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There’s Still Time to Hedge Tail Risk — At Least for Stocks: Kris Sidial (Szn 4, Ep. 29)

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Kris Sidial of The Ambrus Group joins the podcast to discuss tail-risk hedging: how it works, why it’s important, and how investors can still take advantage of volatility mispricings to protect themselves against further downside — at least in stocks.

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Nathaniel E. Baker 0:32
here with Kris Sidial of the Ambrus group. Joining us to discuss tail risk hedging. This is a great topic. I’m actually surprised this this podcast has gone three years, actually, we’re in our fourth season without doing anything on tail risk hedging, because this is the ultimate contrarian move. You take advantage of market activity, usually when it’s good to take out insurance, at least that’s my understanding for it. of it. Obviously, there’s a lot more that gets into this, we will get into it. So let’s start from the top. Kris. tail risk hedging. Yeah, let’s maybe just start from from the basics on it.

Kris Sidial 1:16
Yeah. So you know, first and foremost, you know, thanks so much for having me on the show. I really appreciate it.

Nathaniel E. Baker 1:20
Thanks for coming on.

Kris Sidial 1:22
And I think it’s a really good topic for just the the nature of the show. Tell us hedging is one of those really esoteric niche areas in the volatility landscape? Right. Even when you think of the large allocators and investors who are in the community, even they still struggle with understanding what is tail risk, and how do you really take advantage of it. So, you know, for what we do, we have a hedge fund arm and we also have an RA form. And the hedge fund vehicle what we serve as is really like a protection airy hedge for an investor’s overall portfolio. So let’s say you have an investor that has, you know, investments in equities, alternatives, all sorts of things. Well, you would ask them, okay, what would happen to your portfolio if the equity market dropped, you know, 30% in a month, and let’s say vix went to like 70. You know, what, what would happen? And most people would say things like, oh, you know, I mean, defensive stocks, or I’m in bonds, or gold, or, you know, traditional hedges like that. But what we’ve seen over the last 10 years is that those sorts of traditional hedges have not really performed during moments of extreme market stress. Right? And specifically, this year, too, when you think of the whole 6040. Right, that’s one of the worst performing vanilla blends that we’ve seen this year. So you say, Okay, well, how do I make money in those type of environments? And, you know, entered in tail risk hedging, right, it’s that form where, you know, what we’re doing for investors is the our style of trading really seeks to generate these large returns when markets are crashing and dislocated. So in brick world, what this would look like is, let’s say, if markets are going up, we’re trading trying to be flat. When When markets are crashing, we’re trying to return, you know, 200 300%, these like, very large return is what our goal is. So it’s really there to offset the losses for an investor in their investment. Alright, and the asset, the sizing component is really crucial to this, right, because you wouldn’t put 100% of your portfolio and a tail risk catch, but which, which you would realize is that if you put you know, 5% of your portfolio in something like this, you know, it becomes non existent when markets are rallying. But when markets are crashing, the convexity is there to really offset any losses. So it’s like sophisticated insurance in a sense.

Nathaniel E. Baker 3:49
Okay. So it does go beyond just mere insurance, though, because you are trying to get returns for for this, I guess, this slice of the allocation. So, so if I’m, it’s not like I’m just giving you, I’m telling you, okay, here’s my, here’s my exposure, and hedge it. Because I guess anybody could buy puts on and just roll them over, right? It’s what you actually want to get returns. So you’re just like, I want something that’s completely uncorrelated to my portfolio. And that will generate returns during when the other ones sell off. Right. Right. Right. Exactly. So then this makes that begs the question, and you refer to trading because and you refer to this as in your at the start in your comments. The fact that traditional risk off securities haven’t worked this year, specifically bonds, right. Usually, when stocks go to hell, then bonds are kind of the safe haven that everybody flocks to not this year. In fact, since November 2021, stocks and bonds have sold off in lockstep, which is unusual. And it’s you know, obviously due to inflation and fed and such. So, what is what do you do? To protect somebody who has bond and stock exposure?

Kris Sidial 5:03
Yeah, you know, so that’s a really, really good question. And, you know, it kind of reverts back into, and maybe we’re bias here, right? Because this is our way of viewing the world. But it really reverts back into the volatility landscape and saying that like, look, you know, if you use volatility as an asset class, right to think about tail risk as its own asset class, it could really protect against these type of exogenous moves. So when you think about what’s taking place this year, a lot of people would argue and say that Well, Chris, look at the way how fix is moving. Even the VIX is not really moving. Right? So equity volatility is not really performing. And I would agree, right? It’s, it’s, it’s definitely evident that equity volatility has been quite muted this year. However, if you look from across asset standpoint, in the rates market, and in the FX market, you’re having, you know, 1015, standard deviation type moves that are going on, right, so if you had a tail risk hedge, or you know, you’re invested in, let’s say, a macro based tail risk hedge fund, you’re doing phenomenal this year, right? Because you’re those sorts of that that type of convexity is paying out in a really big manner. So I think like one of the one of the driving points of, you know, we do too, is like on an educational base, we try to sit down with family offices allocators investors, and really explain to them, if you’re really trying to make and design a holistic portfolio, there’s so many different things that you could use in today’s day and age with the way how so many, you know, products have developed, that you can have this sort of, you know, tail risk hedge fund in your portfolio, so that you can protect against this sort of crash, right, the 6040 thing, you know, there’s, there’s a better way to diversify a portfolio than just saying, okay, 6040. And that’s it. Right, you could be in some sort of CTA protection, you could mix it with long, Vol. Right, you could have some commodity exposure, it’s like, people should take advantage of all these sorts of things that are out there, and especially during a time like this, where the markets are showing you that you should be more defensively focused, as opposed to, you know, just trying to buy the dip every every single time,

Nathaniel E. Baker 7:19
which has not worked out very well. Okay, so but this is they are mostly vol based these these hedges that you put on,

Kris Sidial 7:26
you know, there’s there’s ways to do it with with multiple derivatives contracts and exotics contracts. Like, you know, this is an example that I bring up to people, many times, if you think about, you know, is it as easy as buying a put on the s&p, right? So if you think about this, and you go back to March of 2020, you’d realize, okay, if I bought, you know, some, let’s say, 10, Delta way out the money one month puts on the s&p, right, and you put 10,000 bucks into that, right, I’m just using 10,000. It’s just a regular base. Well, great, you could have made, you know, 50 times the return on that. However, you know, if you understood the way helful was in the way how, you know, vol reacts, you could have also bought a variant swap, you know, on the one, the s&p as well. And that variant swap would have paid out 250 times that $10,000 instead of 50 times. Right. So having an understanding in these structures and these payouts, you know, and these different derivatives and how you can structure derivatives, really increase the convexity.

Nathaniel E. Baker 8:33
Got it what so what is a variant swap? Just to give us an idea?

Kris Sidial 8:36
Yeah, so, you know, it’s a variance swap is, is an over the counter product, it’s a swap, that that’s really a exponential type of payout that occurs, right. So when you think of volatility, you know, people think about volatility, and they’re like, Okay, you know, volatility is something that can get going quite fast. And then, you know, you think of a variance swap, it’s pretty much volatility squared, right. So so, you know, it’s, it’s multiples of what volatility could perform, right? So it’s almost like this, this return profile is compounding. It’s not just volatility goes up, you know, two points, this is what it is. It’s it’s compounding to four to 16 to, you know, continue.

Nathaniel E. Baker 9:18
So it’s like, it’s kind of like, is it like a deep out of the money? call option of some kind or? Yeah,

Kris Sidial 9:26
yeah. So it could be looked at you can think of the payout profile. And when you’re thinking about variants in those regards, right. It could be, you know, upside variants and downside barons upside. And so on, you know, vix downside variants on the s&p, there’s a multitude of ways you can, you know, structure these sorts of things. But I think that the important thing for people to kind of get out of it, and one thing I would say is, if you don’t understand your ad swaps, you know, don’t try to go and dive into it. Really what I’m getting at is that there’s so many different types of products and there’s different ways that you can structure even less Steve derivatives to replicate the payoff profile and some of these products where you can really get that convexity for the average investor. That’s the most important part, right? It’s like, Where can I get the biggest bang for my buck when I’m thinking about hedge? Right? Like, and my, you know, my philosophy on investing is more so lead towards a barbell approach where you are long risk assets, but you have something that’s on the other side that has that offers convexity when things go wrong, right. So you only put a few dollars down. But if you’re, you know, things go wrong, those few dollars could balloon into quite a quite a big amount.

Nathaniel E. Baker 10:39
Yeah, yeah. I mean, that’s, that’s the Holy Grail. Of course, you want to be able to buy insurance on the cheap, as cheap as possible. And then get the big payouts, enough to compensate you for whatever losses you have, I guess, in your long book, and these contracts, I mean, the variance swaps, just being one example can can do that. But but they do deliver like, because like we said, like the VIX hasn’t a massive volatility, but that hasn’t really done all that much this year, either.

Kris Sidial 11:06
Yeah, that’s, that’s definitely the, you know, a quick, standout thing, right? It’s, it’s also contingent on the environment that you’re in, where it’s like, you know, you look at one month volatility, and that’s really what the VIX is, right? It’s it’s almost like replicating what a variance swap would would be or the strike. And, you know, you look at the way one month volatility has reacted this year, it’s been quite muted in equities. But if you were long swaps on, you know, FX vol. Right? Like, let’s say, even on the dollar, or something like that, right? The the payout could be tremendously large, or even even in the rates market, right. If you want swaps, or certain sort of structures and payouts, I think you could get onto a million type of of nodes with these things. My background. You know, prior to this, I spent some time on the exotics desk at a large Canadian investment bank. And really, this is what the job was, right. It’s like structuring these nodes pricing these complex nodes, like trying to hedge the risk for the bank. So that’s kind of what you know, really led me into into starting this hedge fund was that you could do things like this to help out individual investors, family offices, fondle funds, and thinking about the payoff profiles. And the convexity is one of the most crucial things when thinking about hedges.

Nathaniel E. Baker 12:23
Totally, totally. Yeah, that’s very interesting. So So basically, you’re, it’s so you have this product, I guess, your own fund, which people which is a tail risk Fund, which people would invest in. And then you also separately will consult people and structure individual to help them put on an individual swaption based on their portfolio or not.

Kris Sidial 12:44
Yeah, yeah. So for larger institutions, we definitely help out with like, custom mandates. thing, right? Because, you know, you think of the investing world, there’s so many things like so many different knows, like, if somebody asked me, Chris, can you? Can you tell me what’s the best stock to buy? Like, I would have no clue, right? That’s just not my own thing. Anybody? You know, like, that’s not my ballgame. So there’s things where there’s these, there’s firms that will outsource their hedging as well. Sure, sure. Sure. You know, I want somebody who understands this dynamic to help take care of it. So that’s kind of that’s kind of how we structure our business.

Nathaniel E. Baker 13:23
Do you have any thought? I’m wondering, do you have any thoughts on if you’ve been following the story out of the UK pensions, and these liability driven investments and how that’s all played out? And by the way, today was Friday, as we record, this was the deadline for the, I guess, the discount window, the BOE? And we haven’t heard anything from it. So I’m assuming it went smoothly. But did you look at that all you have any thoughts on that whole thing and what they were doing? Can you educate us on that?

Kris Sidial 13:49
Yeah, absolutely. So this gets into a, I’m gonna dive a little bit deeper. So at the beginning of September, and and actually in, in early June, when we wrote up our investor letters, we touched on two things. And we one of the main things that we touched on in bold letters was the liquidity in private markets, affecting the public markets, right. And when you think of what has transpired in the investing world, over the last, like 10 years, there’s been so many people that have been investing in private markets, right? So like, on paper, people are getting crazy rich on these type of VC funds, and, you know, these private investments and every single month, right, they’re up 2%, up 2% of 2%. Right? And they’re like, Well, I’m doing phenomenal, but there’s a quote unquote liquidity tax that comes with that, right, because you may be up to 100 something percent on paper, but when it’s time to pull your money out, you know, you’re not able to get the full amount of money. That’s, that’s that’s transpiring there. Right So maybe when you’re pulling your money out instead of being up, you know, 200%, you’re down 20%, which is I’m kind of exaggerating here. Right. But But there can be large disparity in this

Nathaniel E. Baker 15:11
Is this due to lock up provisions in the fund?

Kris Sidial 15:14
I would say that that’s due to a number of things, right, where like, you know, the the, the private vehicles aren’t necessarily doing as well, as you know, they were kind of making it seem right to to be able to liquidate and get that sort of cash to give back to those investors are a little bit difficult. So when a time like, like this year, where and by the way, like this was the narrative with a lot of pension plans, like family offices, pension funds, like everybody wanted private investments, specifically, since 2020, right? People are like, Yeah, I’m thinking about private markets, right? I’m not even concerned about public markets. And then what you notice this year is that some of these larger institutions are struggling with getting that liquidity out of the private markets. So what ends up happening when you are a large pension, and you have certain mandates in terms of what what, what’s the liquidity ratio that you could and should be providing? Well, that has a reflexive impact on what you can do in the public markets, right? Because in the public markets, now you’re saying, shoot, you know, in this basket, I can’t get my money out of these private funds. But as a pension plan, I need to be able to give that money to, you know, the people who have pensions. So how am I going to get that money? Where am I going to get the liquidity? Well, I need to sell in the public markets now. Right? So instead of me selling these private investments, I’m going to sell public equities, right. So US stocks, obviously, European stocks, things like that. Treasuries, and what was going on with the BOE sorry, the BOE understood that the move that was taking place in the gilt market was having a big effect with the way how these pension plans were marked, right, because these pension plans as a pension plan, you have to as I was saying, you know, keep a certain type of liquidity. And, you know, then they were talking about not supporting the pension plans, this could have a really big type of domino effect, if these larger pension plans are not funded, and it could really destroy public markets in a really big way. Right. I mean, think of a world where you have, and I’m not saying that this is the case right now. But if you do continue to see pension stress, imagine these large pensions having to liquidate their public holdings. I mean, you know, that’s what leads to stock market crashes or, you know, crashes in the bond market. So bank rounds. Yeah, yeah, absolutely. So, so that’s really what’s going on from like, a 30,000 foot view

Nathaniel E. Baker 17:55
Okay, got it. Got it. Yeah. Now, what does one do when the market has been selling off already, and you’re already down 30%. And you have to make a decision or whether you want to protect against more downside? Because you can’t really justify taking on more risk. But at the same time, you don’t know things are gonna go lower. So what does one do that?

Kris Sidial 18:15
Yeah. So that that right there, which you said is like the, it’s like the beauty in a strategy like ours, because investors who had a tail risk hedge are able to take on more risk, right? Because they understand that it’s almost like you have like a synthetic putt. Right? If you understand, Okay, I’ve had that put to the downside, like, Sure, I can max out the amount of equities that I could be buying now. And that’s the value edit, right? It’s being able to buy assets, extremely discounted when everybody else is selling, because you understand that yeah, I have a hedge of a backstop, right. This is my backstop. And if things go wrong, great. I’m making a ton of money on my backstop that’s going to offset the losses. And if things go right, well, I’m only losing a little bit of money on on that that backstop, but I’m making a ton of money on all the assets that I just purchased. And there’s something when you think about like portfolio construction, that’s covariance drag, and it’s a lot more. It’s a lot more simple than it sounds. But really, what it is, is when you take two portfolios, the one with the higher volatility in it, right, so the more the drawdowns, the returns are really decayed. So what you realize is that, if you’re able to sidestep those large, those large drawdowns, you’re able to compound gains at a higher rate. So one of the things that we show to potential investors is this chart of the s&p over the last 15 years and we’re like, Okay, if you take out this is like really powerful, in my opinion, at least, if you take out the five largest drawdowns in the s&p over the last 15 years. On a 20 day cycle, so like, let’s just say ever, like on a 20 day market crash, one of the five largest ones of the last 15 years remove that, right? Imagine if I just sidestep that the portfolio return actually quadruples. And that’s just like the biggest thing for us because it shows the value add in having a hedge because like, as a large institution, you’re talking about making, you know, $400 million, instead of $100 million over, you know,

Nathaniel E. Baker 20:31
no doubt, I can see the law. But still, those would have to be hedges that you had put on already. You know, it’s not like you can go back in time, it’d be great if you could, and we’d all be good. But yeah. So what does one do in an environment like this? So like, do people are people still looking to hedge to take on the to build these? I guess, models where that where they would gain a lot if there’s a bigger crash? Or yeah, what kind of stuff? Are you saying?

Kris Sidial 20:57
Yeah, so the interesting thing about the equity space is that vol, is still giving you a chance to hedge, you know, and if you believe, if you believe that this is a bear market, you know, historically bear markets and with large capitulations, right, that’s like a historical fact, whether you want to toggle US equities, to German equities, regardless, right, like bear markets and with capitulation. And if you believe that that is going to come, then, you know, you’re really in the band camp, that a big volatility move is getting ready to happen. And this whole sort of slow train wreck that has happened this year has still allowed people to get in and hedge. So as you know, traditionally, you wouldn’t be able to get in and hedge. But there is a still, there’s still a chance to hedge your equity exposure. However, in like, the whole effects and rates market, that’s a little more challenging, you know, we have if you have, you know, big exposure to the way how FX or FX balls are moving, you know, that would be a challenge. So I would say equities is probably the last ship that has not set sail yet.

Nathaniel E. Baker 22:03
Despite all the draw downs we’ve already seen, okay.

Kris Sidial 22:05
Yes, yeah, absolutely. I mean, you know, like, this isn’t a, this isn’t a view from us, right? It’s an it’s an objective thing. When you look at the VIX and vix balls or pricing, it’s, you know, you still have a chance to hedge the complex.

Nathaniel E. Baker 22:21
Very interesting. And what about, what about the dollar? And, you know, there’s been some talk now the Dollar Tree may finally unwind. But who knows? I mean, with the Fed still hiking rates, it’s kind of hard to see that. Is there a no space to hedge for the dollar gains? Are people willing to do that?

Kris Sidial 22:40
Yeah, that’s one of those shifts that I think he’s like, in my opinion, I think that’s kind of set sail. I mean, you look at the look at dollar skew and the way how it’s reacted, you know, people are, it’s calmed down a little bit, but then you get these these scares that are, you know, take place in the FX market, and those walls really, really start to lift up. So it’s not as it’s not as cost efficient to try to hedge now. And that’s really, you know, that’s really one of the things to win when you’re an investor that you should be thinking of is like, you know, you shouldn’t be trying to get your hedges. You know, when you when your home is on fire, right? They you should. Yeah, and it’s a psychological thing. Well, most investors, right, because when you think of like, and that’s something that we deal with, too, right? If you think of a tail risk hedge in a year, like 2021, when equities went up 20 something percent, right. Most investors want to see Oh, yeah. Are you guys making money too? Right. Did you make, you know, 20? Something percent, right, where it’s like, that’s not really the goal. Right, you shoot, if you have a hedge that is slightly down, right, but offers massive upside convexity. That is the value add. So psychologically, it’s hard for investors to really digest this, this understanding of that, but the ones that do, right, they do quite well. And you know, the one of the young things that I think about all the time is like, and this is public information, by the way, like a large prop firm, like Jane Street, right? Jane Street is one of the biggest and best prop firms that that’s out there. Not only in the quant more plot world, but but in general. And when you look at what Jane Street does Jaishree allocates a portion to just buy a ton of tails, right? They have this this thing where they’re buying a ton of tails, because what they understand is that when markets go haywire, they want to be capitalized to not only make money but put that money to use in other areas that are dislocated. So they’re okay with losing money, you know, on some of their hedge as the time goes on, and it’s just really like a psychological thing that I think most investors still have the commodity.

Nathaniel E. Baker 24:50
Yeah, no question and a lot of that gets into human nature, right? Like when things are going great. You want to lever up and juice all you can out of the returns, you know, FOMO in and such and then when things are bad you want to run away and hide. But that’s when the stuff is most expensive. So this is when obviously it contrarians make their money I guess as long as they stick to their their knitting. Yeah. So that’s that’s, that’s really interesting. Okay, Kris Sidial I want to come back and ask you some more questions, look into your background a little bit. That sounds kind of Big Brother. Not looking here, but just discuss your background, how you got into this space. But I want to first take a quick break and let our sponsors be heard. If you’re a premium subscriber, do not touch the dial, you will not get the break. We’ll be right back. In fact, we already are.

Nathaniel E. Baker 25:41
Okay, welcome back. Everybody here with Kris Sidial, the Ambrus group discussing tail risk the ultimate contrarian move, because when times are good, you want to protect yourself. And when times are bad, I guess you just want to kind of be happy that you did. A lot of people didn’t, and they are now feeling the pain. But let’s first talk more, Kris, this is the segment of the show where we find out more about our guests and what got them interested in into investing in the first place. And a little bit about their career path. As general or specific as you want to get to where they find themselves now. So yeah, take it away and tell us

Kris Sidial 26:20
Yeah, yeah. So you know, growing up, I was always focused on on staff that, um, you know, I started early on, you guys are gonna get a kick out of this. But I was into sports gambling as, as a teenager. Funnily enough, during this time, sports, gambling wasn’t even allowed in the US.

Nathaniel E. Baker 26:39
So of course you only did it legal jurisdictions.

Kris Sidial 26:46
Yeah, we’ll stick with that. But, yeah, but Well, yeah, no, I was I was interested in that. I think I always had the mentality of a speculator than I was, was definitely blessed to get a job as a junior under this veteran from the CBOE. His name is Bob cantor. You know, Bob was this big legend, coming up in the 80s. In the 90s, he ran ETG for a number of years. So very well known vol trader, and yeah, you know, learned, learned a good amount under him where I was, you know, really, I would say, getting my first view of thinking about fall in terms of like, convexity and outliers and things of that nature. Then I went on to the, to the prop side, that was part of a prop trading firm. And two of them actually, you know, one was categorized as like a buy side equity hedge fund, but was ran by a couple X GE two guys. And then I went to a large Canadian investment bank, most of my time was on the exotic derivatives and listed options desk. And when you’re on a desk like that, you know, you’re thinking about all these different sorts of pads that are taking place with the way how the portfolio is moving the way how it could move. You know, it’s just like a bunch of things that are going on in there. And then yeah, you know, March of 2020 came, and, you know, if you were an exotics book at any firm, and you know, you were long volatility, you’re done. Well, you know, and it really had me thinking about these sorts of structures and payouts, and the way how you could kind of kind of combine things from the prop side to also, you know, the sort of exotic structures and you can put together this sort of book that looks to be close to flat if markets are rallying, but then, you know, make a ton of money when markets are going down. And yeah, you know, we here we are at Ambrus. Quite the journey so far.

Nathaniel E. Baker 28:50
Interesting. So do you deal with all with structured notes? Is that part of what these exotics is? Or is that something else?

Kris Sidial 28:57
Yeah, so one of the parts in our book, it is categorized as a note, you know, sometimes, some of these like etps, and things like that, you know, the way how these payoffs are, you could kind of like, structure the listed derivatives, so that they pay off like some sort of OTC stuff. And so I think all those sorts of things are helpful into not accomplishing

Nathaniel E. Baker 29:19
you know, the reason I asked him because we had a guy at Bloomberg who ran a structured notes newsletter, and a couple times he was on vacation or something, and I had to edit it for him. And it was, it was crazy. I mean, talking about sports gambling, like you could actually, this is before sports, gambling was legal, but you could kind of structure these things like based on who wins a Super Bowl, and what the weather is, I’m gonna get a payout of so and so much about the s&p 500 You know, like, yeah, yeah, so it was pretty wild. Yeah,

Kris Sidial 29:47
yeah, no, absolutely. You know, I I get a kick out of these things, right? Because like, when you go to a casino, alright, like like then here we go into like, more so like sports betting and just being regulated. General, right? Like, if you go to a casino and you say, Okay, I’m going to play roulette, and I’m going to run a Martin Gale process on the roulette table. Well, what work, right, because one, you need an infinite bankroll. And then the second thing is that the casinos limit your betting size, right? But there’s an optimal point in you going to casino, right? Maybe you could go to the casino, you know, somewhere down the road. And the rules are different. And that changes the dynamic of the game tremendously, right? So like, when you think of like Ed Thorpe back in the days, you know, obviously, a well known hedge fund manager and trader, they had to change the game, because torque was was, you know, destroy the casinos. And when I think of like the exotics world, and you know, these sort of payouts and things like that, it’s almost like you know, you’re toggling the game, because there is a point where there’s enough value to take the bet. And as a terrorist trader, that’s how you should be thinking about things, right. So it’s like, maybe in the listed market, I’m only going to get paid out one 200 on this. But you know, if you’re structuring something on the exotic side, like what you were saying, like maybe something on the weather or something like that, right? In something that’s correlated to that same s&p type put, but you’re getting 1000 times the payout, right? I’m just making an out what I’m just saying.

Nathaniel E. Baker 31:24
Yes. How big of a systemic risk do you think that might be? Because especially if you’re the one that’s writing these, these contracts, right, because then you’re on the hook to the banks? Do they hedge that out? Or do they? They must some of it, right?

Kris Sidial 31:36
Yeah. So So we wrote a white paper in May of this year, talking about volatility in the changing microstructure and US equities. And one of the one of the things in the paper that I think a lot of people got value from was understanding how the growth of Structured Products has this reflexive type dynamic on the way how the listed options market is, because what will end up happening is, if you’re a dealer, right, post Dodd Frank, now what ends up happening is you have to keep a Delta neutral book, right? Or book that that’s somewhat limited, right? You can’t take on that same risk that you did back in the day. So what ends up happening is you go out structure these notes, price and trade them. But then if you’re doing like millions of dollars, and that you’re going out into the listed options market, and you’re moving the listed options market by as you need to hedge your exposure, right. And when you think of the crash of 2020, a lot of people don’t realize that a lot of that was driven from people that was short variance, right, these back squats, there were a ton of people for four years that were shorting volatility, shorting variance swaps and making a little bit of money. And what ended up happening is when things started to blow up, they need to hedge that right? They were hedging with vix futures, they were driving volatility up there is that that systemic risk that exists, especially because the structure products market in the US continues to get bigger? I wouldn’t say that it’s a massive risk right now. I’d say it’s, you know, still very well contained and small. But it’s an area that, you know, with anything in financial markets, if, if there’s too much concentration in there, it could become it could become a hazard eventually. Yeah.

Nathaniel E. Baker 33:24
I mean, the fact that the banks have to no longer have their own prop desks is huge. One would think in terms of removing that risk. But then there’s others that are that we maybe aren’t aware of it. And that’s why the whole pension thing kind of was because the pensions are these massive, massive, you know, large pools of capital, and they’re doing all kinds of stuff. So maybe, yeah, and there’s a Counterparty on the hook there somewhere. So yeah, one thing I like to ask maybe, towards the end here, is, and I’d like to ask this as people on you as a tail risk guys is particularly pertinent. What right now, as you go up at night, proverbially, I’m not asking you about your sleeping habits, but what is what are you worried about?

Kris Sidial 34:08
One of the things about being a tail risk manager is that you have to understand that things are tail risk, because you’re not able to see it coming. Right? It wouldn’t be tail risk. If you could identify it right —

Nathaniel E. Baker 34:23
You never see the bullet that kills you.

Kris Sidial 34:25
Yeah, no, that’s, that’s, that’s absolutely true. And we really operate on that belief that no matter what, we won’t be able to see it, we won’t be able to time it, you know, it’s pointless and trying to identify it in time. And even when you look at everything that’s going on right now, right? Like, I feel like every single day, I’m waking up and you’re seeing some sort of new headline from, you know, something going on Russia to, you know, the potential issues going on with with China and Taiwan. You know, obviously domestic policy in the US, you know, is really big year hearing about this thing from the BOE in the market, right? Like, I personally think that there is a systemic hazard that is taking place under the hood right now in the derivative market. Um, you know, now a lot of people, I think, fully understand the reflexivity that exists in the US equity market because of this derivative exposure. When you look at what this driver is, a lot of it is like zero DTE options, right? Because of more and more and more more options are being kind of put out there, right, more gamma hedging that’s taking place between these these dealers and the exposure that they’re that they have to, to, to kind of account for. And we saw it during 2021, where, you know, you saw the whole Gamestop thing. Right, the whole AMC thing, and everybody was like, Oh, this is what dealer gamma hedging is. But that’s just one small pocket, right? This is taking place on the index level, this is taking place. And, you know, people will argue that, yeah, that’s being offset by other additional flows. And I agree with that. However, my view is that when you’re faced with an exogenous event, right, when you’re faced with an event where everybody wants to hit the exit doors the exact same time, and these are the way options are being traded, you’re gonna see a very, very different market. And we’ve yet to see, right, because this year, the sentiment has been negative, but there’s not been any panic. And I think that’s undeniable, the way outfalls are priced. And if you just talk to people, right, like, I feel like I talked to no more investors than the average person, you know, and a slew of different investors from high net worth individuals, to really large institutions to you know, just people who are family offices, and, you know, just some personal friends. And nobody seems to be in panic, right? Everybody’s like, yeah, you know, my portfolio is down, like, you know, 10%, or something like that, and not that bad. But, you know, you start talking about sliding down, you know, 20% more, and people don’t really fathom that, right. They’re like, ah, you know, that’s not going to happen, you know, and but the reality is that this is not markets work, right, it can happen. Um, and the hazard that I see coming from that is, if people start all panicking at the same time and an exogenous event, right, if God forbid, there’s some sort of nuclear bomb or something like that, right, it could really create this reflexive market that gets driven down much, much, much faster than then people believe. So when people talk about, you know, and this is in the white paper that we discuss, when people talk about 1987, can’t happen, again, because of the circuit breakers. And you know, structurally, things are different. I hate to sound like a perma bear, you know, just like the crazy guy in the room. But the view is really that the stock market is showing you that it can move, you know, seven or 8% both ways, in a matter of less than, you know, two trading days, it’s showing you you can do that, if things go haywire, it can absolutely go down 20% a day. That is like a undeniable fact. So, I think structurally, some things are very different in this in this market. And I think that, with all the tensions that are going on, it’s just something that people have to account for much tighter than they personally did. You know, a lot of people, I think, have this view that they can tactically get out of markets before something happens and, and CPAs have done well doing that, you know, specifically this year CPAs have done tremendously well. But, you know, if you play the game long enough, you’re gonna get double zero a couple of times, and you’re bound to have a day where you wake up where the market is down 10% overnight is it’s just a fact. Right? Like whether you know, whether it comes tomorrow or whether it comes in 510 years, like that will happen. Right. And I think that structurally, everything that we just mentioned, amplifies. What can take place if that happens.

Nathaniel E. Baker 39:11
How much of a risk is it that the regulators are kind of asleep at the switch? Or? I mean, Dodd Frank, that sounds like it was probably pretty good legislation, as we discussed, but I just remember seeing you get back, go back to the Gamestop thing last year, was early in 2021 day those hearings in Washington, and all these senators and congressmen got up and, and I was shocked. I shouldn’t have been maybe, but I was shocked at just how idiotic these people were. And just how clueless when it comes to like very, very basic stuff, like the difference between private and public markets. Like it was just not something that seemed to seem to be aware of. Yeah, absolutely. That’s high level, right. These aren’t people the CFTC or whatever. But still, yeah.

Kris Sidial 39:56
Yeah, you know, like that’s one of the big things that I would say to is that, you know, when I look at, when I look at some of what was said during those meetings, and you know, you go back and view them, you can tell that there was a little bit of like, chess puffing out, right, where people just wanted to say things to act like they were an authoritative figure. Right. Whereas they were kind of not really getting to the crux of, you know, what was going on what went wrong, like, structurally what was going on, some people didn’t want to acknowledge that. So it was like, it’s almost like everybody had their time to shine. And they were trying to use it as a time to shine, as opposed to like trying to figure out like, the sort of structural flaws and how to potentially fix it, in my view, and there’s a lot of people who are derivatives traders that would argue the against this, but actually think Dodd Frank harm, harm the market to an extent because it adds to this reflexivity. And I’ll give you guys like, I’ll give you a perfect example. Right? If you were a trader, on a desk back in the day, and Apple stock was going against you, right? You could inventory more Apple stock, right? And some people would say, Okay, well, that leads to larger blow ups when they occur, right? Because you’re able to just say, No, keep giving me Apple stock, you know, forget it, I’ll buy more, buy more. But today, what ends up happening is that, you know, if you’re, like, if you have, like, let’s say, let’s say you’re short, Apple puts, right, as a dealer, so like, let’s say somebody comes in and buys Apple pellets, right? What do you have to do? Well, immediately, you have to sell Apple stock, right? Because you have to be delta hedge. And if you’re doing this with large enough size synthetically, that’s driving the price of Apple lower, right, as the delta in the puts are increasing, so you’re synthetically driving the market lower. So that excess frequency to hedge which is what Dodd Frank can implement, right, Dodd Frank pretty much said that, you know, like, got, you can’t take speculative risk, and you need to hedge up this risk. So it leads to more excessive hedging, which leads to these type of cascading effects, as opposed to, you know, what you saw previously, in prior to Oh, wait. So so, you know, I’m not intelligent enough to understand structurally how to suggest a better regulatory fix in the markets. But I do think that there are some things that, you know, are not as, as not as secure, as most people think, you know, like most people, especially, especially, like, on the regulatory side, you know, and if you sit in front of screens and engage in markets all day, you start realizing, like, oh, shoot, like, I shouldn’t be doing this, you know, like, one of the big topics Goldman had early part of this year was that the top of the order book, The liquidity has been pretty light in the Yes. And that’s really true. It’s like, you know, we’re not a huge hedge fund by any means. We’re a small size hedge fund, and we could come through, and, you know, really tackle the order book, which is like that, that’s kind of scary when you think about that, right? At certain times of the day, if one smaller size hedge fund could come in, and really move that, that that market that way. Um, so yeah, I wish I had an answer. But

Nathaniel E. Baker 43:19
no, that was pretty, pretty interesting answer right there. How much of it is that the counterparties? have been a little bit more obfuscated? Because it used to be Yeah, you would, you would know who these people were. And now if it’s all hedged out, like, where does it go? And do we know who’s holding this stuff? And who’s on the hook? And to unravel this? Wouldn’t it take more time? Or is it not that complex?

Kris Sidial 43:39
Yeah, no, so So that’s the other thing too, is that, you know, you think about the exposure and where the exposure is going. And I have this argument that everybody is exposed to the same thing, you know, when you talk about when you talk about, you know, the, the growth of ETFs, right, and the growth of passive investing and, and the growth of some of these, these pension plans and things like that. And I use this example, if you walk into a room, a bar on a Friday night, how many people in that room is in some way shape or form invested in Apple, Amazon Tesla, Facebook, right? It’s like, it’s like correlation with in this market is tremendous. We haven’t we just haven’t been like, we haven’t experienced it yet. But if you’re faced with that sort of crash, you know, that sort of panic, you will experience that because there’s, there’s no way that everybody’s holding the same thing. And then you think of like, the black rocks of the world, right? And State Streets of the world and these huge US institutions that are just packaging the exact same thing and just tossing them off to people. And, you know, it makes you wonder like, oh, wow, like, I wonder if like Apple stock, you know, crashes tomorrow, you know, how much of the market it will draw down with it. Right? And I’m not talking about Slow grinding, I’m talking about like a real crash. So I think concentration of risk is much more relevant in this market when you experience a crash than almost in any other market.

Nathaniel E. Baker 45:11
Yeah, I mean, if you look at a 13 F’s you mentioned BlackRock, I wonder if you could find a single s&p stock where Blackrock isn’t listed on the 13 apps at the top. You probably can’t, right. I mean, seriously, have you ever seen a stock or like looking at? Maybe you can, I don’t know, maybe the smaller ones. But yeah, that’s, that’s just illustrates what you’re talking about. Very good. Interesting. Last question. I want to ask any thoughts on digital currencies? Kryptos. and such? Yeah, I mean, I afraid of that. Let’s see where it goes. Yeah,

Kris Sidial 45:45
no, no, you know, I think, um, I think it’s, it’s an interesting time, I’m not a, I’m not a crypto trader, by any means. Um, you know, I think just from a timing perspective, you know, starting starting this hedge fund and stuff like that, and over the last three years has been taking up the majority of my time, so I’ve never really like dabbled in crypto, but from a from a guy who’s a trader, you know, I’m looking on the outside. And I’m saying that, generally, when you think of times of opportunity, they come when, when everybody don’t, like, doesn’t want to touch it. So I think there could be some opportunity there, you know, are kind of throwing everything out. And there’s some stuff that’s nonsense that was obviously uncovered this year, right? Tons of scams and frauds. And, and all that’s getting, you know, kind of kind of weeded out the same way, like in 2001, right? Like, it uses the exact same thing like 2001, where all these sort of like, tech scams kind of got weeded out. But when you look forward, you know, four or five years, you realize that while there were some core, you know, tech companies, and I think we’re seeing the exact same thing, you know, so I won’t stand behind any coin or anything like that. But I do think that it is an interesting area, that that could be making its way into the way how the economy works. Going forward,

Nathaniel E. Baker 47:07
even though there’s no use case for it, the current for the actual currencies.

Kris Sidial 47:11
You know, that’s the other thing too, is that I think it’s a more so saying, I’m moreso talking about the technology itself, okay for the blockchain technology, and yeah, that’s what I said. I’m not saying Ethereum or Bitcoin or anything like that, because, you know, there’s you’re hearing talks of, of, you know, some some sovereign funds, talking about the interest in governments making some sort of Digi coin and things like that. So there could be that right, but I’m more so talking about the technology.

Nathaniel E. Baker 47:45
Yeah, that’s that’s certainly interesting. Yeah. We’ve had a little bit of talk about that. On here. All right. Cool. All right. Chris city. Oh, thank you so much for joining me contrarian investor podcast today. Very interesting. And off the cuff conversation here, which hopefully left our listeners with a lot to, I’m sure it did think about. So with that in mind, can you tell us where they can find out more about you? Potentially? How do you get in touch? And I’ll put that in the show notes along with if you if you if it’s public, the white papers you mentioned those as well.

Kris Sidial 48:19
But yeah, absolutely. So you guys can find me on LinkedIn, Kris Sidial. And yeah, our link for the white paper. It’s floating around out there, feel free to reach out on Everest group.com and provide it to you as well. But yeah, you know, if you guys are thinking about any tail risk stuff, feel free to reach out. We always like talking markets.

Nathaniel E. Baker 48:48
Cool. Cool. So I very interesting, Kris, thank you so much for joining us today. Thank you all for listening. And with that we leave you. I look forward to speaking to you again next week. See you then.

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