Thread by @breakingthemark

I’m often asked my views on long vol and tail risk hedging and if I’ve looked in it.

I haven’t really said much on the topic before, but I have explored it quite a bit.

Here’s what I’ve found in my journey into the long vol universe

On paper, long vol is a great asset to rebalance and run a Shannon’s Demon type approach. Its negatively correlated with many things, often times very negatively correlated. It’s the perfect type of asset to rebalance with other assets to increase the long term(geometric) return.

Pure theoretical long vol is awesome. I started out working with integrating “long VIX” with geometric balancing (my trading strategy).

The number were so scary good (visions of RenTech) I almost resigned from my engineering job the next day.

Thankfully I didn’t because when I tried to find a product which was close to the VIX to implement the strategy in the real world, I quickly confirmed that the VIX is 100% imaginary, far more so than I ever expected.

The implementable stuff easily available (vol etfs) bleeds 15+% each year typically. The “good” years don’t’ go up even close to enough to make up for the magnitude of total crap years. It’s very hard to overcome that level of bleed with negative correlation portfolio benefits.

You can think of it a bit like the math in this post on mixing assets. Negative correlation is great, but if the return is so low it’s still outside the “mixing range”, then it’s not going to help the portfolio.
breakingthemarket.com/optimal-portfo…

This mean for long vol to help a diversified portfolio, it’s going to have to be in some kind of active strategy. Information on these is harder to come by, but what I found wasn’t a turnkey solution.

There are funds that don’t bleed much…

…and stay fairly negatively correlated to the market. But they seem to do so at the expense of volatility.

One thing that was great about pure VIX is it had some real pop. It was quite volatile and would really move when needed. This is really great for two reasons.

1-The higher vol meant the arithmetic return was higher, even though the geometric was still roughly flat. This is obviously a good thing.

2- It also meant that the portfolio didn’t need to hold much long vol. A few percent was powerful enough to “protect” the entire portfolio.

So a long vol fund which has very little bleed, but also lower volatility isn’t as useful as you might think.

While they do seem to help when mixed with a pure equity portfolio, they have a much harder hurdle to climb when it comes to mixing with a diversified portfolio.

My strategy holds stocks, bonds, and gold. Finding a long vol strategy to improve that kind of portfolio is difficult.

Even when a strategy helped the portfolio some, I often needed to mix it with long vol at nearly 50/50 ratios to see any benefit.

And that benefit would disappear at say 40/60 or 60/40 ratios. This meant not only did I need to hold a large amount of the long vol product, I also needed to get the ratio the long vol product to my core portfolio correct to see a benefit.

A product with zero/negative long term return that needs to be held in large quantities, and in a precise ratio to work with my strategy is a difficult sell.

However when you see what theoretical long vol can do, you can’t really get give up on the idea.

Too much potential.

But here’s an interesting thing about long vol:

When you explore the landscape you see each fund is a bit different. Active long vol isn’t one thing, it’s really just a mission to hold portfolios that are negatively correlated and convex to downward market moves.

There are many different ways to approach that, and they don’t all behave the same. They each have their own rhythm and fluctuations.

Theoretically there is huge opportunity in those differences.

I’ve talked about rebalancing assets and the enormous benefits that provides. If stocks goes up, and bonds go down, you can rebalance them against each other harvesting a return premium from their differences and providing additional long term return.

You can do the same thing with strategies that have different return streams as well.

Example: rebalancing a momentum strategy against a value strategy harvests the volatility between their two unique return streams.

Theoretically the more different the better.

But if you could really pick, you want strategies that are very different most of the time, but 100% correlated with each other when they go UP big.

This gives you the benefit of protecting the downside and harvesting volatility in rough times…

…while still experiencing the full benefit of the upside. Now finding something to behave like this sounds like a pipe dream,

Except long vol products kind of act this way.

Because long vol funds are all a bit unique in their approach, most of the time there is some difference between their returns streams.

Normally they are heading down (negative return) because they bleed, but out of 10 of them, maybe 1 or 2 of them will pop up for the month.

Theoretically this difference can be harvested through rebalancing to make the overall bleed of the portfolio less, or even nonexistent. How much depends on how different the vol strategies are, but every little bit will help reduce the “bleeding” during normal times.

But when shit hits the fan and vol spikes, most of these funds are all going to spike together.

They will be positively correlated with each other to large upside moves as that’s what they are designed to do.

Ideally, you end up with a return stream that is often fairly tame with a small too minimal bleed during normal times, with huge moves up during market stress.

Little to no bleed, high upward volatility (right skew) and negative correlation.

Essentially this kind portfolio has the potential to act similar to the way I saw pure, imaginary, VIX behave at the start of the thread, that wonderful imaginary asset which mixes spectacularly well with other portfolios.

In theory, this is a very powerful concept.

I’ve poked at this a bit with real numbers, and believe it should work at least to some degree in the real world.

It’s still very complicated though, as you have to figure out the right mix of funds, and probably more importantly the right frequency to rebalance the funds.

Now this isn’t really a novel idea. There is at least one Swashbuckling manger that’s been charting this course for a while (@jasonmutiny). There may be more I’m not aware of, but a rebalanced ensemble approach to long vol doesn’t seem common.

If I tried to tackle long vol myself, I’d go down the same path:

Rebalance various long vol strategies against each other to harvest their differences in normal markets combating the inherent bleed while still fully capturing the large negatively correlated moves from vol spikes

I will embark on that voyage someday, but I don’t expect it to be an easy one. I’m saving it for a later date as I think there are still frontiers to push in rebalancing simple assets, but will be watching those exploring this path now with interest to learn from their journey.

Oh and one more thing,

This entire thread was written around the concept of the hero’s journey, which I learned about from @taylorpearsonme . The framework is really useful for crafting stories.

He’s got a lot of other interesting ideas too.

https://twitter.com/TaylorPearsonMe/status/1255997019497402376?s=20