I think the risks as we sit here are skewing still to the downside.
A lot of funds are going to go out of business.
Let's just assume, and we may be in the midst of it right now, that equity indexes on high
volatility end up spinning their wheels over X number of sessions.
When I got into this business, particularly into the hedge fund business, that is Shangri-La
for portfolio managers.
Now it is hell on earth.
Well, my name is Ken Grant.
I am the founder of General Risk Advisors, LLC, which is a risk management solutions
company based in New York.
Love to talk to everybody about how risk management is unfolding in this very interesting environment
that we have here.
I've been a risk manager my entire career and in fact grew up in the markets, in the
futures markets of Chicago, a multigenerational thing.
And so I always had an interest and studied it, undergrad, graduate school.
Ended up joining the staff of the Chicago Mercantile Exchange and built their risk management
department.
I was their first chief risk officer.
And I still work with them to this day.
More than 20 years ago now, I came to New York.
And I found myself in the hedge fund industry, having been hired by Mr. Steve Cohen to help
manage his multi-strategy hedge fund.
And I did that for a number of years, a couple of other similar type of stops.
And for the last 15 years or so, I've been offering risk management on a solutions basis,
mostly to investment platforms but other risk-sensitive entities as well.
The CME was instrumental in establishing volatility protocols, I'd say, particularly for the equity
markets, which is where I do most of my business, not exclusively.
I do deal in bonds and foreign exchange and commodities.
But the advent of index futures all those years ago was really kind of the benchmarking
event.
Before that happened, the markets were completely different.
I know this is going to be hard to believe.
It predates my career.
I don't know a time when there wasn't equity index futures, which then featured long open
interest and short open interest and a very dynamic process to establish what volatility
was.
And without that, you wouldn't have things like the CBOE Volatility Index, which kind
of benchmarks volatility for equities as we now speak.
But the markets go through a number of iterations.
For me, I see them pretty clearly in the rear view mirror.
You start with the dot-com bubble.
Well, that was kind of an identifiable beginning and end.
And it ended around the year 2000.
And then we obviously had the attacks.
I'd say there was another interval that ultimately socialized into the mortgage bubble and the
crash.
And we know what ended that, which was, I would say, the crash itself.
Then there's that interval.
And all of these have their own volatility characteristics.
So you get to 2009, and now we have a recovery interval that, arguably, we're still in, but
I would say really starting to wind down three or four years ago, around 2014, when the Fed
stopped its quantitative easing policy.
And all of those had very explicit volatility patterns, whether they would be correlated
with the benchmarks or whether they would feature a negative correlation.
You could argue we just may be coming out of another one, maybe catalyzed by the 2016
election, where there was a great deal of tailwinds.
They appear to have ended.
And through all of it, maybe perhaps for the first time in 15 or 20 years, what you're
really looking at is volatility that would be differentiated by individual security and
by individual corporate performance and picking of winners and losers.
I think that would be a good outcome if we can get there.
What has tended to happen is that we see volatility concentrated in very short time windows here,
as opposed to dispersed.
So if I look at the year 2017, I think in the rear view mirror, it looks like, whatever
one's view of the election was, with pending deregulation, tax cuts, it's what we might
call a beta trade.
2018, there was some question about how much that would continue.
That's when the tax cuts took place.
But it's the anticipation of the tax cuts.
It's the anticipation of things, a lot of times, that drives market action.
So you may recall early in February, the market absolutely went through a withering seven
or eight sessions, which most prominently featured the absolute melt-up of the VIX volatility
index, which was a really alarming event.
That was early February.
After that, it calmed down and almost didn't move.
You're talking about the S&P 500 in a top to bottom 5% or 6% range from March till September.
I had a feeling that the fourth quarter was going to be volatile.
And in fact, it is.
So volatility, not to get too philosophical here, it's a reflection of uncertainty, which
doesn't go away.
So when you get these periods where volatility just kind of disappears out of the market,
all you can do is kind of bury it underground.
But it will come up eventually.
And that's some of what we're experiencing now is, I think, a built-up volatility cycle
that is in some ways a downbeat from flatlining for two quarters mid-year.
Well, I think the market is having a difficult time finding direction.
If you go back to what I said a couple of minutes ago, in the rear view mirror, we can
see where the catalysts were, whether we're talking about an internet revolution, a mortgage
frenzy, a collapse, a reflation, a supposedly market-friendly outcome in Washington.
Right now, it's we're sitting here, 2018 winding down, I really believe that it's about as
opaque as you would ever fear it to be.
I really don't believe that there's a paradigm that exists right now that describes market
direction.
I think it's going to be very path-dependent.
Right now, what I'm seeing is more in the short term of a correlation with political
and geopolitical events, which is not a great environment to be in.
It's not one that my old bosses would love the best, where you made your trades based
on debates about valuation.
Right now, we've got these path dependencies.
And we all know what they are.
What happens with the Fed?
What happens with China?
Can there be any functionality that manifests out of Washington?
And I don't have any clarity there at the moment.
I think you have to recognize that the task of portfolio management, no matter what your
strategy is, tends to become more difficult with time.
Go back to the buttonwood tree.
Well, the guys under the buttonwood tree had inside information.
Don't let anybody tell you otherwise.
And then I'll wind the clock forward several decades.
When I first got into the hedge fund business, there was asymmetric information.
If you did research, if you understood and did a deeper dive on securities, there was
an ability to outperform.
What happened was pretty natural.
Capital flowed in there.
Resources flowed in there.
Technology improved, regulations change.
And right now, there's really not terribly much of an edge in the liquid markets.
And that is showing up in professional investment return performance.
So there's two things that I really try to tell my clients.
Number one is, I think, the most blinding glimpse of the obvious I could come up with,
which is that if there's no edge, then I don't think you walk away and go home.
But you probably should be lightening the load.
And that's, I think, where we are.
The other point, a little bit more technical, is that if you have any appreciation or understanding
for risk management tools, they rely on pricing histories backward in time.
It happens to be the recent past.
But there's a default assumption in most risk models, which I believe in, rather than trying
to go out there and predict using some obtuse mathematics that, let's think in Newtonian
terms.
Tomorrow is going to look like today, only when it doesn't.
What has happened is, because risk analytics reflect a period of extended calm for most
of the year that I mentioned, they have been understating risk.
They're starting to catch up now after October and, lord knows, into November.
They're starting to reflect more what the current volatility conditions are.
But I have been compelled to say, look, if it looks like you have a net position of 30%
or 40% in the equity markets, that may be more the equivalent of 50% or 60% in terms
of the amount of volatility you could actually experience here.
So these are about all you can do.
If we focus on the equity markets, I think one of the things that I believe in that I
don't necessarily feel is socialized among professional investors is just how biased
the return opportunities are on the long side.
And this was not always the case.
But every professional investor I know in equities makes almost all of their money on
the long side, which does not mean that they shouldn't be trading long and short, because
there are certain benefits to doing that.
But the idea of making money on the short side may have existed 20 years ago, now it's
a myth.
And there are reasons for that.
If you sit down and think about it, 98%, 99% of the economic entities, individuals, and
enterprises that have the ability to impact stock pricing benefit when stocks go up.
And I'm not just talking about fund managers.
I'm talking about CEOs and regulators, even, and politicians and investment bankers.
That's a hell of a tailwind.
And the reason that I bring that up is that in general, while I do believe long-short
trading is very appropriate, I do see the performance returns on the long side, which
means when you go through periods of difficulty here, it really becomes about preserving capital
so that you can buy stuff cheap, because if you think you're going to sell Apple at $210
and write it down to $170 and that that's going to be an easy trade, it's not Yeah,
that's a lot more difficult path than just trying to figure out when it's cheap and getting
long there.
That's what the game is all about.
I routinely work with people who have that viewpoint.
And one distinction I have to make is, if you have that viewpoint as part of an overall
strategy that would, in industry nomenclature, be called a macro strategy, so that specifically
what you're doing is trading equity indexes and foreign exchange and interest rates and
commodities, you almost have to have a viewpoint long or short.
To get short there in a diversified portfolio, by all means, it's appropriate.
It's risky, but it's appropriate.
If you are involved in the equity markets, and that is your focus, and you trade both
sides of those markets, and you are convinced that the market is going to go down dramatically,
you certainly are free to adapt that positioning in your portfolio.
I will tell you that, as a rule of thumb, a short
position is probably three times as risky as a long position.
And there's reasons for that.
There's mechanics.
Some of it has to go to those incentives that I mentioned.
But the mechanics of having to borrow and hold that short position are intentionally
designed to impede your success, in my opinion, after a lot of years.
In addition, I think that you need to bear in mind, 25 to 30 years of experience, it
tells me that the vision of other market participants-- and there are participants in this market,
and they are growing, who are really just there to try to take advantage of what they
see as weakness in portfolio construction.
And quantitative models do this all the time.
But on the short side, you're much more visible than you would think.
If you're hanging out there net short, you're doing it in plain sight.
And then, because you can't hold that position into perpetuity, because, as a mathematical
reality, there's unlimited risk, it's not the most difficult thing in the world to just
bid up the securities that you're short and force you out of them.
That's what we call a short squeeze.
And every time this market has rallied since it came off its highs in September, including
yesterday, part of that was being driven by a short squeeze.
So I want to come back to your original point.
If you're super bearish on the market, go ahead, knock yourself out.
Just understand that you're betting against the odds in terms of how to make money.
First off, in hedge fund land, on what I would call an alpha basis, a relative performance
basis, the first nine months of the year were probably the worst of the decade.
It sounds like a big statement.
But we're not talking about including the crash.
That was last decade.
That follows on by October, which was probably, almost certainly, the worst month of the decade.
And now we have November, which is now in the running.
I would say my observation is that for the most part, fund managers were caught unaware
by the volatility spike, reacted late, and have catalyzed some impairment across the
board.
And that is something which I'm greatly concerned about.
I lived through this long enough to know that when they're in impaired capital pools out
there, they don't make decisions that are constructive to an orderly market.
It's a little bit like being out on a speedboat in Minnesota in August at 5 o'clock at happy
hour.
Maybe a good boater, but not everybody on the lake can say the same thing.
I think that it depends on how much longer the externally catalyzed volatility lasts.
I'd like to think it's going to wind down.
I'm on record as saying that it should go till at least Christmas.
It's my belief that there's a great deal of capital out there trading in the world right
now that would like to use their financial resources to induce the Fed to reconsider
raising rates on the 18th or the 19th.
I don't know why you'd get long in front of that.
So I think the risks, as we sit here, are skewing still to the downside.
A lot of funds are going to go out of business.
The redemption periods in hedge fund land are mostly in.
We don't know exactly who's not there.
But how they go about unwinding their portfolios and over what period of time is some concern
for me.
On the other hand, herein lies the opportunity.
If there are investment pools that have to undertake fire sales to meet redemptions and
closures, at the end of that, if you've managed your risk-- and that's the important point.
That's one I'd really like to get across.
And you didn't get crushed here, maybe you can do some shopping.
That's kind of where I'm trying to take people to.
Well, these would be the big global capital pools.
I don't think that these things exist in isolation.
And I don't know how much it would matter one way or another.
But if you look at the overall risk flow position, which is something that I spend a great deal
of time working on-- this is really the art of my science, is, what is going to cause
risk to flow in and out of the market or to redistribute itself.
Well, you have trade wars, and you have a Fed that, on paper, has said it wants to raise
rates.
At the same time, those trade wars, I think, are problematic economically.
I don't know.
I won't comment on whether they're the right move or the wrong move.
Same thing with the Fed, it wants to be on a path to have higher short-term interest
rates.
In the meantime, longer-term interest rates have not moved.
If anything, they've gone down.
And the world's GDP is dropping here.
And we're entering a period of slow global growth.
So I do wonder what the hurry is here.
And I think the totality of that, whether explicitly-- I don't want to act like a bunch
of people are sitting in a room saying, let's send Jerome Powell a message here.
Better not raise rates in December.
It's more of an ethos that says, how can you really have confidence in the policy conditions
of the market right at the moment.
It's a little bit difficult to put on risk with these uncertainties here.
And the end result of that is that capital, I think, naturally flows in a way that kind
of forms this opinion that, no, most of the invested resources would prefer that the Fed
not raise rates and prefer that we were not in a trade war with China.
So it's a little bit more implicit than explicit.
Yeah, I think that's fair.
But look, I don't want to be redundant.
It was always path-dependent.
So there was the results of the 2016 election.
Nobody can be faulted for thinking that that might be accretive to valuations.
And 2017, in fact, that's what happened.
And it was what I call a beta environment.
You had to have gotten the beta right.
It didn't matter.
You really had to be long.
Were those policies going to be followed through?
Would inflation present itself significantly, particularly on the wage side?
Well, all of those things are now rendered fairly ambiguous here.
It's not clear to me that rates are going to be higher next year or whether or not we
are going to be in an all-out trade war with our trading partners or any of that.
So the dice have just tumbled in a way that make things look pretty opaque right now.
And I hear guys all over the place say, well, OK, you've got your projection for 2019.
And everything's fully valued.
And returns are going to be very flat, if not negative.
Well, guess what.
Something's going to happen, good or bad.
It always does.
So I am not prepared to say that.
What I would say is that, before we see the blossoms on Park Avenue, the world is going
to look like a substantially different place.
And I have no idea what form that's going to take.
But that's, again, what makes it the great game it is.
I try not to hang out with risk managers so much.
But risk-takers have a big challenge on their hands.
And I can give you an example.
So let's just assume-- and we may be in the midst of it right now-- that equity indexes
on high volatility end up spinning their wheels over X number of sessions.
They go from 2,750 to 2,550 on the S&P and then back to 2,750.
And that happens over, say, a two-week period.
When I got into this business, particularly into the hedge fund business, that is Shangri-La
for portfolio managers.
Now it is hell on earth.
That round trip is absolutely-- they will lose money nine out of 10 on it in the current
environment, whereas 15 years ago, that's exactly what they were looking for.
So you have to take this into account.
And I think, a just on a related note in risk management, if you read up on it-- and god
help you if you do.
I have to.
But there's a lot of conflating of the concept of risk management with one of preservation
of capital.
You're really trying not to lose money, at least beyond what's parameterized.
And if that's job one in risk management, then there is the job 1A, and that is preservation
of investment themes.
The performance differentiation that I see for several years now, with maybe a few temporal
exceptions, is, did you get blown out of your positions at the lows, because you didn't
manage your risk well.
Or were you a little bit more prudent and managed not only to preserve capital but to
be able to buy names that you wanted down near the lows and ride them up?
I write a weekly update.
And in it, just at the end last week, I saw a statistic that said that the net positioning
of hedge funds, how much of an edge they have, long or short, is at its lowest level since
the beginning of 2016.
It's 20%, whereas typically, it'll range in the 30% to 40%.
There's a time series about that, OK?
So it's kind of a hedge fund concept.
But typically, an equity hedge fund will have long positions and short positions.
If we add up those and compare those in dollar terms to the net asset value, we get something
called gross exposure, which will usually be about 130%, 140%, maybe 160%.
So if you have $100, you might have $150 invested.
And that's all without using any leverage.
That's old school.
REG-T allows you up to 200%.
The difference between the long and the short positions, preserving the sign, is the net
position.
That's how much of an actual exposure, at least on paper, you have to the markets.
So if I take $100, and I buy $100 worth of stocks, and I sell short $100 worth of stocks,
then my net exposure is zero.
If I take that same $100, and I buy $100 worth of stock, and I sell short $80 worth of stock,
I've got a net position of $20, or 20%.
So these numbers will rise and fall.
But they are at the lowest ebb that they've been since the beginning of 2016.
And by the way, from that time period, you're talking about, I think, 10 quarters from those
lows in about February of 2016 to the highs that we had in September of this year, 57%
increase in the S&P 500.
So I'll just tell you, it's about staying one step ahead of the game.
But it ain't easy.
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