastic volatility derivative strategy. We look around in play, we’ve got a hedged equity strategy. And if you’d like to look under the hood a little bit, we’re happy to educate you within the derivative space. And then and then there’s the other side of the equation, too, I think it’s been quite interesting because we have to, we have to bring the retail crowd into the alt space through some of these new things like the liquid alt mutual fund strategies. And then at the same time, we have to educate the traditional alt players in the saying, look, you almost none of you are 100% alternatives, right? So let’s do that core satellite thing but instead of doing passive equity core, let’s do liquid alt, better version of core and then still bring VIX strategies and that kind of stuff into your into your Dell satellite, all portfolio, whether it be you know, it can be real estate, it can be private equity, or more like what we talked about managed futures.

Jeff Malec  33:56
So, and how much of the I don’t want to say back tested or tested performance, you know, the, what you bring is from the rebalancing effect as well. Right, I’m gonna get this to kick in, right, as equities are down, invest more of that back in equities. So what do you see is that rebalancing premium

Brett Nelson  34:17
there’s a, there’s a pretty fair amount of rebalancing premium, most of the alpha that we see, when we go through, you know, we go through decades and decades of history and attribution in the options model. Most of the alpha is actually generated on people have a really hard time adjusting to the reality of what the market is right now. Right? So let’s let’s use that absolutely huge, you know, hedged equity mutual fund as an example. When we look at that, you know, hedged equity, huge mutual funds. We say it’s incredibly static. It’s simple, but it’s static. doesn’t account for path dependency in the market doesn’t account for volatility, circumstances or anything like that. When it does don’t account for any of that it doesn’t really account for overcompensation, rebalancing a portfolio trying to redeploy capital or anything. And so what ends up happening is you say, I put on this exposure, and I put on these hedges, and now the market has moved. And it the market can move huge or can move very small, very small increment in a short amount of time or a large amount of time. But what you do know is that the reason you put the position on the hedge on or the or the other trade on in the first place is because that was the optimal place to put it on at that moment. And as soon as the market moves or time passes, it may or may not probably isn’t optimal anymore. And so we’re talking about rebalancing, we have to be exploiting the market that exists now not the one that existed a month ago, right? And so ever all of the rebalancing effects and the and the fluctuations and volatility in the market. Those are exactly what caused the opportunity, so long as whoever’s managing the portfolio is adjusting their optimal positions to be re optimized at the moment.

Jeff Malec  36:03
Yeah, I think like some buffer note, people, structured products don’t understand, right? If the, if the markets been up 50% in the last 10 months, like it has been, and you have a 20% down, knocking knock out like, you’re risking that 30% from where you made plus the 20% it’s not a trailing SAP, so to speak, right? From the wind you It’s from when you did the deal 10 months ago. Yeah.

Brett Nelson  36:28
And it’s and it’s also, it’s the idea that, you know, we call the thinking on the margin, right? Or thinking at the margin, it’s, it’s this idea of saying, Oh, well, I’m up 10% in my portfolio. So if I gave that 10% back, it’s not a loss. So people get it in their head that that’s not their money. And I’m like, No, any money that’s in your any liquid in any liquidation value in your account is yours right now. That’s the same person wouldn’t be looking at their account and saying, Oh, I’m at a 50% drawdown, but it’s not a real loss. Now, that’s a real loss. It’s there, right? And you should make all of your choices based or your decisions based on that existing. And if you’re at the top end of a note where it’s not going to pay any more for the next three years. That’s the other problem with the notes, right, that we didn’t mention is not only that knock in events, but you’re locked in forever. You don’t get to get back out of them.

Jeff Malec  37:19
Yeah, and you just made me think all these people freaking out when it got floated, they’re gonna tax all investments, like mark to market end of the year. Yeah, Twitter was blowing up. I’m like, hey, that’s, that’s our world and options and futures. It’s not that we’ve always been there. Right. And I’m like, I feel like people do think like, if I’m up 100k, I feel like that’s my money. I don’t just bet that’s the markets money.

Shifting gears a little bit. We’ve talked a little bit about the volatility arbitrage. So wanting to kind of pick your brain and some of the standard vol ARB trades out there and kind of just get your off the cuff thoughts of one of those pros, what are the cons of those different types of trades? So I’ll start with VIX calendar spreads, either whatever you think, what’s the typical trade, they’re in a VIX calendar spreads.

Brett Nelson  38:23
The typical trade, the heaviest trade, as far as indirectly or directly is going to be, you know, kind of short for long back, whether it’s whether it’s short, the first month long, the second or some version of that. And the reason that’s the biggest is because that’s the that’s the premium selling trade, right? That’s the volatility of selling trade, which is going to make money, 90 some odd percent of the time. Right. It’s very consistent until it’s not, and then it’s absolutely catastrophic.

Jeff Malec  38:53
But the being long the back end is in theory supposed to help you mitigate that, that potential for catastrophe, right?

Brett Nelson  39:01
Yeah. And if you’ve done it correctly, there actually is opportunity there. If, if someone’s very unsophisticated in their understanding of vol, then it’s kind of playing with fire, right. But if you can do it correctly, that’s actually one of our more favorite methods of exploiting, not necessarily short and long back, but the calendar spread in general, whether it’s Lille long, near month, short fire month, we tend to do things in ratios. So we want to know exactly how much protection we’re going to get to your point and not back month. So if, if we’re collecting some short volatility in the near term, we want to know that at a certain point, our the convexity for example is going to kick into our favor and kind of come and swoop in and give a safety net at the portfolio. So that’s, that’s best exploited as a vol ARB strategy, so it’s not static over time. You don’t want to just sit in that trade forever. You want to make sure that you’re analyzing the VIX term structure, and you’re coming in and you’re saying what’s the where along the VIX curve is the best value right now?

Jeff Malec  40:07
And then do you see that being implemented when the curve shifts? But like sounds like you’re saying you don’t want to just come in the fifth of every month and sell front month by three months out?

Brett Nelson  40:17
Yeah, that blind calendar, you know, rolling methodologies. They’re so indiscriminate that they’re, they’re bound to get it wrong. And, you know, there’s a behavior in that in the VIX term structure where you say, okay, there’s pivoting in the term structure, which means kind of a steepening, right? And then there’s shifting where there’s not much of a change in the shape of the term structure shifts, right shifts on her, she’s down. And the interesting part is that a pivots under certain conditions, and it shifts under certain conditions. So let’s say you can put exposure on where you’re saying, Okay, yeah, for example, short, short, front long back in a pivot scenario where it’s pivoting against you, that’s going to it’s going to sting. But if you know that with a high level of confidence that it’s going to start shifting at a certain point, then that spread is going to stop blowing out on you and your, your, let’s say your ratio, your extra Long’s on the back are going to start shifting higher to dramatic rate, right. And so you can exploit those tendencies and, and there’s a lot of, there’s a lot of nuance to the structures there. That gives a lot of freedom into how you can do that, which is kind of what our macro Vega is based around, we have many says seven or eight different primary structures with nuanced variations, that you can exploit the different tendencies of the curve, though.

Jeff Malec  41:38
And so ratio, you’re saying maybe I’m short one front month, and long four back month, or whatever the

Brett Nelson  41:43
ratio would be one to four, it could be one to two, Time to expiration or tenor has a lot to do with that.

Jeff Malec  41:51
Next one, the so called long, long, short, short trade where I’m long the S&P and as a hedge, I’m long VIX or I’m long some puts would be a similar thing. So like simplistic trade there was, you know, when implied lower than realized, I’m going to go long, long do I have that? Right. But um, whatever the end or short, short, right, I’m short, the market and I’m short. The thing that goes, you know, short, short, long, long thoughts there.

Brett Nelson  42:22
Yeah, we’ve seen it done successfully. I’m on a couple rare occasions. The rest of the time, it from my perspective as being one of the guys it’s been in VIX so long. It’s an incredibly tricky trade to get right. You have more you have times where the relationships kind of let’s just say they, I don’t want to I don’t like to use the term break. Let’s just say the relationship breaks for an extended period of time, something like you know, a year or a year and a half. And then at other times, you have a very short-term circumstance where the relationship breaks like let’s reference an actual example, late 2018, the October November December 2018. where, you know, normally with that size of a move in the S&P to the downside, you would have had VIX 50 VIX, 60. But instead, you have VIX 25 bucks. 28. Right. And so if you’re sitting there, your short equity or your long equities and you’re saying it’s okay, I’ll be long involved as a hedge, you didn’t get any hedge? Yes. And that speaks to the nature of trying to just rely on a very consistent relationship between volatility and equities, and it’s not consistent, it’s not perfectly correlated, right? And so when you’re using volatility as a hedge, you need to be somewhat diversified and then you need to actually be able to layer on that convexity pretty heavily when you need to and so I don’t inherently love the long short trade

Jeff Malec  43:49
I think it’s I think there have been a effort on the part and saying that he’s there’s no signal there when he ran it back through some testing and sure it can work but there’s no signal there.

Brett Nelson  44:01
Yeah, interesting part is that when someone actually shows that they’ve got a lot of kind of consistent gain from it, when you when you run the attribution on their model, what you usually find is that they were just kind of behind the scenes selling volatility and it was a short ball trade that they managed to kind of escape a couple hairy circumstances that eventually hit them so

Jeff Malec  44:26
with the market going up and then I think last month September is kind of an example of that in reverse right you had the market go down but the the far out of the money stuff did nothing.

Brett Nelson  44:37
That’s the interesting part if you know, you know, for someone like myself that has a long history in options and then and then jumped into VIX futures incredibly early and use the VIX as an instrument like right as it wasn’t as it was released. You have a different understanding because you can look into the mathematics of the options if you dig deep Enough, and the options will actually tell you how sensitive the volatility complex is going to be to a sell off. So it’s not a it’s not going to catch you by surprise. For example, if it for example, if we talked about that late 2018 circumstance, the options market was indicative that if the move continued, there wasn’t going to be much of a vol response. And then more recently, the setup within the options complex specifically the Vega curves and everything are telling you that there is going to be an kind of over exaggerated vol response for a very small move at 2% down move in the market is going to be a 10% 15% up moving ball.

 

Jeff Malec  45:41
And then well I guess we touched on a similar traits can be done with options as we’re saying, right? So you could be long the underlying and In short, some so we’ll skip over that one and the other one, seem kind of some people say this is baller but I’m not sure but essentially selling ball one to, you know, close by and buying, whether it be VIX calls or whatnot buying way out of the money VIX calls, you know, I’m kind of selling the VIX 20 down, and then if it spikes up to 60, I’m going to get paid out way more on those calls than I lost on the the spike up.

Brett Nelson  46:19
Yeah, and that’s an interesting one. Because, intuitively, you might say that makes sense in terms of saying I’m going to exploit a tendency within the mall complex. And then because it can go really bad in a hurry, I’m going to put some type of like heavy convexity trade in so that, you know, I don’t get absolutely crushed by it. I don’t disagree with the mentality of it. I disagree with the execution in a lot of circumstances, because I will say, if someone doesn’t have an options model that they’re highly certain in, that is saying that, for example, those long calls are underpriced somehow, the non-general assumption is that they’re accurately priced. And they’re accurately reflecting exactly the amount of hedge that they’re going to give you or not give you for the circumstance. So and that’s the case with options in general. If you can’t say that they’re incorrectly priced, then the base assumption is that they’re correctly priced and that there’s no inherent edge in any structure you’re going to put on right.

Jeff Malec  47:17
Now what been my theory for a long time like that the price the option is reflecting the actual probability of that event. Right people we

Brett Nelson  47:26
always we always say that’s, that’s primarily someone mistaking structure for strategy, right? Yeah.

Jeff Malec  47:32
Struggling rack, which is back 10 years ago, that was in a bunch of pitch books that came across my desk of like, what’s your alpha? That options decay over time? Yeah, like, I’m not sure that’s alpha, that seems just like a structural structure. That’s not strategy. Yeah. And it seems to me even if you’re selling that, nearby, or the belly, we call it and having those roads kind of, uh, you know, if you ran that over 100 years, it’s gonna be net breakeven, right? Yeah. So you have that you’d have that some sort of timing mechanism, or I’m going to oversell and then quickly shift to those calls or something of that nature.

 

Jeff Malec  48:57
So you mentioned the x x there, there’s two new VIX ETFs coming out. I’m sure you saw that news. Any thoughts on that? Welcome, good, bad or what?

Brett Nelson  49:08
I my general, my general thought is welcome. more liquidity is better. Yeah. I and I say that for basically just the markets in general. I, I will all express my opinion without risking, say, sounding in support of the products themselves. Their structure is better than their predecessors. Yeah. So a lot of people inherently in the VIX space that some of us knew that those the ETS were going to blow up. It was just a matter of time. It should have happened in August 2015. And they got lucky and it didn’t happen until February 2018. But had the had the market stayed at its Mid Day highs, or I should say the volatility market standards Mid Day highs in August 2015. The blow up would have happened to them. So the writing was on the wall for years, and then it finally happened. Right? And part of that was because a lot of the participants in the ETF, the VIX etn, market didn’t understand the significant nature of the counterparty risk, right? A lot of people say etps as if there’s no difference between an ETF and ETN. There is a distinct difference between the two. And the new products are ETS, which just give a little

Jeff Malec  50:27
better. I’ll give some explainers there. So etps is the overall umbrella exchange traded product paid for product, ETF exchange traded funds, so think mutual fund, but with minute by minute liquidity, and then an etn is an exchange traded note. So yeah, the T VIX was actually Credit Suisse, I believe was their note. So you’re actually their Counterparty? And if they wanted to buy the VIX futures and do everything on their own, they could, they could also just be like, well make good whatever happens on that product, right? Like they just they owe the price, whatever the price, the dn was, they owed everyone who bought that etn that, that gain or that loss? Without? I think mostly that they were hedging, and that’s what caused everything to unravel. But yeah,

Brett Nelson  51:15
that’s the interesting, the interesting nature of the two et ends is so you might ask, why did the first one What did x IV like? Why did the reverse VIX right? Or the inverse VIX? Why did that blow up in February 18. And the other one didn’t until later, right? The etn is a double edged sword. On the one hand, any inverse product in VIX is going to blow up as an etn because the bank is not going to be left holding the bag, when VIX skyrockets to infinity, right? And so that one’s going to blow up in a in that catastrophic meltdown type event. The other, the other problem with the etn that the ETF doesn’t have is that in an extreme reward scenario, where you’re actually on the right side of it as the investor and you’re you stand to make a fortune, and then the bank isn’t able to pay you the fortune that you’re right. That’s a huge problem. So so you, as the investor in an etn scenario get burned both ways. It’s terrible. Whereas on the ETF side, you might still have some of the significant problems with the inverse product. But at least with with the regular product, even if it’s leveraged something, the assets are supposed to be held, right. So you will be paid out on your positive side, at least as er, that’s the argument.

Jeff Malec  52:30
So and then we’ll dig further into the super technical hole here before we pan back out. But some of the problems with all those products was the VIX settlement, everything around that a lot has moved towards Taz. Any thoughts on how all that plumbing has gotten better or how it used to work how it works now, the

Brett Nelson  52:51
the creators of the two new ETS, I will give them a little bit of give them a little bit of props, I guess I would say for the way that I structured their clothes compared to they recognize the weakness before Taz is is better. As far as you know, being able to use the Taz market is better, but that the bigger thing is a time weighted clothes value, right? Instead of just using that, you know, the, the special quotation of the VIX or something like that, which is an instantaneous price, and everyone has to adjust to it. Now, I will I will say we at Certeza. We actually don’t like past that much. And the reason for that is we’re quite guys, we’re mathematicians, we don’t like blind prices, and whatever like to structure something where we say whatever price you’re going to give us at the close. That’s the one we’re going to take. We hate that stuff. Yeah, and

Jeff Malec  53:44
has no another definition here just trade at settlement. So you put that in, and you get the settlement price essentially a little more.

Brett Nelson  53:52
And so yeah, so if you’re trying to move a huge amount of volume through the market, you might say, because I don’t want to push the market the benefit of Taos is that we’ve been in a situation where we’ve had to move some pretty significant volume through the VIX market when it’s when it’s pretty thin. And yeah, you know, you end up chasing the market a bit, you just start pushing it around a task kind of prevents that. But at the same time you have two assumptions. First of all, the liquidity is going to be there that the volume you need is going to be there in the test market.

Jeff Malec  54:20
That’s a pretty big assumption in our heads it needs it needs a match at settlement, right? It

Brett Nelson  54:24
needs a match, right? If there’s if there’s if it’s all one sided, it breaks, right? Yeah. And then the other thing is that blind pricing is never good from our estimation. So but a timing weighted close helps with that. Right? So if you say there’s going to be a time weighted settlement, so it’s not just some like arbitrary price that no one knows exactly where it’s going to hit that. That helps quite a bit.

Jeff Malec  54:47
Yeah, in theory tasks could be 20% off where you thought when you put the mark order in, right?

Brett Nelson  54:53
Absolutely. And that was the criticism that was a criticism of VIX futures. You know for years now as I if I hold One to expiration. Where is that special quotation going to be when it hits? Right? A lot of people tried to predict it, not very many of them do a very good job of it.

Jeff Malec  55:16
Coming back out now, just your overall thoughts on there’s been tons written and argued about that. All that matters in the volatility space is market makers Delta hedging, the rest is just noise and junk. Right? It’s where those big guys are, where they need to dump the hedge where they’re making the market. And the rest is just noise. And that’s where things are going to basically settle out that it provides support provides resistance. Just your general thoughts on that line of argument?

Brett Nelson  55:46
Yeah, I mean, I would say, more so than any other market, if we want to talk about flow in general, right. Flow is is critical within the volatility markets.

Jeff Malec  56:26
Right. And I would say, I would speculate that in terms of the volatility market, market makers specifically Delta hedging is a larger part proportionally of the volatility markets than it is, for example, maybe the equity markets, the argument being there’s probably a larger retail component to equities than there is in volatility, it’s more niche, and ornatural gas or something, right?

Brett Nelson  56:28
Yeah. And market makers play a very distinctly important role in the volatility space still, and so it’s undeniable that they’re Delta hedging would be just absolutely critical to you know, how the pricing is going to come out. Flow effects on, you know, both the options, and the futures within the VIX complex, are going to be quite pronounced.

Jeff Malec  56:52
And how do you square that with your own models of red? It seems hard to model that or have the math around, like, How do I know where those positioning are? Right? If I’m just looking at a simplistic, I believe for my option pricing that this is underpriced or overpriced, but there’s some flow dynamic that might flip that equation. How do you think about that?

Brett Nelson  57:15
Yeah, and that’s difficult within it’s not such a big deal in the equity markets. So as far as what we do, for example, for our mutual fund is different than what we do for our macro Vega Fund. The on the macro Vega side, you do have to within volatility arbitrage. When we talk about volatility arbitrage, we’re almost always talking about statistical arbitrage, right? Because there’s not there’s not like an absolute arbitrage we’re talking about Yeah, yeah. might be the case in other assets.

Jeff Malec  57:42
Right. So relative value as another

Brett Nelson  57:45
relative value, right. And anytime you talk stat ARB you’re talking law of large numbers, right. And so when you build your model, a lot of people might say, for example, I’ve been in the industry for so long, I have so many connections, that I can start making phone calls and see who’s positioning where and who has what exposures. If someone has those kind of connections, more power to them, being able to make a phone call and, and know that there’s a big player trying to unwind a huge position is insightful information. But I it’s a precarious situation to be in at the same time, because you’re saying, my relationships and knowing exactly who’s causing what is, is my edge.

Jeff Malec  58:28
Right? Yeah, versus lose that relationship. Yeah, don’t

Brett Nelson  58:32
don’t lose that and, and, and hope that you have access to the information quickly enough, or that someone’s not kind of fleecing you on some aspect. And the rumor mill can be can be wrong as well, as far as, you know, the gossip across Wall Street. So, so we, you look at it and you say if if relationships are your edge, we never relied on that. We always say the mathematics and the structural mathematics is the edge. And what that requires is incredibly sound risk management and money management. So that if you’re on the wrong side of someone distorting the market, it’s just another one of those outliers that you just get past and you move on. But on the other hand, if you’re if your model has you increasing exposure into that loss, and it just goes further and further and further until you’re blown up. It’s I don’t think someone has the luxury of jumping in and saying, Well, if it hadn’t been for them, the model was right. Yeah, you can say that all you want when you’re blown up, but the reality is, if you build a model that is susceptible to blowing up in an event like that the model was incorrect. Right?

Jeff Malec  59:44
Right. But it’s also to me like it’s, and you said this earlier sort of priced in, right. So if everyone knows that’s where JP Morgan hedged equity needs to be, and that that got a little disproved last week. of everyone’s I can’t remember the numbers but 4340 or there was you know, is below that call strike, and then we’re gonna have to re strike it and wherever they’re gonna go, and bunch of delta hedging and there was like 18 billion worth, but then they came in and did a basically, they did another option trade to smooth out the, the Delta hedging because they knew that everyone knew this right? So it’s like a game within games. Yeah, if you know every, you can’t just come in and tell the edge that immediately you’re gonna get screwed the markets gonna get. So everyone’s playing the same game. They’re trying to smooth it out. And I feel like that’ll be reflected in prices, which goes back into modeling. And, yeah,

Brett Nelson  1:00:34
and the question there is, did it simply with everybody playing that game of chess? Right? Did it simply just make for slightly larger swings than would otherwise have happened? Right, slightly more volatility mispricing. Because what we’re really talking about is changes in implied volatility of the options, right, that shouldn’t be what they are. And so it’s still a volatility game. And it’s just basically coming through with your model and saying, we don’t want to create a model that is incredibly price sensitive to one event or one strike being pushy, right? Yeah, we want to we want to in you know, the the famous celeb, you know, coined phrase is the anti fragility, right? We want to create a model that is anti fragile, it can withstand, you know, if you’re saying, Get the model is so fragile that an unknowable or unpredictable circumstance will just absolutely wreck the strategy, then you have to ask yourself, why did you build it that way? We have plenty of those that are on the books in the past 4050 years, you might as well jump in and say, yeah, we can build a strategy that’s anti fragile against all those, why would it not? Why would it not be anti fragile against for example, JP, Morgan’s hedged equity having a move a large position?

Jeff Malec  1:01:47
Right? Yeah, I think the more nefarious way would be if it doesn’t blow it up, but it like eats away at the edge every time, right? If there’s like, just it’s throwing off the option pricing minimally, to a point where the the edge disappears. Yeah,

Brett Nelson  1:02:03
that’s common, not just with big players, like, you know, like that fund. But, you know, we talked about that iron condor trader, you know, yeah, when selling the body of volatility and buying the wings, and that’s gotten, you know, so incredibly popular as the markets gone up, that it does have the effect of kind of depressing the amount of premium that volatility sellers get, and then increasing the skew on the options to the point where it’s hard to buy, you know, hard to buy reasonably priced insurance, you know, so, so there’s that effect over time. But at the same time, I also think that those types of people pushing the market around also have effect on the way that the pricing moves within the underlying. So, for example, there is an effect. While there’s a muted effect with a muting effect, I guess, within the volatility complex on the options, there’s also an effect within the underlying price action.

Jeff Malec  1:02:58
And so also muted or less, well,

Brett Nelson  1:03:03
initially muted. And then, and then prone to large moves once it breaks out. Right. You might say, for example, let’s say you had a portfolio. And this is just some theorizing here. Let’s say you had a portfolio of equities. And you had quite a bit of insurance. Because you have that insurance in place. Are you more prone to selling your equities? When that when they start moving down? Are you less prone? Got it? Yeah, class so so that’s, that’s the thing is that when people are well protected, they’re sleeping well at night they get leads to people who otherwise would be sellers not selling in the short term, which provides support to the market and it mutes the market itself. So a lot of protection actually mutes the market, until things get really crazy. And then you’ve got a situation where banks have to start hedging where dealers, for example, have to start h