Download Volatility of an Impossible Object Risk, Fear, and Safety in Games of

Volatility of an Impossible Object
Risk, Fear, and Safety in Games of Perception
Note: The following research paper is an excerpt from the Third Quarter 2012 Letter to Investors for
the Artemis Vega Fund LP published on September 30, 2012.
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Volatility of an Impossible Object
Risk, Fear, and Safety in Games of Perception
The global financial markets walk on the razors edge of empiricism and what you see is not what you think, and what you
think may very well be impossible anyway. The impossible object in art is an illustration that highlights the limitations of
human perception and is an appropriate construct for our modern capitalist dystopia. Famous examples include Necker’s
Cube, Penrose Triangle, Devil's Tuning Fork, and the artwork of M.C. Escher. The formal definition is “an optical illusion
consisting of a two-dimensional figure which is instantly and subconsciously interpreted as representing a projection of threedimensional space even when it is not geometrically possible” (1). The fundamental characteristic of the impossible object is
uncertainty of perception. Is it feasible for a real waterfall to flow into itself; or for a triangle to complete itself in both
directions? The figures are subject to multiple forms of interpretation challenging whether our naïve perception is relevant to
understanding the truth. The impossible object is of vast importance to mathematics, art, philosophy and as I will argue...
modern pricing of risk.
Modern financial markets are a game of impossible objects. In a world where global central banks manipulate the cost of
risk the mechanics of price discovery have disengaged from reality resulting in paradoxical expressions of value that should
not exist according to efficient market theory. Fear and safety are now interchangeable in a speculative and high stakes game
of perception. The efficient frontier is now contorted to such a degree that traditional empirical views are no longer relevant.
The volatility of an impossible object is your own changing perception.
Our cover illustration pays homage to M.C. Escher’s 1961 masterpiece Waterfall and is intended to be an artistic abstraction
of the self-reflexive mechanics of modern monetary theory. In a capitalist cityscape the aqueduct begins at the waterwheel of
monetary expansion churning out a torrent of boundless fiat currency that streams through the dense metropolis. The river of
money flows from the edge of the aqueduct into the waterfall of deflation and then over the waterwheel suspended in a neverending cycle of monetary expansion and crisis. Beneath the city the fires of inflation burn threatening to one day consume the
monetary mechanism. Is the reflexivity of flowing fiat currency the solution or the very source of the paradox? We don’t
know.
Likewise how certain are we that the elevated two-dimensional prices of risk assets and low spot volatility have anything to do
with fundamental three-dimensional reality? In this brave new world volatility is an important dimension of risk because it can
measure investor trust in the market depiction of the future economy. The problem is that the abstraction of the market has
become an economic reality unto itself. You can no longer play by the old rules since those rules no longer apply. I know
what you are thinking. You didn’t get your MBA to be an amateur philosopher - your job is to make cold-hard decisions about
real money - not read Plato. You are out of luck. For the next decade this market is going to reward philosophers over students
of business. Why? Because the modern investor must hold several contradictory ideas in his or her head at the same time and
none of them really make any sense according to business school case studies. Welcome to the impossible market where…
Knowledge is not what you know but certainty in what you do not
Volatility is cheap and expensive at the same time
Fear is a better reason to buy than fundamentals
Risk-free assets are risky
Common sense says do not trust your common sense
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The Great Vega Short in the Impossible Market
Global central banking is the architect of the modern impossible
object. On September 13th the Federal Reserve touched off a
speculative frenzy in risk announcing QE3 in the form of
unlimited $40 billion monthly purchases of MBS, low-rates until
“at-least mid 2015”, and the continuation of Operation Twist in
an effort to stimulate job growth. Across the pond the ECB also
agreed to fund unlimited purchases of Euro-zone debt to tame
the sell-off in Spanish debt. Massive injections of monetary
stimulus by the world’s two largest central banks have reignited
another round of international currency wars motivating central
bank action from Japan to Turkey. In the face of a faltering
global economy nearly all asset classes rallied during the quarter
including domestic stocks (+5.75% SPX), international equity
(+6.08% EFA), high yield bonds (+1.93% JNK), gold
(+10.83% GLD), oil (+7.25% USO), corporate bonds (+3.49%
LQD), and USTs (+0.49% IEF) as volatility fell (-7.9% VIX).
It is the Goldilocks bull market of fear. The data is just bad
enough for monetary authorities to keep printing but not so bad as to usher in the next deflationary collapse. If the Fed follows
through on its promise to buy MBS indefinitely they will own the entire market in a decade (2). In addition the Fed is already
the world’s largest holder of US treasury bonds and currently owns all but $650 billion of the bonds maturing from 10-30
years(3). To appreciate the cumulative effects of this stimulus consider a research report released by the Federal Reserve in
2011 that concluded since 1984 a staggering 80% of the premium earned from domestic equity was achieved in the periods
leading up to FOMC announcements(4). How ironic.
As expressed in past letters, in the mind of this volatility trader the current paradigm of monetary stimulus may best be
understood as the greatest leveraged volatility short in economic history (“The Great Vega Short” Artemis Q4 2010). The
monetary policy of asset purchases is analogous to continuously rolling “naked” put options on the global economy and
reinvesting the premium to collateralize the system with the goal of short-term growth at the expense of long-term systemic
risk. In the case of QE3 this policy action is quite literally a volatility short because the purchase of MBS is also a
simultaneous sale of pre-payment optionality. The stimulus regime socializes "tail risk" to generate short-term prosperity.
Despite higher asset prices experimental monetary policy seems to be doing very little to support the middle and lower class.
Following QE2 GDP growth actually slowed down from +2.4% to +1.6% and unemployment adjusted for discouraged
workers went from 22.5% to 22.7% according to shadow government statistics (5). The middle and lower class do not own
stocks and they cannot buy homes because they remain overleveraged. Raising bank profits has not helped the economy
because credit cannot be extended to households that are in debt. For example less than 1% of all mortgages originated in the
past 18 months went to borrowers with an impaired credit history, and 1 out of every 5 homes sold was purchased in an all
cash deal by an investor rather than a live-in homeowner. Every $1 increase in equity prices raises consumer spending by just
3 to 5 cents so a 10% increase in stocks will add, at best, 45 basis points of GDP growth to the US economy (6). In addition by
keeping interest rates artificially low the Fed is creating a large funding gap for pension systems and other programs leading
up to what could be a demographic time bomb. It is very hard to justify the risk to reward payoff of this monetary experiment.
The defense of quantitative easing rests largely on an assessment of what would have happened to the economy absent its
support. Nonetheless we should fear the law of unintended consequences because it takes a very small shift in perception to
result in uncontrollable socio-economic change. We may get higher asset prices today but at the expense of inflation, class
warfare, social unrest or something even worse tomorrow.
Right on the Button Square: The question the Fed and ECB must be prepared to answer is how “open” is “open-ended”
stimulus? If need be are they willing to fully corner liquidity in UST bonds, MBS, and the bonds of the European periphery in
an effort to maintain the façade of economic recovery? If you're going to talk-the-talk you had better be prepared to walk-thewalk. To this point I was shocked at the bravado of ECB Governing Council Member and Bank of Cyprus Governor Panicos
Demetriades. When asked about the ECB’s pledge of unlimited bond purchases he responded that the threat alone may mean
no action is ever needed, “No one will speculate against the unlimited firepower of a central bank. A central bank has this
wonderful ability that no other player in the market has when it says, ‘I’m going to do whatever it takes,’ and everyone
believes that, in the end they may do nothing” (7). That is just asking for trouble. Demetriades seems lost in his ivory tower.
His is the same dangerous logic that resulted in the September 16 th, 1992 Black Wednesday devaluation of the pound after the
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UK withdrew from the European Exchange Rate Mechanism. Words are cheap and a demonstration of strength is only
meaningful if everyone knows you are NOT at the limit of your ability. Think of a clumsy fighter throwing desperate but
strong punches as he teeters on the brink of a knock-out. To this effect the ECB governing council should watch more hockey
and quoting former Detroit Red Wings enforcer and Stanley Cup Champion Darren McCarty, “The important thing is that
when you fight you have to be willing to take a punch. You’re going to have to, and it’s not about how many you give but
about how many you can take and who’s the best about learning to take a punch properly” He adds, “as long as he doesn’t
get you on the button square, then you’ll be alright.” (8)
The reputation of being able to take a beating is more powerful than the threat of giving one. The ECB must realize that when
bail-out enthusiasm wanes inevitably some anti-austerity political party or bond vigilantes will dare to punch the Euro right on
the “button square”. So despite all this bravado how many credible punches does the ECB have left to give before issues of
Euro solvency come back into focus? Can the ECB walk-the-walk without the backing of true fiscal unity in Europe?
Obviously Demetriades has never been in a proper fight and given fair comparison of wisdom and rhetoric perhaps Darren
McCarty deserves a seat on the ECB Governing Council. Fortunately Bernanke is more modest than his counterparts in
Europe and does not publicly challenge the “Gods of Risk” to a throw down. Bernanke states more humbly regarding the
threat of accommodative policy, “Whether we have the credibility to persuade markets that we’ll follow through is an
empirical question… we will have created (by following through) a reserve of credibility that we can use in any subsequent
episodes that occur”. (9) His game theory comment does not convince me that monetary policy is the answer to full
employment but at least he is not absurdly arrogant. Either way the fate of markets rests largely on the psychological fight
between the credibility of global central banks to defend an optical illusion against the will of risk markets to test the fragile
boundaries of human perception. We are now in the middle of a bull market in equities, commodities, bonds, and fear all at
the same time. How can these conflicting visions of reality co-exist in the same multi-dimensional space? Welcome to the
postmodern economy.
Games in the Impossible Market
Bull Market in Volatility (Fear)
Bull Market in Tail Risk (Fear II)
Cumulative Probability
30%
10%
Expiration (yrs)
0.0%
12m %G/L
in S&P 500 index
Bull Market in Global Equity (Risk)
Yiled%
Bull-Market UST
inYield
UST
Bonds (Safety)
Curve (1-20yrs)
-25.0%
May-12
-50.0%
Jun-11
0%-10%
Nov-11
Aug-10
Sep-09
Jan-11
1.17
0.17
0.67
May-12
Jan-12
Sep-11
Apr-11
Dec-10
Aug-10
Apr-10
Mar-10
Oct-08
10%-20%
Nov-09
Jul-09
Mar-09
Nov-08
Jul-08
Feb-08
Oct-07
Jun-07
Feb-07
Sep-06
May-06
Jan-06
Sep-05
Apr-05
Dec-04
Aug-04
Apr-04
Nov-03
Jul-03
Mar-03
Nov-02
Jun-02
Feb-02
Oct-01
Jun-01
Jan-01
Sep-00
May-00
Jan-00
20%-30%
Apr-09
0%
Jan-00
Jun-00
Nov-00
Apr-01
Oct-01
Mar-02
Aug-02
Feb-03
Jul-03
Dec-03
Jun-04
Nov-04
Apr-05
Sep-05
Mar-06
Aug-06
Jan-07
Jul-07
Dec-07
May-08
Variance Swap / VIX Spot
20%
2.10
1.90
1.70
1.50
1.30
1.10
0.90
0.70
0.50
Growth of $100
175
8
6
125
4
75
2
Nasdaq
S&P 500
Hang Seng
DAX
Jul-12
Nikkei 225
Jan-12
Jul-11
Jan-11
Jul-10
Jan-10
Bull Market in Monetary Expansion (??)
Jul-09
1 4 7 15
Maturity
Jan-09
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jun-12
Feb-12
Sep-11
May-11
Jan-11
Sep-10
Apr-10
Dec-09
Aug-09
Apr-09
Nov-08
Jul-08
Mar-08
Oct-07
Jun-07
Feb-07
Oct-06
Jun-06
Jan-06
Sep-05
May-05
Dec-04
Aug-04
Apr-04
Dec-03
Jul-03
Mar-03
Nov-02
Jul-02
Feb-02
Oct-01
Jun-01
Jan-01
Sep-00
May-00
Jan-00
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
25
0
Bull Market in Commodities (Inflation)
Growth of $100
800
Assets Billions
600
10,000
400
8,000
6,000
Jul-12
Jan-12
Jul-11
(310) 496-4526
Jan-11
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-12
Jan-12
www.artemiscm.com
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
Jan-08
Jul-07
Fed
Jan-07
ECB
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
BOJ
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
2,000
-
200
0
4,000
Oil
Silver
Gold
The Postmodern Economy
“The simulacrum is never what hides the truth
it is the truth that hides that fact that there is none.
The simulacrum is true “
Ecclesiastes
The perfectly efficient market is by nature random. When the market has too much influence over the
economic reality it was designed to mimic, the flow of information becomes increasingly less efficient
with powerful consequences. Information becomes trapped in a self-reflexive cycle whereby the market
is a mirror unto itself. Lack of randomness ironically leads to chaos. I believe this is what George Soros
refers to as "reflexivity". The impossible object is a visual example of reflexivity.
Deeper dimension markets like volatility, correlation, and volatility-of-volatility are
important because they measure our confidence in the financial representation of
First Dimension
Economic Reality
economic reality. If financial markets are the mirror reflecting a vision of our economy Second Dimension
Financial Markets
third dimension markets measure the distortion in the reflection. If you are familiar with
Third Dimension
Volatility
Correlation
Plato’s Allegory of the Cave volatility is best understood as our collective trust in the
shadows on the wall. In the 1985 work “Simulacra and Simulation” French philosopher Fourth Dimension Volatility of Volatility
Jean Baudrillard recalls the Borges fable about the cartographers of a great Empire who
drew a map of its territories so detailed it was as vast as the Empire itself. According to
Baudrillard as the actual Empire collapses the inhabitants begin to live their lives within
the abstraction believing the map to be real (his work inspired the classic film "The Matrix" and the book is prominently
displayed in one scene). The map is accepted as truth and people ignorantly live within a mechanism of their own design and
the reality of the Empire is forgotten (10). This fable is a fitting allegory for our modern financial markets.
The market is no longer an expression of the economy… it is the economy
In the postmodern economy market expectations are more important to fundamental growth than the reality of supply and
demand the market was designed to mimic. Our fiscal well being is now prisoner to financial and monetary engineering of our
own design. Central banking strategy does not hide this fact with the goal of creating the optional illusion of economic
prosperity through artificially higher asset prices to stimulate the real economy. In doing so they are exposing us all to hyperreality or what Baudrillard called “the desert of real”. In Fed speak this is what Bernanke calls the “wealth effect” and during
his September 13th press conference he explained the concept: “if people feel that their financial situation is better because
their 401k looks better or for whatever reason… they are more willing to go out and spend, and that’s going to provide
demand that firms need in order to be willing to hire and to invest.” (11) In the postmodern financial system markets are a
self-fulfilling projection unto themselves while trending toward inevitable disequilibrium. While it may be natural to conclude
that the real economy is slave to the shadow banking system this is not a correct interpretation of the Baudrillard philosophy.
The higher concept is that our economy is the shadow banking system… the Empire is gone and we are living ignorantly
within the abstraction. The Fed must support the shadow banking oligarchy because without it the abstraction would fail.
creation/destructi
on cycle of money,
credit, leverage
Postmodern Economy = Market is the Economy
Reality
Economy
Third
Dimension Markets
Equity/Credit
Markets
Financial Models
www.artemiscm.com
Volatility
Correlation
Vol-of-Vol
Simulacrum
Simulation of the Simulacrum
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Third & Fourth Dimension Markets & Global Central Banking
The price discovery mechanism of markets is held together by fragile
psychology that is increasingly dependent on money creation to sustain itself
rather than economic growth. When systems become abstractions upon
themselves they contain less and less information, are less random, and hence
more susceptible to extremes in either direction. This is a source of tremendous
opportunity and shocking systemic risk.
If this sounds esoteric look no further than to how volatility markets are
dependent on the expansion of the Fed balance sheet for stability. Third and
fourth dimension markets (like volatility and vol-of-vol) become increasingly
unstable the minute global central banks (Fed and ECB) cease to provide
monetary stimulus. As seen below the reflexive cycle described herein is not as
much an obscure philosophy as it is a cold hard mathematical reality. Is the
economy anything more than shadows on the wall of a cave? The fact that tail
risk and volatility-of-volatility markets are historically expensive only shows
that investors have never been more certain of their own uncertainty.
40
Flash Crash
90%
30
80%
25
70%
60%
90%
1075
80%
975
20
70%
875
15
60%
775
Jul-12
Sep-12
Mar-12
May-12
Nov-11
Jan-12
Jul-11
110%
85
Aug 11 Crash
80
75
100%
Flash Crash
70
90%
90%
95
80%
85
70%
75
70%
60%
65
60%
65
80%
60
55
Jul-12
Sep-12
Mar-12
May-12
Nov-11
Jan-12
Jul-11
(310) 496-4526
Sep-11
Mar-11
May-11
Nov-10
Jan-11
Jul-10
Sep-10
Mar-10
May-10
Nov-09
Jan-10
Jul-09
Sep-09
Mar-09
May-09
Sep-12
Jul-12
Mar-12
May-12
Jan-12
Sep-11
Nov-11
Jul-11
Mar-11
May-11
Jan-11
Sep-10
Nov-10
Jul-10
Mar-10
May-10
Jan-10
Sep-09
Nov-09
Jul-09
Mar-09
May-09
Source: Artemis Capital Management LLC, CBOE, Federal Reserve Board
www.artemiscm.com
Sep-11
Mar-11
May-11
Nov-10
Jan-11
Jul-10
Sep-10
Mar-10
May-10
Nov-09
Jan-10
Jul-09
105
No Fed Action
QEI
QEII
Op. Twist+LTRO(ECB)
QEIII
CBOE SPX Implied Correlation
120%
115
Flash Crash
Implied Correlations↑ without Fed BS Support
130%
125
Sep-09
100%
1275
Flash Crash
1175
Mar-09
110%
1375
100%
135
Aug 11 Crash
1475
Aug 11 Crash
No Fed Action
QEI
QEII
Op. Twist+LTRO(ECB)
QEIII
SPX
May-09
Jul-12
120%
Financial
Markets
S&P 500 Index ↓without Fed BS Support
110%
Sep-12
May-12
Mar-12
Jan-12
Nov-11
Jul-11
Sep-11
May-11
Mar-11
Jan-11
Nov-10
Jul-10
Sep-10
May-10
Mar-10
Jan-10
Nov-09
Jul-09
Sep-09
Mar-09
May-09
Volatility of VIX↑ without Fed BS Support
No Fed Action
QEI
QEII
Op. Twist+LTRO(ECB)
QEIII
Vol of VIX (VVIX)
Economic
Reality
Implied Correlation(%)
35
Post-Modern
Economy
S&P 500 Index
120%
100%
130%
Fed BS % Change since September 2008
45
Volatility of VIX (%)
Fed BS % Change since September 2008
110%
Aug 11 Crash
130%
Fed BS % Change since September 2008
No Fed Action
QEI
QEII
Op. Twist+LTRO(ECB)
QEIII
VIX
120%
50
Fed BS % Change since September 2008
VIX index ↑ without Fed BS Support
Volatility of VIX (%)
130%
Correlation
Knowledge is not what you know but certainty in what you do not
“There are known knowns; there are things we know that we know. There are known unknowns; that is to say there are
things that, we now know we don't know. But there are also unknown unknowns – there are things we do not know, we
don't know.”
Donald Rumsfeld, United States Secretary of Defense
VIX index (%)
Modern volatility markets put a price on “unknown unknowns” and rarely has that price been higher. Volatility-of-volatility
(“VOV” or “Vol-of-Vol”) is a fourth dimension derivative that measures our confidence in the market as an accurate
representation of the economy.
How certain are you that an M.C. Escher landscape could actually exist? That unsettling feeling you get when you look at
the waterfall flow into itself… that is your own perceptual volatility-of-volatility.
It should not be a surprise that episodes of elevated vol-of-vol are associated with lower equity returns. For the S&P 500 index
periods of high realized volatility-of-the-VIX underperform periods of low VOV by 13% annually (95th percentile compared
to lowest 5th). A recent research paper by Baltyssen, Van Bekkum and Van Der Gruent found that individual stocks exhibiting
high implied vol-of-vol underperform low vol-of-vol stocks by 10% a year (12).
Uncertainty is now very expensive. Vol-of-Vol premiums are rich in today’s market despite a low-spot VIX. The chart below
shows the predicted range of future VIX for a one-month variance swap constructed using VIX options. The VOV swap
routinely anticipates the VIX rising from the teens into the mid-20s to low-30s. As you can see the VIX options have never
been less accurate in their prediction with 40% of the observations falling underneath the range predicted by the VOV swap
since November 2011. As of today 3-month VIX options are predicting a future range on the VIX between 16 and 30 with the
VIX at 15.73.
How Good are VIX options Predicting the Future VIX?
80
Known Unknowns & Unknown Unknowns
70
How Good are VIX Options at Predicting the Future VIX?
Range of 1-month VIX levels implied by options vs. actual future 1m VIX Index
60
VIX Future Log-Contract Prediction Success/Failure %
Volatility Regime
50
40
30
20
10
Vol of VIX(%)
Sep-12
Jul-12
Mar-12
May-12
Jan-12
Sep-11
Nov-11
Jul-11
May-11
Mar-11
Jan-11
Nov-10
Sep-10
May-10
Jul-10
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
Mar-09
May-09
Jan-09
Sep-08
Nov-08
Jul-08
May-08
Mar-08
Jan-08
VVIX/ Volatility of VIX Index
140
120
100
80
60
Within
Greater Less than
Prediction than Upper Lower
Bound
Bound
Bound
Sep-12
Jul-12
Mar-12
May-12
Jan-12
Nov-11
Jul-11
Sep-11
May-11
Jan-11
Mar-11
Nov-10
Sep-10
Jul-10
May-10
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
May-09
Jan-09
Mar-09
Nov-08
Jul-08
Sep-08
May-08
Mar-08
Jan-08
Total
(2007 to Mar 2012)
71%
10%
18%
Bull Market
(2006 to July 2007)
77%
23%
0%
Credit Crisis Onset
(Aug 2007 to Aug 2008)
78%
8%
14%
Market Crash
(Sep 2008 to Feb 2009)
63%
29%
8%
Recovery to Flash Crash
(Mar 2009 to May 2010)
71%
7%
22%
Post-Flash Crash
Steepening
(May 2010 to Oct 2011)
74%
9%
17%
LTRO Steepening
(Nov 2011 to Sep 2012)
59%
1%
40%
Fiscal Cliff is a Volatility Cliff
VOV curves provide a glimpse into the psychology of fear by making predictions
Predicted Volatility of VIX vs. 5yr Realized Vol of VIX
September 28, 2012
about when the VIX is likely to explode or drop. Local VOV curves extracted from
VIX-based derivatives anticipate a more violent VIX heading into the January 2013
US fiscal cliff showdown (compare the blue line expected VOV to the red line
US Fiscal Cliff =
Higher Vol-of-VIX?
representing actual VOV since 2007). Volatility markets are only telling us what
we already know - if the Congress doesn’t act in time a list of things will occur that
will be difficult for market’s to digest. The Bush tax cuts will expire. The
temporary payroll tax cut will end. Unemployment benefits will be severely
curtailed. There will be more than $100 billion in automatic cuts to the Pentagon
and domestic agencies. All on Jan. 1, 2013… so take a wild guess where predicted
future volatility-of-volatility is highest?
We don’t know whether the US fiscal cliff will result in recession. We don't know what a collapse of the Euro would do to the
global economy. We don't know whether China will experience a hard landing or whether Israel will start war with Iran…
These are “known unknowns”. The probability of each shock event is already priced into markets meaning their occurrence
may still undermine returns but not as much as if they came out of the blue. What are the “unknown unknowns”? Ask a
psychic… I have no idea (that is the point) but if someone put a gun to my head and forced me to guess I would answer volof-vol itself. The more traders use ‘uncertainty’ as a market timing indicator the more unstable and cross-correlated markets
will become. If you extend that concept to high frequency market microstructure and take it to the logical extreme you may
see the problem. Today everyone is afraid of the next 2008 but I am afraid of the next 1987 (in equity or bonds).
240
220
200
Volatility of VIX (%)
180
160
140
120
100
80
Future Volatility of VIX Market Prediction (local VOV)
5yr Average Realized Vol of VIX
60
40
02-May-13
25-Apr-13
18-Apr-13
11-Apr-13
04-Apr-13
27-Mar-13
20-Mar-13
13-Mar-13
06-Mar-13
27-Feb-13
20-Feb-13
12-Feb-13
05-Feb-13
29-Jan-13
22-Jan-13
14-Jan-13
07-Jan-13
28-Dec-12
20-Dec-12
13-Dec-12
06-Dec-12
29-Nov-12
21-Nov-12
14-Nov-12
07-Nov-12
31-Oct-12
24-Oct-12
17-Oct-12
10-Oct-12
03-Oct-12
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Volatility is cheap and expensive at the same time
Dec-11
Feb-12
1.50x
1.00x
Ratio of SPX 1-year Variance Swap Strike to VIX Index
1990 to 2012
Aug-12
Jun-12
Aug-11
Jul-11
May-11
Jan-11
Mar-11
Sep-10
Nov-10
Jun-10
Aug-10
Feb-10
Apr-10
Oct-09
Dec-09
Aug-09
0.50x
Mar-04
May-04
Jul-04
Sep-04
Nov-04
Jan-05
Mar-05
Apr-05
Jun-05
Aug-05
Oct-05
Dec-05
Feb-06
Mar-06
May-06
Jul-06
Sep-06
Nov-06
Jan-07
Mar-07
May-07
Jun-07
Aug-07
Oct-07
Dec-07
Feb-08
Apr-08
Jun-08
Jul-08
Sep-08
Nov-08
Jan-09
Mar-09
May-09
Jul-09
Vix Futures/Spot Vix
Bull Market in Fear / VIX Futures Curve (normalized by spot VIX)
2004 to Present
2
Ratio
2012
2011
2008
2010
2007
2009
2006
2005
2004
2003
2002
2001
2000
Oct-11
Forward VIX index (%)
Today volatility is its own impossible object. Volatility markets are simultaneously calm on the surface and fearful
underneath. Look at volatility one way and you see nothing but complacency with five year lows in the VIX index, but look
at it from a slightly different angle you will see a furious bull market in fear. On August 17th the VIX index fell to the lowest
level since the summer of 2007 generating significant media attention. Every time the VIX falls into the low-teens you get the
same clichéd range of “volatility is cheap” and “now is a good time to hedge” sound bites from the financial media.
Low spot-volatility does not mean cheap volatility. Volatility may be cosmetically low compared to historical averages but
this ignores many important factors. For example, this past August it
35
Low Volatility? Really?
was more expensive to buy 1-year forward volatility with the VIX at
VIX Futures Curve Comparison
13.45 than it was one day after Lehman went bankrupt in September
August 2012 vs. September 2008
30
2008 when the VIX was above 31. Think about that! Even though
!
spot volatility was 18 points lower (-57%) the VIX futures on the back
of the curve were priced higher in August than they were during the
25
start of the financial crisis. If you had followed the advice of the
media your “cheap” volatility hedge executed at the August 2012 low
20
in vol would have already lost -12% of its value even as the VIX
increased by +15%. To this point an internet stock was not cheap in
August 17, 2012 / Lowest VIX in 5 years
15
1999 just because it traded under $10. The absolute price is not
September 15, 2008 / Day after Lehman
relevant when looking at fundamental value. Volatility has
Bros. Bankruptcy
fundamentals too and what matters is not the absolute price but the
10
Spot Month Month Month Month Month Month Month Month
variance premium paid in relation to the expected movement of the
1
2
3
4
5
6
7
8
underlying asset. To this effect, the VIX in the low-teens was also
expensive on the basis of how it tracked actual movement in the S&P
VIX Index Premium to 1m Realized Volatility (%)
500 index. The VIX recorded its highest premium to realized 175%
volatility in history in early September when it briefly traded at 200%
compared to a historical average of 39%. You cannot expect to 125%
succeed hedging your portfolio by following simplistic heuristics
75%
based on the absolute price of the VIX index. You will get killed
doing this. The smart hedger must utilize a relative value approach.
25%
Today this means buying less expensive volatility on the front of the
curve and selling overpriced volatility on the back while dynamically
-25%
hedging exposures.
M6
VIX M3
Expiry
Bull Market in Fear
1.5
1
(%) lognormal
0.5
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Vix Index
1yr SPX Variance Swap Strike
36
SPX 1-year Variance Swap Strike and VIX Index
lognormal / 1990 to 2012
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Fear is a better reason to buy than fundamentals
We are trapped in a binary market governed by the flip of a macroeconomic coin with deflation on one side (left tail) and
government reflation on the other (right tail). It is easy to forget the coin has two sides. The more people fear the left tail of
the probability distribution the more you should buy the right. The post-financial crash options market is marked by the
transfer of risk premium from the center of the return distribution to the left tail in what I refer to as a ‘bull market in fear’ (see
comparison below). The phenomenon is not unique to domestic equity and can be observed in many asset classes. Tail risk
bets protecting against extreme declines in equity markets are still priced near multiple decade highs. In my last research letter
I made the case that the fear of deflation was not misplaced but rather mispriced (“Volatility at World’s End: Deflation,
Hyperinflation, and the Alchemy of Risk”). Central bank intervention in markets has the effect of suppressing spot volatility
but perception of risk is not destroyed and instead is shifted to the left tail of the distribution.
It is hard to have a bear market in a bull-market for fear
When everyone has already bought portfolio insurance doesn’t that mean you kind of own portfolio insurance too? When you,
your neighbor, the neighbor’s dog, and the Federal Reserve are all hedging the market, it is very hard for that market to
decline in an uncontrollable fashion. This is exactly where we are today with monetary expansion and very steep volatility
curves. The worst crashes usually occur when investors are not prepared or excessively leveraged. Very rarely are you
ambushed when you are totally ready for it. Widespread hedging provides an unseen floor to equity prices. In a hedged market
the majority of investors are 1) not forced to sell in a decline or; 2) have the ability to buy on the dip. Even when markets are
hedged self-reinforcing crashes often occur in phases with the first wave wiping out weak portfolio insurance defenses and the
second wiping out portfolio equity (see September 2008). It may be counterintuitive but you shouldn’t be afraid to climb the
wall of worry when there is a mosh pit of hedged investors below you and below them a central bank financed mound of
pillows stuffed with fiat currency. When the Fed is scared they expand their balance sheet to support the economy. When
investors are scared they buy portfolio insurance putting a floor underneath stock prices. Ironically markets are at their very
best when everyone is scared out of their minds.
Cross Asset Implied Probability Distribution Comparison (2008 pre-crisis to 2012)
Variance Swap Weighting / SPY, EFA, EEM, TLT, IEF, HYG, USO, GLD
Pre-Crisis 2008
60%
50%
Gold
Oil
HY Bonds
UST 10yr
UST 30yr
Intl. Equity (Emerg)
Intl. Equity (Dev)
US Equity
40%
30%
20%
10%
Gold
Oil
HY Bonds
UST 10yr
UST 30yr
Intl. Equity (Emerg)
Intl. Equity (Dev)
US Equity
40%
30%
20%
10%
0%
Expected 1yr Asset Class Return Distribution
by Standard Deviation (Historical)
Expected 1yr Asset Class Return Distribution
by Standard Deviation (Historical)
25%
S&P 500 Index Options 12-month
Implied Probability Distribution of Expected Returns
(2005 to September 2012)
25%
New Regime of Tail Risk?
Average 1yr Implied Returns Probability Distribution from
SPX Options
20%
15%
10%
5%
0%
Actual from Sep 2008 to Sep 2012
Implied from Jan 1990 to Sep 2008
Implied from Sep 2008 to Sep 2012
September 2012 (avg)
Cumulative Probability
25%-30%
20%-25%
15%-20%
10%-15%
5%-10%
0%-5%
20%
15%
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Implied 12m %G/L in S&P 500 Index
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40%
35%
30%
25%
20%
15%
5%
10%
0%
-5%
-10%
-15%
-20%
-25%
-30%
-35%
-40%
0%
-45%
Implied 12m %G/L
in S&P 500 index
-50%
-27.5%
-20.0%
-12.5%
-5.0%
2.5%
10.0%
17.5%
-35.0%
-42.5%
-50.0%
Aug-11
5%
Mar-12
Jul-10
More peaked
distribution with
less implied tail
risk
Massive change
in tail-risk
assumptions
following 2008
crash
10%
Jan-11
Jan-05
Jul-05
Feb-06
Aug-06
Mar-07
Oct-07
Apr-08
Nov-08
Jun-09
Dec-09
Cumulative Probability
+2.5σ
+2.0σ
+1.5σ
+1.0σ
+0.5σ
+0.0σ
-0.5σ
-1.0σ
-1.5σ
-2.0σ
-2.5σ
+2.5σ
+2.0σ
+1.5σ
+1.0σ
+0.5σ
+0.0σ
-0.5σ
-1.0σ
-1.5σ
-2.0σ
-2.5σ
-3.0σ
-3.0σ
0%
50%
Probability Of Return
Probability Of Return
60%
30%
Today
Left
tail
bias
Right
tail
bias
$3.50
0.20%
$3.00
3.5x
0.40%
2.5x
0.60%
1.5x
0.80%
1.6x
$2.50
1.4x
$2.00
1.2x
Fed BS in Trillions$
4.5x
0.20%
1.0x
$1.50
0.8x
$1.00
Avg. Daily S&P 500 Index Change >= Vol Term Percentile (Return)
Stdev of S&P 500 Return >= Vol Term Percentile (risk)
Return to Risk Ratio (annualized)
1.00%
95th
90th
85th
80th
75th
70th
65th
60th
55th
50th
45th
40th
35th
30th
25th
20th
15th
5th
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Jan-11
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May-10
Sep-09
Jan-09
Sep-07
May-08
Jan-07
10th
0.4x
May-06
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$0.50
Sep-05
-0.5x
Percentile of Volatility Term Structure (higher percentile= hedged market)
0.6x
0.5x
Jan-05
1.20%
0th
Risk = Standard Deivation
1.8x
5.5x
0.00%
SPX Volatility Term Structure Steepness
& Fed BS Expansion
Volatility Term Structure (Var Swap K 1yr/ VIX index)
Daily Risk Adjusted Returns of S&P 500 index
by Volatility Term Structure Steepness (Hedge Market Factor)
0.40%
6.5x
1990 to September 2012
Risk to Return Ratio for SPX
Avg. Return
1-1881
5-1886
9-1891
1-1897
5-1902
9-1907
1-1913
5-1918
9-1923
1-1929
5-1934
9-1939
1-1945
5-1950
9-1955
1-1961
5-1966
9-1971
1-1977
5-1982
9-1987
1-1993
5-1998
9-2003
1-2009
Fear over Fundamentals: Fear is a better reason than fundamentals to own
Cyclically Adjusted PE Ratio
50
(Price to Average Inflation Adjusted Earning from past
stocks right now. The cyclically adjusted price-to-earnings ratio of the S&P
45
10-years)
40
500 index is higher today at 22.86 than it was in July of 2008 and 6+ points
1881 to 2012
35
over its historical average. Equities are expensive… but given the high degree
30
25
of investor hedging and the Fed back-stop they can get even more expensive.
20
During weeks with a steeper than average volatility term structure (1-year
15
10
variance swap strike to VIX ratio) combined with central bank balance sheet
5
expansion the S&P 500 index has increased +0.61% on average with a 66%
0
chance of a gain since 1996. This compares favorably to the average weekly
return of +0.09% and 55% chance of gain over that same holding period. To
Source: Irrational Exuberance by Robert Shiller/ http://www.multpl.com/
this point a simple tactical allocation strategy that switches between the S&P
500 index and cash based on a steep volatility term structure and simultaneous Fed balance sheet expansion would have
outperformed a majority of hedge funds since 1996. The “tactical fear” strategy would have earned a +9.9% annual return
with a 1.29x return to risk ratio compared to +4.83% annually with 0.25x ratio for the S&P 500 index (see below). Look to
monetize further potential upside in domestic equity through the purchase of call options which minimize exposure to the left
tail and take advantage of the lower than normal volatility on the right. If the volatility term structure starts flattening pull
back your equity exposure quickly. It pays to face your fears. If the Fed follows through on an idea of targeting nominal GDP
they may as well just start targeting equity PE ratios as well. Fear will be the only “fundamental” we have left.
Risk-free assets are risky
We all know shorting volatility is dangerous. We learned our lessons from the financial crisis. We all meticulously read “The
Black Swan” and then watched the scary movie adaption of the book starring Natalie Portman. We all know that this method
produces a steady stream of smooth returns making people think you are a genius until the inevitable disaster forces you to
pawn off your Nobel Prize. We all know that shorting volatility will cause you to go insane with a twisted psycho-sexual
obsession to master the art of ballet. It’s picking up pennies in front of a convexity steamroller. Don’t do it. Ever!! Worst of
all … If you ever …ever… short volatility… Nassim Taleb will personally insult you and hurt your feelings (13).
Knowing these facts I would like to pose a question… which is riskier right now? Shorting a collateralized far out-of-themoney S&P 500 index put or buying a “risk-free” US treasury bond? In the “bull market for fear” and “bubble in safety” the
paradox is that these two vastly different investments have shockingly similar risk to return profiles (albeit to different risk
factors). This goes against everything you have ever been taught in business school or on a CFA exam. In fact I will attempt
to make a semi-compelling argument that the collateralized far-OTM put sale offers… gasp… a better risk to return profile
than a long-dated UST. For the record I don’t recommend either.
First off measuring the risk to reward of a volatility short position is often a complex endeavor involving greeks like
gammas, vegas, volgas, and vanna whites (14). Let’s just simplify that entire process and “pretend” a put option is an
alternative form of a bond. As an investor in this hypothetical “volatility bond” you receive an annualized “volatility yield”
represented by the premium of the option divided by the capital commitment required to fund the obligation. In return for
this yield you assume the risk of “default”, essentially meaning an obligation to buy the S&P 500 index at a pre-defined
discount to current market value (say -25% or -50%). Now you will collateralize that option by setting aside the dollar
amount of monies over the specified term needed to cover that purchase commitment. That collateral is equivalent to the
“face value” of the bond and the “yield” is the option premium divided by that collateral and annualized. If the default event
is a $100 stock falling to the -50% strike price in one year you would set aside $50 for the term of the commitment to cover
mark-to-mark losses on the short option position. If you receive $2.5 in premium for selling the put option your yield is 5%
(against a face value of $50). We looked at several different types of hypothetical “volatility bonds”. The first requires you to
purchase the S&P 500 Index at a -25% discount to the current price for the duration of a year. The second obligates you to
buy the S&P 500 index near the March 6, 2009 lows (650 strike price or -55% lower) for the duration of a year. We also
obtained bank pricing on a 10-year over-the-counter put option at the 2009 low of 666. We can then compare these
“volatility yields” to traditional fixed income yields. No complex greeks required.
14%
12%
Yield(%)
"Volatility Bond" Yield vs Traditional Fixed Income Investments
1990 - 2012
Insurance Strike Rate Breached
Volatility Yield (sell 1yr SPX put / -25% discount)
10yr UST Yield
Moodys Corporate Bond Yield (AAA)
Moodys Corporate Bond Yield (Baa)
30yr Mortgage Rate
16%
Wow! Yields are comparable
10%
8%
6%
4%
2%
0%
Volatility Yield of 1-year SPX Put at 2009
Lows vs. 10-year UST
4.0%
Yiled (%)
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Jul-12
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Jan-12
Oct-11
Jul-11
Apr-11
Jan-11
Oct-10
Jul-10
Apr-10
Jan-10
Volatility Yield (Sell 1yr SPX Put / 2009 Lows of 650)
10-yr UST Yield
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2012
2011
2010
2009
2008
2007
2005
5.0%
4.5%
2006
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
For the first time in history the volatility bond yield is consistently
competitive with the yield on a wide variety of traditional fixed income
investments (see above).What does it say when the market will
compensate you more in annualized yield for the obligation to buy the
S&P 500 index at the 2009 devil’s bottom of 666 (1.90% annualized yield
for 10-year OTC put) than it will to own a government bond (1.87% yield
for 10-year UST) of equivalent maturity? Consider that the 1-year
volatility bond with a -25% SPX purchase commitment currently yields
2.69% annually or 82 basis point over the 10-year UST. In periods of
equity market duress the spread can go much higher hitting 454 basis
points over the 10yr UST this past May. I know what you are thinking…
what about the risks?
Yield to Risk / UST Bond vs. "Volatility Bond" (Collateralized Short Put on S&P 500 index)
Investment
Volatility Bond / Short SPX Put + Collateral
Yield
SPX Put (Strike @-25%)
2.69%
SPX Put (Strike @2009 lows) 0.51%
US Treasury Bond
US Treasury Bond / 10-year
US Treasury Bond /30-year
Maturity
1 year
1 year
Stress Test #1
SPX ↓ -9%
Est. MTM
Loss
Historic Prob.
%
Stress Test #2
SPX ↓ -14%
Risk to
Reward
-2%
68%
1.373x
-0.4%
68%
1.319x
UST Rates ↑ 100bps
Est. MTM
Loss
-4%
-0.9%
Historic Prob.
%
Stress Test #3
SPX ↓ -25%
Risk to
Reward
Est. MTM
Loss
39%
0.616x
39%
0.588x
UST Rate ↑ 200bps
-11%
-3%
Historic Prob.
%
Stress Test #4
SPX ↓ -50%
Risk to
Reward
Est. MTM
Loss
13%
0.242x
13%
0.176x
UST Rate ↑ 325bps
-33%
-15%
Historic Prob.
%
Risk to
Reward
2%
0.081x
2%
0.034x
UST Rate ↑ 600bps
Yield
Maturity
Est. MTM
Loss
Historic Prob.
%
Risk to
Reward
Est. MTM
Loss
Historic Prob.
%
Risk to
Reward
Est. MTM
Loss
Historic Prob.
%
Risk to
Reward
Est. MTM
Loss
Historic Prob.
%
Risk to
Reward
1.87%
3.09%
10 years
30 years
-9%
-18%
68%
68%
0.214x
0.176x
-17%
-31%
39%
39%
0.113x
0.099x
-25%
-44%
13%
13%
0.074x
0.070x
-41%
-62%
2%
2%
0.045x
0.050x
No te: A ll data as o f September 14, 2012. Estimated unrealized lo ss o n po sitio n given stress test scenario . Histo ric pro bability data based o n perio d o f 1960 - 2012 fo r the UST bo nds and 1950 to 2012 fo r the S&P 500 index.
Optio n pricing based o n estimated lo cal vo latility shifts, ho wever actual shifts may differ fro m estimates during a real crash depending. A ll stress tests are assumed to o ccur clo se to the purchase perio d o f the instrument. Unrealized lo sses may differ clo ser to maturity.
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25-May-12
1-Jul-11
9-Dec-11
19-Feb-10
6-Aug-10
21-Jan-11
May-09
5.0%
May-07
May-11
30.0%
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May-05
-50%
May-03
-15.0%
12-Mar-04
27-Aug-04
11-Feb-05
29-Jul-05
13-Jan-06
30-Jun-06
15-Dec-06
1-Jun-07
16-Nov-07
25-Apr-08
10-Oct-08
20-Mar-09
4-Sep-09
Implied Vol / ATM Vol Ratio
The volatility bond and the UST bond have opposite risks factors as the first is exposed to deflation (stocks crashing) and the
second inflation (higher interest rates). For the purposes of this analysis we assume a neutral macro-economic view. As a
baseline for comparison our stress test uses historical bond and equity prices over multiple decades to match the equivalent
probability of each stress event. It may feel as if a 325 basis point increase in rates is extraordinary but it is easy to forget that
the historical probability of that occurring is much greater (13%) than that of a 2008 style crash in equities (2%). Of course
this is backward looking. Ultimately the true future probability estimate is always left to the best judgment of the investor.
Mark-to-Market Risk: Fair comparison of risk includes analysis of potential unrealized losses for both investments when
exposed to adverse market conditions as modeled by the stress tests above. The volatility bond will experience a mark-tomarket loss if stocks decline and vol rises, however if the short put option remains out-of-the-money by maturity those losses
will not be realized and the investor will keep the full premium. In a similar manner the UST bond will have negative price
swings if rates increase but could still make all payments on time. The investor holding either instrument to maturity may be
none the wiser if he received his principal back in full and never looked at mark-to-market prices (a retired broker once told
me this was how client reporting of fixed income worked at his firm back in the rising rate environment of the 1970s).
Important to note that both positions have convex return profiles and prices will not change linearly given shifts in volatility
or rates.
Default Risk: I think it is funny when academics claim that the US government will never default because it can just print
money to pay off its debt obligations. That is the logical equivalent of saying my house will never be burglarized because if
someone tried to break in I could just light it on fire. For the UST bond inflation and currency devaluation are alternative
forms of default. For the volatility bond the definition of default is not as complex. If the short put ended in-the-money at
maturity the investor would be obligated to own the discounted SPX at the higher strike rate resulting in a loss on posted
collateral. This “default” scenario may not be a bad thing if the investor doesn’t mind owning stocks at a -50% or -25%
discount from today but it still counts for our purposes. Hence the volatility bond has much higher risk here. One unique
attribute of the volatility bond is that it is a contractual obligation to ignore behavioral bias and purchase stocks only during
periods of deep discounted value.
When the “bull market in fear” meets a “bubble in safety” a collateralized
TLT 20+ US Treasury ETF-360Day Volatility Skew
2004to Sept 30 2012
short volatility position and “risk-free’ UST bond have shockingly similar
2.00x
1.80x
risk-to-reward payoffs. Of course you would rather own the UST bond in
1.60x
deflation or the volatility bond in inflation but we are assuming a risk1.40x
neutral world. To this effect both investments suffer comparable losses to
1.20x
their worst case scenarios. Without endorsing either investment, when
1.00x
evaluated on a pure risk-to-reward framework the volatility bond (with
0.80x
embedded short optionality) is superior to UST bonds at current prices.
What kind of world do we live in where the risk-return pay-off of short
selling equity volatility is equal or better to that of a supposedly “risk-free”
government bond? The UST bond market is one of the most liquid markets
in the world where investors look to first for preservation of capital during
% OTM
periods of crisis. Now the market for safety has an efficient frontier on par
with the penny in front of the steamroller trade? If you don’t find that 0.80x
TLT 20+ US Treasury ETF - 10% OTM Vol Skew
scary then you’re not paying attention. It used to be that you would post 0.60x
margin against your tail risk options using risk-free UST bonds. Now those 0.40x
risk-free assets are the source of the tail-risk. When risk-free is risky 0.20x
maybe it is time to buy volatility on safety itself (see right diagram).
0.00x
Common sense says do not trust your common sense
Aesop’s Fables (numbered 40 in the Perry Index)
Mathematician and the Artist(15)
The mathematician crosses paths with an artist on a crowded village street. The mathematician is meticulously
dressed in the finest business-casual attire of the day while the artist is unshaven and haggard as if he just
woke up from bed. "Excuse me! I must ask you something" the artist says with urgency. "What do you want?
My time is valuable" replies the mathematician. "I am an artist; I create alternate realities that do not yet exist
to explore the human condition". The mathematician laughs, "My job is to model reality as it is, not invent
new ones” He points to the busy street, "the movement of the people, the animals, the weather, the geometry
of the buildings... it can all be modeled perfectly through numbers. Imaginary worlds and alternate realities
are the work of children …mathematics allows for no hypocrisy and no vagueness"(16) The artist smiles, “well
my hypocrisy knows no bounds.”(17) The mathematician adds, “You are a fool! What type of artist are you
anyway? Painter, sculptor?” “Cut!” screams the artist. Time stops… wheels stop turning, crowds freeze in
their paths, the sun goes black leaving the world in darkness. "I'm a Hollywood film director and you
somehow walked past security onto our soundstage and right into our shot! Would you mind moving along so
we can get the extras back in place?”
Mathematics is the language of god… but art is the highest form of mathematics.
Never forget investing is an art
A woodcut from Spain (dated
1489) depicting the
Mathematician in business
casual attire and Hollywood
soundstage from the famous
Aesop’s Fable (Perry Index
#40)
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Common Sense in the Pursuit of Alpha
Hedge fund marketing conferences are sort of like late-night infomercials except
Hedge Fund Strategies 12m Correlation to
far less entertaining. If you ever have the poor fortune of attending one you will
ATM Short Straddle on SPX
(HFRX Absolute Return, Equity Nuetral, Hedge Index, Merger Arb, RV
1.00
Arb, Convertible Arb / Monthly)
notice that everyone is always talking about “alpha”. As much as everyone talks
0.80
about it not a lot of funds are actually finding it as the HFRX Global Hedge Fund
0.60
0.40
Index is up only +2.76% way behind the +14.56% performance for the S&P
0.20
500 index through September. In these highly crowded and correlated markets
the asset selection component is negated and alpha becomes increasingly driven (0.20)
by rising and falling volatility and liquidity. When this happens many classic (0.40)
(0.60)
hedge fund strategies converge to simple synthetic volatility trades. You can see (0.80)
this by the high correlation of monthly returns for a range of hedge fund
strategies vs. the monthly return of rolling an ATM short straddle on the S&P
500 index. In a highly correlated world alpha generation is often a closeted volatility short. There is also the problem of
hedge funds crowding into the same trades. I remember at some emerging manager conference where a woman said that her
definition of “emerging” was a fund with only $1 billion and anything less was not worth consideration. That’s a little like
saying you heard the cupcakes are really good at your neighborhood bakery but you won’t shop there until it is listed on the
NASDAQ. Today 49% of hedge fund assets are controlled by the top 3% of the largest institutions. If everyone is chasing the
same investments a lot of that “alpha” begins to look like “beta” with leverage or liquidity premium. This is why many of the
largest managers are actually giving money back to investors. You do not “think different” because you own AAPL stock.
To this effect I recently met with an institutional investor who told me that high cross-asset correlations between investments
were hurting their performance. They were interested in volatility strategies as a potential solution and my return profile was
intriguing to them. During my presentation they asked what “box does your core strategy fit into?” I told them it didn’t
cleanly fit into any of the hedge fund strategy “boxes” they routinely index. My response was not well received and I was
told verbatim that I had a “marketing problem” if my fund couldn’t “fit into a box”. I understood right then and there why
they had diversification issues. I look at things very differently…. that marketing problem is a competitive edge.
Despite the great lip service paid to the pursuit of “alpha” I think many institutions are not compensated to take risks to find it
and therefore are perfectly happy with “beta” wrapped in pretty bow. This is one reason why the biggest funds get a majority
of the assets despite strong academic evidence that emerging funds outperform. Institutional investors prefer to play it safe so
they can keep their jobs. I don’t blame them given their incentive structure as it is the path of least resistance. Common sense
says you don’t get fired by investing in the establishment. Common sense also says you’ll never lose money investing in a
UST bond.
Do not blindly assume old fables are genuine or true
What may be common sense today could be very dangerous tomorrow
Definition of COMMON SENSE
: sound and prudent judgment based on a simple perception of the situation or facts
Merriam-Webster
What is the common sense of an MC Escher painting? There is none – that is the point.
When the market is an impossible object the price of risk can change radically as perception shifts. Hence what may be sound
judgment one minute may be completely foolish the next. If two contradictory ideas can exist simultaneously then there is no
such thing as “simple perception” anymore. How is it possible for safety to be risky and for otherwise calm markets to be rich
in fear?
Paradox is now fundamental. The investor who can adapt to shifting perspectives will endure the volatility of an
impossible object. Common sense says do not trust your common sense anymore. Don’t live in a box or walk a flight of stairs
that leads back from whence you came. We cannot assume that the paradigm of the last three decades of lower interest rates
and debt expansion will be relevant going forward nor can we find shelter in the consensus rules formed around that standard.
Today’s market is the most infinitely complex impossible object ever imagined and for the investor to thrive in it he or she
must think creatively and be adaptable to the changing modes of acuity. You must be able to imagine different realistic states
of the world and think as both the mathematician and the artist. Ironically he or she who plays it safe may be assuming the
greatest risk of all.
Vive la vérité
Vive la volatilité
Artemis Vega Fund, L.P.
Christopher R. Cole, CFA
Managing Partner and Portfolio Manager
Artemis Capital Management, L.L.C.
www.artemiscm.com
(310) 496-4526
THIS IS NOT AN OFFERING OR THE SOLICITATION OF AN OFFER TO PURCHASE AN INTEREST IN ARTEMIS VEGA FUND L.P. (THE “FUND”).
ANY SUCH OFFER OR SOLICITATION WILL ONLY BE MADE TO QUALIFIED INVESTORS BY MEANS OF A CONFIDENTIAL PRIVATE PLACEMENT
MEMORANDUM (THE “MEMORANDUM”) AND ONLY IN THOSE JURISDICTIONS WHERE PERMITTED BY LAW. AN INVESTMENT SHOULD ONLY
BE MADE AFTER CAREFUL REVIEW OF THE FUND’S MEMORANDUM. THE INFORMATION HEREIN IS QUALIFIED IN ITS ENTIRETY BY THE
INFORMATION IN THE MEMORANDUM. AN INVESTMENT IN THE FUND IS SPECULATIVE AND INVOLVES A HIGH DEGREE OF RISK.
OPPORTUNITIES FOR WITHDRAWAL, REDEMPTION AND TRANSFERABILITY OF INTERESTS ARE RESTRICTED, SO INVESTORS MAY NOT HAVE
ACCESS TO CAPITAL WHEN IT IS NEEDED. THERE IS NO SECONDARY MARKET FOR THE INTERESTS AND NONE IS EXPECTED TO DEVELOP.
NO ASSURANCE CAN BE GIVEN THAT THE INVESTMENT OBJECTIVE WILL BE ACHIEVED OR THAT AN INVESTOR WILL RECEIVE A RETURN
OF ALL OR ANY PORTION OF HIS OR HER INVESTMENT IN THE FUND. INVESTMENT RESULTS MAY VARY SUBSTANTI ALLY OVER ANY GIVEN
TIME PERIOD.CERTAIN DATA CONTAINED HEREIN IS BASED ON INFORMATION OBTAINED FROM SOURCES BELIEVED TO BE ACCURATE,
BUT WE CANNOT GUARANTEE THE ACCURACY OF SUCH INFORMATION.
REPRODUCTIONS OF THIS MATERIAL MAY ONLY BE MADE WITH THE EXPRESSED CONSENT OF THE AUTHOR AND MUST BE
APPROPRIATELY SOURCED AS BEING PRODUCED BY ARTEMIS CAPITAL MANAGEMENT LLC.
The General Partner has hired Unkar Systems, Inc. as NAV Calculation Agent and the reported rates of return are produced by Unkar for Artemis Vega Fund LP.
Actual investor performance may differ depending on the timing of cash flows and fee structure. Past performance not indicative of future returns.
Artwork
"Volatility of an Impossible Object" by Brendan Wiuff / Concept by Christopher Cole
2012 / copyright owned by Artemis Capital Management LLC
"Penrose Triangle, Devil’s Turning Fork & Necker’s Cube” Derrick Coetzee / Public Domain
“Plato’s Allegory of the Cave” istockphoto.com
“Aesop woodcut Spain 1489” Public Domain/ please note this does not depict the mathmatician but instead Aesop himself surrounded by event from his stories.
“Waterfall” by M.C. Escher / 1961 Lithograph / Fair Use Copyright Law
“Drawing Hands” by M.C. Escher / 1948 Lithograph / Fair Use Copyright Law
"Liberty Leading the People" by Eugène Delacroix 1830 / public domain
Notes & Data

Unless otherwise noted all % differences are taken on a logarithmic basis. Price changes an volatility measurements are calculated according to the following
formula % Change = LN (Current Price / Previous Price)

Security price data from Bloomberg and Yahoo Finance

Options data from Market Data Express with calculations executed by Artemis Capital Management LLC

Central bank balance sheet data obtained directly from the Federal Reserve, Bank of England, Bank of Japan, European Central Bank, and the Bank of
International Settlements
Footnotes & Citations
1.
Definition of "Impossible Object" / Wikipedia / http://en.wikipedia.org/wiki/Impossible_object
2.
“The Scary Math Behind The Mechanics of QE3, and why Bernanke’s Hands May be Tied” ZeroHedge September 7, 2012 / statistics from Michael Schumacher
of UBS September 2012
3.
“Breakfast with David” by David Rosenberg / Gluskin Sheff Research September 14, 2012
4.
"The Pre-FOMC Announcement Drift" by David O. Lucca & Emanuel Moench / Federal Reserve Board of New York Staff Reports/ Staff Report no. 512 /
September 2011 and revised June 2012
5.
Shadow Government Statistics/ John Williams / www.shadowstats.com
6.
“Fed seeks ‘wealth effect’ so we’ll feel like spending” Associated Press / September 16, 2012
7.
"ECB Policy Maker Says Bank May Not Spend a Cent on Bonds" by Jeff Black and Stelios Orphanides / Bloomberg September 13, 2012
8.
Spence, Ron (2003), Darren McCarty: Enforcing by Committee, Hockey Enforcers, retrieved April 12, 2007.
9.
"Transcript of Chairman Bernanke’s Press Conference" US Federal Reserve / September 13, 2012
10.
“Simulacra and Simulation” by Jean Baudrillard / University of Michigan / 1994
11.
"Transcript of Chairman Bernanke’s Press Conference" US Federal Reserve / September 13, 2012
Statistic courtesy of Joseph Gagnon or the Peterson Institute for International Economics
12.
"Unknown Unknowns: Vol-of-Vol and the Cross Section of Stock Returns" Guido Baltussen, Sjoerd Van Bekkum and Bart Van Der Grient / Erasmus School of
Economics & Robeco Quantitative Strategies/ July 30, 2012
13.
"The Black Swan: the impact of the highly improbable" by Nassim Nicholas Taleb / Random House 2007
Note: I am not certain if Nassim Taleb will personally insult every person that shorts volatility but it is a tail risk.
14.
Vanna is the sensitivity of an option delta with respect to change in volatility/ Vanna White is the hostess of the popular game show “Wheel of Fortune” and is
not involved in any known option pricing framework.
15.
Aesop’s fables are a collection of stories credited to Aesop who was a slave and story-teller that lived in Greece between 620 and 560 BC. The story of the
“Mathematician and Artist” is NOT one of Aesop’s fables as evidenced by the fact that there were no Hollywood directors in Ancient Greece. Had Aesop been
around today I am certain he would approve of this fable so I took the creative liberty of attributing it to him. The actual #40 fable in the Perry Index refers to
the story of “The Astrologer who Fell into a Well”.
16.
Quote attributable to Marie-Henri Beyle better known as Stendhal.
17.
Quote attributable to Doc Holiday (played by Val Kilmer) in the 1993 film Tombstone directed by George Cosmatos and written by Kevin Jarre
www.artemiscm.com
(310) 496-4526