Moontower #111

Friends,

This week I published the 3rd and final post in a series of recent reflections based on what I am seeing around me in financial markets and my own blindspots. I’ve been overwhelmed by the response to them especially since they have a combined reading time of 45 minutes.

The final post is entitled Talking To Diamond Hands. The message is a simple but heavy idea: risk is deeply personal.

What you’ll find:

• How finance brains think of risk and how it can make them narrow-minded.
• How wide a range there is how normal people think of risk.
• A script for finance people to help normal people clarify the difference between risk and their investment thesis.
• How an empathetic approach to seemingly insane risk management can teach you about what people really desire.
• Setting personal goals. You are not your neighbor.
• And of course a description of risk management approaches that match your goals.

Many, if not most, of the diamond hands crowd don’t understand risk. But many “risk” professionals fail to recognize that risk in its most abstract sense is the possibility of not meeting your goals. The practice of risk management is a set of tools to tack a course to a goal. But goals vary widely, so what’s risky depends on what the final destination is. Divergent goals, demand divergent strategies. The risk professional’s expertise (I’m picturing Ben Stiller’s character in Along Came Polly right now) is not really what you need.

You need self-awareness.

You must be intentional in your goals. They are yours alone. Even if those goals are grandeur (or “thymos”). The line between recklessness and chasing a dream depends on how honest you are with yourself and your family. Own your goals so you can strategize for them. Own your risks so you can have a chance.

To read the full post, continue to Talking To Diamond Hands (22 min read)

If you missed the first 2 posts, you can find them below.

1. Why Investing Feels Like Astrology (19 min read)

2. How I Misapplied My Trader Mindset To Investing (14 min read)

The Money Angle

The corner of finance Twitter or #fintwit that is concerned with options (#voltwit) is a melee lately. There’s passive aggression in the form of subtweets and outright battles on people’s timelines. I won’t re-hash the feuds but there are 2 categories of accounts catching heat:

1. Clever sounding accounts with weak track records

   They are accused of being marketers without substance to back it up. It’s the “podcast-appearances-as-contra-indicator” effect. If those with edge stay quiet, the silver-tongued must be imposters. Of course, the asset management business is not this cut-and-dry (Twitter Spaces would actually be a fun venue to dissect why this is a grey area if anybody wants to tackle it). There are good reasons why genuinely strong managers talk. But also, a weak manager that may have been lucky might not talk. So the podcast-hopper can be the real deal, and the podcast non-hopper can be hiding, content to profit from their own private, captive audience.

2. People whose followings dwarf their accomplishments

   Some of this stems from people being haters (or worse…there is some terrible behavior out there). Some it stems from people who have hard-earned reputations feeling like their craft is being diluted or sullied by imposters. It reminds me of “Batesian” mimicry in nature. The harmless Kingsnake mimics the colors of the venomous coral snake as a form of defense. It can fool many predators…except the real coral snake itself. Game recognizes game. And game also recognizes not game.

A few thoughts about this:

• Some of the malice has been fired at young people who are outspoken and trying to build businesses but are also upfront about their lack of relative experience. The rules of engagement about what is out of bounds and what isn’t is self-regulating by bystanders. The crowd is the arbiter of decency. This is probably the strongest reminder I had of the trading pits and I didn’t even include it in my post Twitter Reminds Me Of The Trading Pits. On the trading floor, there were exchange rules just as Twitter has user policies, but there is lots of latitude within the rules that are governed by social norms and enforced by the community.
• For people that are using social media to grow their influence, they risk living and dying by the sword. Furthermore, I think most pros would tell you that the conversion rate of influence to institutional money is close to zero. Retail is different, but still, the verdict is out on the ROI of social efforts and in what segments it might be more effective. I suspect it’s far more effective in say self-storage syndication (the irony of using Moontower as a subtweet in a discussion of subtweets IS why you’re here right?) than raising money for a factor ETF.
• Benchmarking a track record in the options world is tricky. The vol community is not homogeneous. There are long vol funds, risk premia funds, over-writing strategies, tail funds, and absolute return or vol arbitrage funds. In addition, the bulk of the capital in the vol trading space is held by private market-making firms like Citadel Securities, SIG, and Jane Street.

With that context, here’s a few related links:

• Chris Cole Explains How To Build A Portfolio That Outperforms For 100 Years (podcast)
  Bloomberg Odd Lots

  3 key ideas:

  1. “Prepare not predict”

  You don’t know what the future holds, so you should diversify for all weather

  2. The recency bias in almost all investing advice you see today

  The conventional wisdom in the US would look nothing like what the Japanese believe. Sure, we might be exceptional, and there are many differences between the US and other developed nations. But if that’s your bet, at least know that you are making it and not ignoring broader base rates.

  3. Sharpe ratio is useful at the portfolio level, not individual investment level.

  He uses a powerful and correct analogy. Your portfolio is a team of complementary players (investments). If they are all scorers your team cannot win in the long-run. Long vol and long tail strategies look terrible in isolation. If you fail to appreciate the impact of convexity and correlation in portfolio construction, you don’t understand diversification. You are a baby who can’t reach the pedals. A good starting place for learners is The Diversification Imperative.

  Overall the episode is an outstanding reference. It’s one of the first places I’d point a novice who was starting to learn about portfolio construction. That said, there is one section that I (and probably other vol folk) find distracting to the whole message, but it should not lessen your view of Chris’ understanding of proper diversification. [That’s the section about back-fitting vol surfaces to extend the history of options to a time before they were listed. The purpose is to backtest a vol allocation. But since options markets are forward-looking any constructed implied vol history is doing more hand-waving than a pageant winner. Backtesting a vol allocation even with the official history is a highly speculative exercise since options markets have evolved so much. I’d have little confidence in any assumptions about liquidity and slippage to say the least.]

• Speaking of #voltwit feuds. Here’s a well-respected but anonymous account, @quantian1, going after Chris Cole. This tweet is a doorway to a deep understanding of portfolio construction. How did it go down?

  1. Quantian called out Chris’ poor returns.

  Chris’ published returns for his stand-alone fund fall way short of how smart Chris sounds (and is). This would seem to make him a target for a seasoned anonymous account (the reason anon accounts can be extremely credible is that many employers forbid social media presences, so many professionals will not use their own names. But the ecosystem is pretty efficient at recognizing who is legit despite the alt identity. I find that anon accounts serve the same truth-finding function as short-sellers since they can speak freely).

  2. Quantian’s critique is sophisticated because Quantian understands the value of tail strategies:

  I love tail risk funds, and I love the idea of diversifying with a high-vol, convex asset. But this isn’t that! This barely has more vol than a t-bill. It’s *less* volatile than a 30-year zero. You need to allocate a *huge* chunk of capital to this to have it work. If you had a fund which was routinely posting +30%, +40% months in a crisis, and was +100% in March, then that’s absolutely worth paying 2 and 20 for a 5-10% position in. But if you’re a vol fund up a measly 150 bps in Feb of 2018? That’s not worth the price of admission. If you are selling tail risk insurance, it needs to be as capital efficient as possible to allow your investors to maximize their beta exposure elsewhere. Imagine if insurance required you to post collateral equal to half the car’s value- nobody would buy it, it’s not insurance.

  3. Chris responds head-on to Quantian’s critiques but in private. Here’s what Quantian revealed:

  Let it be known that Chris has graciously responded to my questions about vehicle structure to a sufficient degree that I consider this beef “squashed”. The fund is a small component of assets relative to SMA overlays, which are adjusted to fit the client and perform quite well

  Quantian’s “apology” is pretty on-brand:

  I do consider the willingness to engage with anonymous trolls on Twitter, many of whom live in basement apartments and drink Leoville-Las Cases because they cannot afford Latour, to be a positive characteristic in an investment manager, so he gets bonus points for that too.

  Chris has been building a brand in public for over a decade, he’s a popular speaker at vol conferences and well-respected within the industry. On the one hand, you could say what Quantian basically said: for an investment manager to indulge an “anonymous troll” is gracious. But it’s not gracious, so much as tactical. It was actually a strong move because Chris defended himself from a formidable, well-respected adversary competently. This actually makes him stronger. Going back to my first bullet about these #fintwit feuds…how many investment managers are not willing to expose themselves to the scrutiny? Live by the sword or avoid public battles altogether.

  I should call attention to a wonky extension of this discussion. It’s the importance of the tail allocation living under the same umbrella as the risk-on investments to maximize the synergies of portfolio margining. This lessens the drag of the hedge and demonstrates why vol “solutions” often make more sense than stand-alone tail funds. It’s an adjacent discussion to why you want individual managers to run their strategies at as high a vol or leverage as possible subject to prudent margin management. This is more fee efficient. Too bad many professional investors don’t understand fee math. But this principle is also important because it means that vol is best managed at the portfolio level and not the individual manager level. If there is an investment that has an annual volatility of 40% and the equivalent fund running at 20% and they have the same fee structure you should pick the 40% vol version and allocate half as much. Notice how this incentive is the mirror opposite of an asset-gathering manager — they want to run maximum diversification to keep their vol low and the assets sticky.

  [And if you really want to examine incentives, think about the PMs at the fund. The non-equity owners want maximum vol since their downside is just losing their job, but their upside is a percent of their performance. Their equity-owning counterparts want the assets to stick. Notice how the non-equity-owning PM has the same incentive as the LP, not the GP.

  Comp structures, just like fee structures, are about shifting incentives to create alignment. But there’s a lot of haggling under the hood that looks an awful lot like options trading. When you negotiate comp, do you ever wonder who the patsy is? Or do you think you are in the ballpark of fair value AFTER considering all the levers/scenarios.]

Permalink to this week’s Money Angle: On #Voltwit Melees

Last Call

A couple items that piggyback on the money topics for this week:

• Unofficial List of The Best Deals Ever (thread)
  @TrungTPhan

  Having diamond hands is easier when the investment is illiquid and you cannot sell it. This thread lists the greatest investments returns of all time (min of $1b).

• Corey Hoffstein Interviews Tina Lindstrom on Commodity Volatility (podcast)
  Flirting With Models

  Tina has been a friend since I joined SIG in 2000. She’s a partner at First NY where she manages their commodity volatility business (the same sandbox I’ve been in for 16 years). She shares some great trading stories (the astrologer story is a long-time favorite) and does an outstanding job explaining what it’s like to trade commodities and options.

  Follow her on Twitter: @moreproteinbars

  If you want to hear more about Tina, Yinh interviewed her in 2019 on Growth From Failure (it still stands as one of the most downloaded episodes of GFF ever).

From my actual life