Link: https://blog.thinknewfound.com/podcast/s2e7-wayne-himelsein/
About Wayne: CIO of Logica Capital
Transcription: Otter.ai
Overview
Every trade is implicitly long or short volatility or optionality
- There is variability in every asset and its distribution dictates whether you are long or short.
- Every trade is either a bet on convergence or divergence. Convergence trades are short volatility
Quant vs Discretionary
“There’s good and bad in all of it. So the best you can do for yourself by going with what you know because you’ll be able to ask better questions and be more comfortable with what’s happening day-to-day.”
- Myth of quants building a black box then “going to the beach”
“The market is always changing. In fact, it’s funny even the idea of factors and categories, if you think of something like value and growth. These two big facets of the market, even those are evolving. [Consider] that you buy a value stock, and it turns around and starts moving in your favor. Well, now it’s a growth stock. So literally, the categories are changing on us. So if you bought a value book, and you leave it for six months, you’re now a growth book, if you were right on your picks.”
- Using quant to “mechanize” what works vs mining for patterns
“Finance algorithms that developed from logic and experience that simply seek to mechanize what is already well understood, have a chance at success. Those that begin in data analysis, categorization, quantification, or statistical or numerical gymnastics do not.”
Opportunities in volatility trading
Traders have different “assumptions across the volatility surface, the strikes up and down and across the calendar upwards and outwards, There are different prices for every option. Because of all this modeling and people having demand for different options at different calendars in different strikes, there’s going to be cheaper and more expensive….Take advantage of the weirdness and pricing and model variants across the option surface.”
An inverse relationship between signal strength and opportunity size
- As your signal strength declines you need to diversify more. “To have more probabilities repeated more often, [so] more positions”
- Hoffstein: “Information ratio is equal to your information coefficient times square to breadth. If you have to lower your information coefficient, but your breadth goes way up, you can actually end up with higher information ratio”
Re-phrasing a bit: expectancy scales with number of trials but volatility scales with square root of number of trials. If your bankroll is large and your business diversified, it follows that your focus should be on hunting for high expectancy games, not minimizing risk.
Evaluating a strategy
- Use daily returns to get more data points. Monthly returns mask too much.
- Are you achieving your premise?
“So you’ve said yourself, I know where I want to neutralize, and I know where I want to get my alpha. And if that’s where you get your alpha, you have to know that number one, you have alpha there. So if you look at your growth tilt and measure that against Fama growth factor, do you beat it? If not, you’ve got no edge.”
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- Map the strategy.
- Compare the exposures to time series of different exposures to see how it behaves. This requires using mathematical tools that do not rely on linearity (ie regressions).
- “I don’t ever listen to what [the manager] tells me. I just run it versus we have in here about 180 different exposures that we have time series for factors or exposures [to find out] “what is inside this thing?”
- How intentional are the exposures?
- Managers will tell you that they’re doing something but don’t even know what they’re exposed to. “Did you know you have a 30% exposure to momentum? Oh, no, I didn’t. I’m actually a value investor.” (Me: sounds similar to performance attribution frameworks behind “hedge fund replication” strategies)
- Compare the exposures to time series of different exposures to see how it behaves. This requires using mathematical tools that do not rely on linearity (ie regressions).
- Map the strategy.
Risk
Beta is a poor quantity to use to balance your portfolio
- Beta equals correlation times vol ratio
- It’s easy to compute which makes it popular
- …but since its inputs are non-stationary, non-linear and themselves volatile it’s garbage in/garbage out.
- Important to understand if a beta-hedge portfolio will bleed longer or shorter as correlation increases. (Me: This is why gross exposures are important to constrain)
- How to balance a portfolio without relying on beta?
- Geometric approaches that account for non-linearity
- Clustering distance approaches
- Stochastic dominance
- Geometric approaches that account for non-linearity
Market neutrality is a “funny” concept
- What does it mean to even be neutral?
- “What do you want to be neutral to? Are you directionally neutral? Are you factor neutral? You can [initiate] a directionally neutral portfolio that has equal long shorts, with a complete growth, tilt, or a value tilt or some other factor tilt like a volatility tilt.“
Overcrowding
“If we find a good pair trade, rest assured, many others have found it. And there’s just gobs of computing power, and PhDs and all the rest doing the same thing. And so we’re all going after the same edge. When things start to go wrong, the differences between the different groups is that they manage the risk differently. And one of the best means of managing risk in these markets [is to manage leverage]. The overcrowding risk is that everybody’s in this trade, and it’s a good trade. That’s why everybody’s in it. So you’ve done the right thing. But as some of these bigger shops start to unwind, it becomes everything going the wrong way. Others are needing to exit because they have LPs to answer to or they have risk that they’re managing to, so as long as you’re in it, you’re exposed to that. And it’s difficult to manage because at the get-go, you made the right bet.”
Walking away or sticking with a “broken” strategy?
Difficult question since the pricing may be more favorable as anomaly gets stretched but unclear whether the relationship will revert and on what timeline. There’s career risk is sticking with it vs the weight of the historical evidence for the opportunity.
“The more your measure won’t determine whether something’s out of favor, the more time you might give it to try to fix it”
“Comes down to a personal decision. How much time am I willing to spend tweaking and contorting to try to figure out whether I can fix it. And we all have our limits. It comes down to a business question as well. It’s not just tweaking and contorting and trying to fix it. But how much time can you spend defending it? How sticky is your capital? Even if it does come back still be in business?”
An easy example was the trade that shorted both the triple long and triple short ETFs on the same reference asset. The trade was over once the cost to borrow the shares exceeded the edge in the trade. This was easy to measure and therefore abandon when it became too crowded.
Hedging non-linearity or skew
- “The only way to get rid of the left tail is to balance it with the right tail. And to have that obviously, you have to have the right offset temporarily. You need the time association to match that when this thing goes down, the other thing goes up. So you need to understand the time relationship between the two.”
- Stop-losses are “synthetic left tail mitigator”. They are not fully reliable because of:
- Gaps
- Discipline
- Tradeoffs between hit rate and cost of the hedge. Need to define what type of exposure you are ok with to target the right option hedge. Just like insurance has cost levers like premiums, coverage amounts, durations, and deductibles options portfolios can be custom tailored.
- Flight to quality assets like gold, USD, treasuries in a permanent portfolio
- Managers who engineer defensive market-neutral portfolios
- Stop-losses are “synthetic left tail mitigator”. They are not fully reliable because of:
Final words on hedging
- Depending on the nature of the crisis hedges behave differently. Since we cannot predict the nature nor timing of a crisis it’s best to be diversified across hedges.
- “Back to the larger insurance analogy, you have your medical and you have your dental and you have your vision. And so I don’t know where I’m going to get hurt. But either way it’s covered.”
- Tolerating the cost
- “Optionality being potentially the heaviest cost again, to me, it’s not expensive when you get what you want. But since it is more often a bleed than a payoff, perhaps people should have more treasures and gold and a little bit less optionality. But definitely all concurrently.”
Thought experiment
You can only own 1 asset and never trade it again, what do you pick?
SP500. The only reason people underperform the market is they want to control volatility and liquidity needs. But if we remove these concerns the best thing is to just own the market in perpetuity.