In this episode I speak with Dennis Davitt, CEO of Millbank Dartmoor Portsmouth.
Dennis began his career in the option pits of New York and Chicago and eventually worked his way to managing the equity derivatives desk for Credit Suisse. These experiences taught Dennis two important lessons. First, respect markets over models. Secondly, always ask: “what’s the motivation behind this transaction?” And for each of these lessons, Dennis offers a number of stories to entertain us.
In 2013, Dennis left the sell side to join the buy side, and shares with us some important lessons learned about both productizing knowledge and client communication.
In the back half of the conversation we discuss Dennis’s new firm, the opportunity he currently sees in short volatility, ideas for creating a hedged equity strategy when hedging is expensive, and why investors might want to take a page from Moneyball.
I hope you enjoy my conversation with Dennis Davitt.
Corey Hoffstein 00:00
All right 321 Let’s jam. Hello and welcome everyone. I’m Corey Hoffstein. And this is flirting with models the podcast that pulls back the curtain to discover the human factor behind the quantitative strategy.
Corey Hoffstein Is the co founder and chief investment officer of new found research due to industry regulations he will not discuss any of new found researches funds on this podcast all opinions expressed by podcast participants are solely their own opinion and do not reflect the opinion of newfound research. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of newfound research may maintain positions in securities discussed in this podcast for more information is it think newfound.com.
Corey Hoffstein 00:50
This season is sponsored by simplify ETFs simplify seeks to help you modernize your portfolio with its innovative set of options based strategies. Full disclosure prior to simplify sponsoring the season, we had incorporated some of simplifies ETFs into our ETF model mandates here at New Found. If you’re interested in reading a brief case study about why and how. Visit simplified.us/flirting with models and stick around after the episode for an ongoing conversation about markets and convexity with the convexity Maven himself simplifies own Harley Bassman. In this episode, I speak with Dennis dabit, CEO of Milbank, Dartmoor, Portsmouth, Dennis began his career in the option pits of New York and Chicago, and eventually worked his way up to managing the equity derivatives desk for Credit Suisse. These experiences taught dentists two important lessons. First, respect markets over models. Secondly, always ask, what’s the motivation behind this transaction. And for each of these lessons, Dennis offers a number of stories to entertain us, a 13th. Dennis left the sell side to join the buy side and shares with us some important lessons learned about both productizing knowledge and client communication. And the back half of the conversation we discussed Dennis’s new firm the opportunity he currently sees in short volatility, ideas for creating a hedged equity strategy when hedging is expensive, and why investors might want to take a page from Moneyball. I hope you enjoy my conversation with Dennis dabit. Dennis, welcome to the podcast excited to have you here. Recommended from maybe I think it’s my only repeat guest at the moment, Ben eifert. A crowd favorite so big recommendation here. We’re expecting big things from you. But after talking to you, I know you’re going to deliver. So thank you for joining me.
Dennis Davitt 02:48
Yeah, well, Ben is certainly tough shoes to fill. I mean, especially in the fin twit universe, I think we all know him personally and his family more than my own family at times. So
Corey Hoffstein 02:57
well, if it makes you feel any better, there’s been a number of people that have called for him to just take over this podcast instead of me. So there you go. So I want to start the episode with some of your background. Again, whenever I get a chance to talk to someone who is trading in the pits in their career, to me, it’s just such an ample opportunity to talk about the wisdom that was gained there and and perhaps some of the wisdom that’s lost for folks that didn’t have that opportunity to come up in that environment. So I know you spent the late 80s all the way through the early 2000s. Working in the options pits of New York and Chicago, you spent more of your recent years on the buy side, which in many ways couldn’t be much more different. Can you talk to me about some of those formative lessons that you learned in the pit that are still relevant to you on the buy side today?
Dennis Davitt 03:47
I mean, there’s a lot of formative things you learn in the trading pits. I mean, I always tell people, I feel like I graduated from one of the best universities specializing in a task and that was the options trading pits starting in 1988, all the way through 2001. It was a university where you could go and options were in their early days of forming. So there was a lot of experimentation with different models and Cox Rubinstein and Black Scholes and modified Black Scholes and all that kind of nerdy stuff housed inside this locker room for lack of a better term. were people that were geniuses, the money was made on the trading floors back then that’s where the edge was. So it was came down to information flow. And the greatest pivot point of all information was within those trading pets. This is before you had 17 different exchanges. I mean, you basically had four exchanges. You had Philadelphia, the AMEX, the CBOE and the P coast. And even back then there were certain even have dual listings early on and single stock trading. But the one thing that carried through was the lack of Investment drift. And I know that’s probably a big leap from models and everything and investment drift that your job was there to make money. But when you came out of college and you got a job down there, you were hired as a runner and as a clerk, and you would hand calculate deltas and gammas and keep them on cards, and you had trading sheets that you’d print out the night before. And if you lost the trading sheet, it was under penalty of death by the firm that you worked for. Because these were the secret sauce to valuing options, and nobody else you couldn’t see somebody else’s sheets, even though we all stood in the pit next to each other and made the basically the same markets all day. But when I get back to investment drift was, it’s something as simple as not straying from what you were assigned there to do. And what I mean by that is, don’t be trading SPX index options. And because you have access to you take a position in IBM, and start moving out from where your area of expertise is. That’s a lesson that I still use today. I mean, even when I was at Credit Suisse, it was asked the people I worked with, one of the things I would always say is like, what do we know, we can only speculate on what we think is going to happen, what this guy’s position is going to do. But when you’re in that kit, or you’re in that trading desk, at a bank, where all Crossroads come through you in essence, you know, this person has this position on or you know, what your position is, more importantly, and then on the back of that you stay true to that cause. And that’s carried me through even to today, like people who invest in my strategies and my funds. After three or four years, they’ll come to me and be like, No, it’s shocking if you continue to do what you said you were gonna do. And I said, Well, why wouldn’t I do that. And they were like, the list of people who have come in here. And they are specialized in one biotech sector, and then they have energy, or they’re investing in green technology, even though they’re biotech, and it’s not their area of expertise. And I always say, Well, you stray out of the things that, you know, this is a business where I feel, being an inch wide and a mile deep, is the most important thing. So knowing whatever pit you’re in whatever stocks you are trading, or whatever commodity options, you were trading at that point in time, you just didn’t drift, because if you drift, you got fired, if you had large delta positions, never work, your futures was always a thing, like you make your money in the options pit, you capture bid, ask there, and then you would just sell your futures at the market. If you got caught working limit orders in futures, you would get fired, you would also be trading the partners money, which there aren’t any partnerships around anymore. But back in 80s, to the 90s, where I worked for Wolverine trading was an amazing place. It was the two partners money, it was all of the partners money that we were trading, so it wasn’t kind of you seriously took the risk. You never put risk on that could put the whole company out of business the next day. And I think that’s something that was lost, obviously was lost to 2008 when you saw a Bear Stearns and Lehman Brothers, and a lot of these firms go out of business because there was never that feeling of I’m putting the entire firm at risk. So staying true to what you know. And not allowing investment drift is something that I learned there and I still learned today. And then there’s all there’s always this shenanigans to on the floor like you had to be good to your word. The funnier stories that people like to hear was keep it up and I’ll see you at the horse. And the horse was this big horse statue that was outside of the CBOE. I never saw a fight at the horse. But I saw a lot of people saying I’m going to see you at the horse. And so there’s always the physical intimidation that would go on if somebody felt like they were wronged in the trading pit.
Corey Hoffstein 08:51
I want to spend a moment on that cultural aspect though that being wronged in the trading pit are staying true to your word. In an earlier conversation we had you compared the ODX pit versus the SPX pit and actually credited the behavior of market makers for the success of the SPX pit over the LAX pin. I thought that was really a fascinating story. And I was hoping you might be willing to sort of retell it on the podcast.
Dennis Davitt 09:20
It’s easy for me to make fun of the ODX pit now. I mean, at 55 years old, I would say most of the people who made fortunes and could beat me up from the LAX pit are now at least 65 or 70 years old. So I don’t feel physically threatened like I may have I was 25 and they were 35. But the SPX fit was just first of all, it’s a better design product. It had a fungible, underlying asset to it. And it also did not have early exercise. So the American options vers European options, so you did not deal with somebody early exercising and then the customer would get taken out of a position to this risk that he wasn’t aware that he had. So there was a lot of gamesmanship. There’s a lot of like, sharp elbows. I don’t was equated to like hockey or lacrosse, like when the refs not looking at somebody throws an elbow and that kind of the retaliation and the pit was just there was the only index trading pit out there. There were the the X semi, which was the missiles that were traded on the AMEX and the OE x and the OE X was definitely the, at the time, that better product than the SMI. But SPX came along, and it was originally launched. And it failed. It didn’t go well at all. And there were customers that came into SPX. And they wanted, there’s a guy, we’ve had many crosswords over the years, but I’ll give him some credit, a guy named John Sukho, came into SPX, and met with the people in the SPX. And said, I’m going to make this a great product. But you guys have to provide fair markets and allow me the ability to cross some of these orders, everything legal and aboveboard. And he did just that. And the reputation of the pits started getting really good. And what I mean by that is, if the market was quoted, the market was valid. And that kind of loses some punch in today’s market, you can see what’s on the screen. But as an institutional trader, if you wanted to come in and move weight, if you wanted to move $500 million, or a billion dollars of at the money puts, you got to market in the SPX pit, I always said it was an institutional pit. Our screen markets were very wide. But we can routinely fill people on size inside the bid ask spread. And if something traded outside the bid, ask or somebody had changed a market on the screen and took it off an auto quote, and it was an invalid market, it was still made good more often than not to retail investors. But once that reputation got out there that it was fungible to an underlying product, unlike the OE x, and the people in the pit, basically, I don’t say stood up to markets, like their job was to make money. And the reality was, we were going to make more money by being 75 cents wide, and trading hundreds of 1000s of contracts than being $3 wide, and trading a few 100 contracts. And you saw in other products, like there were products that traded cash settled indexes on other exchanges that were just when I worked at Credit Suisse, I’d have to go trade some of these cash, these indexes, and it was literally like the country song like a lost and found border town looking for a diamond ring. And you go in there, what’s the market, it’s this, you go to cross it in the middle, suddenly they take you out of it, then your underlying basket goes away. And they say no, you did the whole thing. And it was horrific to trade now ETFs eliminated a lot of that with the success of ETF and ETF options. But yeah, though the ODX pit versus the SPX, there was a big transformation, how it took over. And another thing too, at the clearing house has gotten significantly better on span margining. And that span margining. And the ability for a firm like the one I work for Wolverine, or some of the other firms that can win there and be able to trade big size, and offset it with s&p 500 futures options, which are traded across the street at the Merck. So you had the way to kind of lay risk off in different areas, which was really successful.
Corey Hoffstein 13:14
It’s no secret that market structure has changed dramatically. You’ve seen it over your career, the pits have moved from man to machine. I’m curious as to what you think the implications of that change has been on markets,
Dennis Davitt 13:30
there was a rule that was ever so often enforced, going back to my days in the trading pit. And you could be saying options trader in the IBM pit. And if there was some internet dog food company that was on the other side of the floor, and there was nobody in the pit, and somebody wanted a market on it. And the specialist there was like physically nobody there. The broker could walk over to the IBM pit and you were bound to make a market in this thing. Now this flies in the face of what I just said about inch wide and a mile deep, but you are mandated that you had to make a market index some market to satisfy a retail customer order. And it was kind of that responsibility that it was a shared responsibility that people had that you would always make a market in something in all conditions. The worst thing that you could ever do as a market maker was walk out of the market. Like this is too crazy for me. I made a few and early on there were like a lot of the Timber Hill and Hall had their screens. And those guys great. But occasionally they would somebody would just flip the switch from upstairs. If stuff was too volatile and they wouldn’t make markets and they’d leave then reappearing the next day when we’re in a much more calmer, more orderly market and expecting to be able to get on those tickets that we’re you’re making 75 cents why and somebody sells 500 options, picks Five Guys, everybody gets 100 The sixth guy is invariably the person who walked out at the pit the day before and wasn’t making markets. So I feel with the move to technology that the one thing is the lack of consequence. And people will argue with me about this all the time. But there’s less consequence now, in turning your machines off than there was back before the machines really ran single stock options trading. And that can be seen in the, it’s made a comeback. And a lot of it’s skewed towards GameStop. And some of the Twitter stocks that are out there. But single stock options trading had really gone away for the most part, post 2010 until this more recent upside call buying resurgence. And if you really look at what’s the concentration of that volume, per stock, versus the top 100, single stock options, stocks that are traded. And that’s come from the move towards machines, the tightening of bid ask spreads, I’m not going to touch payment for order flow, because I don’t want the hate mail from both sides. But if you do like severe volume on a tight spread, you’re going to make a lot of money. We’ve kind of made it like people don’t deserve to make money if they’re a market maker, and I kind of hate the term market maker, I actually like the using the term risk transfer agent. Because that’s really what they are and options like you’re not necessarily a specialist very rarely takes down an inventory as a trade, and then puts another trade on and a single stock, you buy 100,000 shares of IBM, there’s one other side of that trade, you sell 100,000 shares of IBM, you buy the three months 10% at the money call and IBM you may sell a two month 5% out of the money call and IBM is a hedge. So you’re kind of this risk transfer agent. You’re like an automatic transmission on a car and your housing stuff. And you’re ideally making some money while you do that, because you are taking risks. And as a risk transfer agent, you should be allowed to make money. market makers are not the exchange, they shouldn’t collect a de minimis amount of money like the exchanges do, because the exchanges don’t take any risks. And like I said, People argue with me about that. But when I look at the number of market making firms that are out there, and there’s just less and less every day, it’s easy to argue both sides of that it’s good and bad. To me, it just means there’s a part of the business that’s gone away. And the only way it’ll come back is if people are able to make money and doing it. Fast forward
Corey Hoffstein 17:25
a bit to when you were hired by Credit Suisse and eventually ran their equity derivatives desk. And in our conversations, and you telling me stories from this time. And from the pits as well. One of the recurring themes that I kept hearing you talk about was this idea of what I’ll call sort of markets versus models. And I want to spend a little bit of time unpacking this idea. But maybe we can start with a story. And one of the fun stories you told me was about when you were at Credit Suisse, this Starbucks warrants story. So I was hoping you could tell that story for me.
Dennis Davitt 18:00
And Credit Suisse, we would do, there would be these warrant trades and put it in its simplest form, somebody would hand you a pile of money. And then you would hand them back a piece of paper that had Credit Suisse written on the top of it with a guarantee to pay you X dollars if the stock performed above a certain point. So we’ll just say, I forget when the stock was trading, we’ll just make it $100. And the stock was Starbucks. And there was this consistent person would come in, what they would do is it would be a note structure. And you in essence, we’re buying a call on Starbucks. And characteristically, these were not put into comp, they were kind of internal clients, but then every now and then there’d be clients who would put you in competition with five or six different banks. And you would price it, basically you would look and there will always over one year and duration because they’re a capital gain tax ramification, you would always look at the one year $120 Call in Starbucks trading at one year. And you would kind of interpolate that and you would bid the bid, maybe bid a little bit below the bid because it’s just OTC it didn’t need to be printed on exchange. And there was it’s a warrant into notes. So there’s more wiggle room in it for lack of a better term. So we would kind of bid slightly below the market, we’d win 50% of them. That was roughly where you want it to be it kept the marketers happy. This one client came in and kept asking for these and we would fit below the bid we’d lose and then we’d lose again. And then we’d lose again. And each time the marketer would come to me and yell at me that my traders were terrible because they weren’t aggressive enough and everybody else is better than us. I bet Alright, so I go over to the trader and say that can we bid a little bit higher this time because I’m tired of getting yelled at by the marketer to be fully honest. There was no financial motivation behind this at all outside of I didn’t like getting yelled at by the marketers. So he said fine, so we bid you mid market, and the person came back and said, can you improve on that, and bidding mid market on an OTC structure product where the salespeople were going to take a huge chunk out of it for their at risk capital, and all these imaginary math things that you do investment banks to pay salespeople, they would do that. So bidding mid market was like for boat and you did not do that amongst traders. But we were getting yelled at a lot. So we’ve been mid market, can you improve on it? And then I started scratching my head and saying, Fine, let’s be the offer. This call option is offered at whatever the market is $4.25. At $4.75. We used to bid for 15, we bid four and a quarter. Now we’re bidding four and a half. And they’re asking us to improve. So we said fine, we’ll pay $4.75 for it. We’ll just say we were asked, and we needed to really buy this volatility this one time, so we didn’t have to do it all the time. And then the salesperson came back to us and said, Yeah, we lost, you got outbid again, you guys suck again. And we just kind of this is impossible. And there’s a guy and I don’t know if hopefully he’ll listeners, but it is a brilliant trader out there named Gotama Hoosier who used to work with me now as a private equity. He’s like, this is crap. And he went that he backed the volatility back down to the four and a quarter bid. But we forgot. The note, part of these trades was an afterthought. You just kind of went into you looked at Euro dollars, you built the curve out what interest rate are you using, and it was plus or minus 20 pips and whatever your GC rate internally at the bank was, it was more of like, it wasn’t even a trading decision. It was like expiry strike the internal GC rate for what we’re going to get on the money that we take in in hand and this piece of paper with Credit Suisse written on it. And it turned out that they were using, I think were five and a half percent that 10 years or something they were using, like a 12% interest rate. So whomever beat us had a 12% interest rate that they were paying, it kind of like completely flipped upside down. It was not the option, part of it had nothing to do with it. They were just getting back to the basic thing. I’m going to hand you a pile of money, and you’re going to hand me back a piece of paper. And that piece of paper didn’t say Credit Suisse on it, it said Lehman Brothers on it. So it was really going back to what I said earlier, like, that was a great nexus of information. It’s like holy cow. These guys are paying 12 13% Just to get cash in the door at Lehman Brothers, at which point then I called the guys upstairs and fixed income. And I’m like, well, where CDs on Lehman Brothers trading. And they told me a number I forget, we backed it out. And I’m like, Yeah, I wouldn’t sell any of that, because they’re actually borrowing money from their clients at this level. It was an eye opener, and it was one of my more memorable stories like, how do you extract information out of that? And listen, I love telling the story. And I’ll take credit for it. But mostly credit does go to go Tom, because he was the guy who really backed it out, figured it out. But I’ll take the victory lap for him.
Corey Hoffstein 23:08
Well, I think that story leads so nicely into a quote that you told me about a couple of times one of your favorite questions to ask while you were leading that equity derivatives desk. And the question is, what’s the financial motivation behind this transaction? Why did you think that question was so important? As you were leading that desk?
Dennis Davitt 23:29
It’s like a broken podcast. Yeah, it goes back to gathering as much information as you could. There are different sorts of clients. So when I went from the floor trading community, to where my job is to make money, period, that’s it haps, your bid, ask spread. I’m not your friend. I’m not your brother. I’m here to make money. It changed. When you went upstairs to the investment bank, you had more information. You knew who the client was, majority of the time, you knew which way the client was going on the trade. I used to kill the salesperson stand up and be like, Where can I sell 500. And I’m like, just asked me for a market to weigh because more than likely somebody sees something that’s overvalued. And if I make it to a market, and the market on the screen is will go back to the same one, the other four and a quarter at four, three quarters. And I make my market for bid at a half not knowing you’re a seller. That’s valuable information that that client can take and if he has a four and a half bid somewhere else, then he should definitely sell that because that’s my offer on my thing. But the financial motivation came from different types of clients. And listen, a lot of people were found guilty of insider trading. The weapon of choice for insider traders through that period was options. I mean, it was the most options are inherently levered. If you want to buy something for 10 cents and have it be worth $10 overnight, buy calls on a stock that’s about to be taken over. So asking what the finance some motivation is behind the trade. It was just a simple way to clear the air, I will say 90% of the time. And really, by the end of my tenure, 100% of the time, the customer would say, listen, we’re long the stock, they have earnings coming out tomorrow, I’ll put you on the phone with the analyst. We’re concerned, we think the stock could sell off 10%. Okay, well, the stock sell off 30%? Well, I’ll sell a 40%. No, but this is where we think we are. So then I could talk them into doing something like a put spread, instead of just outright buying puts, and say, Well, you don’t need to own all this extra protection down there, because you’re going to be buying the stock down there anyway. So why don’t we just do a put spread. And then that way, if I put the hedge on it, and they were right, but wrong, and the stock went down, 50%, we would actually make money on that short put spread, because of the way you hedge them out, you’re gonna make money on that. So the financial motivation was really a way of one gathering information. Because you’re sitting on a desk, you’re trading 30 different stocks across three different sectors. And then you have somebody call you up and say, in this one particular stock in this one particular sector, that has earnings out tomorrow, make me a market in this, and you have two minutes to do it. So saying, Well, why do they want to do this, and it really helped build a bond between the traders, and the eventual customer. And yes, the salesperson was in between. And it helped build trust with the salesperson and the trader. And everybody kind of got on board, and really ran it as one desk. I mean, nowadays in my current role, is the first thing I do is volunteer the financial motivation behind whatever trade I’m doing almost ad nauseam. I think the younger traders get tired of listening to the old guy saying, This is why I want to do a put spread collar here. But yeah, that’s it. And it also helps separate the wheat from the chaff or the insider traders. Because if the financial motivation is, well, my boss’s friend is on the board of this company, and they’re about to get a cash injection. So the stock is going to be up 25%, tomorrow, they’re probably not going to volunteer that to you over the phone, they’re probably going to tell you to go to hell, and just make me a market. And then all right, if that’s your financial motivation is just for me to shut up and make a two way market. And I hope that you have not good insight and information, then that’s just not a customer that I’d want to do business with.
Corey Hoffstein 27:16
This theme of sort of markets versus models, or people versus models isn’t a particularly new one for you. You told me that early in your career, there was a lot of times you’d actually get sent new pricing models or new options models or new risk models. And you’d actually have to go into the pit and test them out and provide your feedback. I’m curious, in that experience, what do you think, sort of the common nuance was that quantitative models were often overlooking.
Dennis Davitt 27:50
At times, there was I mean, I’ll go back and steal another quote from one of my early mentors who still in the business will be mad that I mentioned his name. But Rob bellick is the founder at Wolverine trading. And he was one of the guys who said, listen, at the end of the day, a model is just a starting point. And my favorite expression is jelly beans. And anyone who works with me knows I use it all the time. I’m like, You’re training exotic options for Swiss bank across three different currencies. You didn’t even know what currency was. So I just refer to everything is jelly beans, like alright, this thing’s worth 25 jelly beans. It’s worth 25 jelly beans. Our market is 20 jelly beans at 30 jelly beans. And when the world comes in and lifts you at 30 jelly beans, you got to sit back and going back to what I mentioned earlier, you make good on your original market. And then you reassess. And you say okay, I am not the smartest person in the world. And I may actually make a mistake every now and then. And this stuff is all on bespoke spreadsheets half the time anyway, back then could have been a hard coded sell. And ideally, you have what’s the financial motivation behind this trade. And you may just find and then you just skew your market. The next market is you trade a respectable amount. And then your next market is I’m 25 jelly beans at 30 jelly beans. And if you’re right and somebody else comes in and knocks you out, well, you just made your five jelly beans and you move on and you’re back to 20 minute 30 Or you get lifted again. I mean, there are these great stories about the size that gets traded in the US. The US is a unique market and especially in terms of index options trading. And having grown up in it. I did not know how unique it was. And the US is the ability and the want to take risk in the US it surpasses any other country in the world, be it Australia, Europe, Asia, it’s all like especially in derivative land. Everybody has a theoretical value and the job is to solve your eight sided Rubik’s Cube faster than the other guy or make it so complex that you laugh at them because they can’t figure it out. The US is a little bit more like this is our market. It’s vanilla. I have an opinion on ball or I have an opinion on rates. are the underlying and that’s what I’m going to do. So their size here can be really big. And people would come over from Europe to trade on us trading desks. And they were brilliant. I mean, absolutely brilliant Paris. Colet, French, chess masters is a term we always used to like to use. And their model would say that they should do something. But meanwhile, you knew that going back to say like, what do I know, I know that this fund will come in and sell calls to me at a 5% implied volatility my head keeps and so there’s no reason to buy these things at 7%. Even though it’s the cheapest volatility you’ve ever seen, they have another inventory coming, you know, long dated volatility variable annuity funds need to buy 10 year ball, and they will pay up to a ridiculous amount of volatility for it. Well, people would come in and man verse models, instead of assessing the market, and instead of truly using elasticity, they will be married to the model. And they would just make their markets, they would stay 20 bid at 30, Jelly Beans till the whole world lifted him at 30. And then it would go 35 bid. And then they would be out there selling them at 35 defending the position they had on it 30. And eventually, they need to get tapped on the shoulder and have to cover it, or the event would happen. And the thing would go to 50 or 60. I mean, we saw a lot of this in going into the financial crisis. Like the story I told before knowing that like listen, Lehman is significantly worse off, than most people realize, because they’re paying this much money to borrow money. So we would just have a short bias in that stock, we would not sell puts on that stock, because regardless of how high it was, somebody’s like, it’s an ad vol. And I’d be like, alright, it’s an 80% Vol, it’s an option with two weeks to go, you’re selling something for $1.50 on an $80 stock, that could go to zero and that putt could be worth 60 bucks. It’s just not worth it, the members model it. But when you had to cover your ass, you would always be able to go to certain banks that were notorious for correlation trading. And you could kind of lift them out on something in the broker dealer market that they thought was ridiculous. If you had a really strong opinion, that was the best place to go.
Corey Hoffstein 32:31
So one of the dangers of doing a lot of media spots as you have over the years is that they sort of live forever, which gives me a tremendous archive to go back and pick from and I want to return to a day, August 3 2007, which was actually the day of Jim Cramer’s famous, they know nothing rant. What most people probably won’t recall is you were actually the guest who appeared right after that rant. And you were actually pitching at the time to be short puts on xls, which is the financials ETF. We all know sort of what would happen over the next year. But I want to go back in time and get your thoughts. What was your thesis at the time? And with the benefit of hindsight? What do you think you got wrong in that thesis?
Dennis Davitt 33:24
Everything? I mean, the short puts on XL F there’s a great story around that. My age, a lot of great stories. But yeah, the Jim Cramer thing was very funny actually ran into Jim Cramer at a conference once that CNBC through and I was there with him and and I remember I went up to him and I said, I have some Jim Cramer trivia question for you. And he was very kind and kind of like, okay, what’s the stock? What year, blah, blah, blah, and I go, No, it has nothing to do with stocks I go, when you famously melted down with Erin Burnett, who followed you when you came out of commercial who was on camera. And he looked over and he said, I have no idea. I was getting yelled at by all the producers. I thought I was never going to be on television again. And he’s like, Hey, I just want to hate to been that poor son of a bitch. And he’s like, who was it? And I’m like, it was me. And if you know me, I actually look like Jim Cramer on steroids. So he was kind enough to take a picture with me and I had him stand up on two or three steps. And I said, What’s a tweet this picture I tell everybody that Cramer really is six foot five. Look, he’s standing right next to me. It was fun to meet Jim Cramer after that. But I was in the green room in a remote studio where I didn’t have a feed and Kramer lost it. I went in sat down with a mic me up I did the whole piece and came out much to my then BlackBerry exploding saying, Dude, you just said sell puts after Cramer said the world is gonna end. The trade was interesting because we were seeing an enormous seller through those warrants to strike her product of puts and Citi Group and all the different banks, it was a trade that was very popular in Europe. So we were able to acquire OTC very inexpensive downside volatility. And as soon as we got it in the door, we would chuck it out as quick as we could, because it was one of those things like we knew more was coming. And then as the financial crisis really started heating up, and even with that information that we had, that we felt Lehman was in a lot of trouble. We look to SLF. And the quote was, I remember the trader, I was working with a kid named Tyson Crawford, kidnaps a man. But I looked at him like this is going to be a great trade. And he’s like, Why do you say that? And I said, because the only way we’re going to lose money on this trade is if the financial system as we know, it completely melts down. We were selling down 25% puts in X LF for I love to use the term from when genius failed, at a level that was guaranteed to be usually profitable. So yeah, we did that trade. And over the next two months, probably like two or three weeks, because things really started heating up. And they were just better opportunities to deploy short downside puts, they were everywhere, that we took the trade off. And I remember asking Tyson I said, let’s just run this position, and a book, paper trading book on the side and see how much money we left on the table by covering this for like a three or $4 million loss, like how many hundreds of millions of dollars would we have made on this and it obviously went the other way would have been a disaster, it would have been the year’s budget for the derivative trading desk in the US. So that’s what I’m here to tell people is, you always remember your worst trades. And I would have to say taking that trade off was probably one of the best trades I did, even though it lost a bunch of money. You remember those sorts of things. But yeah, we had everything wrong about the financial system going in, even with the window that we had. That’s what a different time it was. And right now, I think
Corey Hoffstein 37:00
another spot that caught my eye that you did was on February 7 2018, which was right after the vol mageddon episode when the XIV ETP blew up the short vix futures ETP. in that spot, you said quote, short volatility is not the story of what happened. What really happened was unrealized leverage. I thought that was a really interesting distinction. And I was hoping you could explain what you meant by it.
Dennis Davitt 37:31
The interesting thing about that was actually went on CNBC with Brian Sullivan in the afternoon in November ish. It’s probably December ish, because I remember I was in Denver on vacation. And we had talked about was the VIX. It did indicator was the topic. And he said, I don’t know the VIX is at nine and there’s never going to be volatility anymore. In 2017. I always warn people, that was the outlier and volatility. I used to joke I say, volatility hasn’t been this low in the equity markets since commercial airplanes had propellers on them. And it was just unprecedented. And maybe I’m a little sanguine, because I was pitching a long volatility strategy at that point, getting no traction, because it just kept going lower and lower. And everything that was shortfall was making tons of money. But those etps I said, the only fly in the champagne is these Exchange Traded products. Nobody knows how they’re going to behave in times of market stress, because they were all invented, post the financial crisis. And they were invented in a way that the banks could buy volatility from the street, buy volatility from small investors to help them pad their downside. And they became wildly successful, and they should have been wildly successful. You’re basically selling levered short volatility post financial crisis, which was a great trade. The problem with that is it was the embedded leverage in that product. The only way I can explain it is if you looked at the returns for the previous three years, in that product, it was like 100% returns and 50% returns and a 200% returns. Now, mind you, this is a short volatility product. And the VIX went from 14 to nine. So it wasn’t like the VIX went from 80 to 20. It went from 14 to nine, and you were realizing 100% return and by nature, everybody knew that it had leverage in it except the retail public that was investing in it. And I always felt like those products were the devil because they just created more volatility being sold into the market, which made the VIX go lower, which created more to be sold into the market, which made the VIX go lower. It was a poorly designed product. And it really it knew Have a whole investor class out of the derivative space. And I went on CNBC that morning afterwards, and said, like, it’s not short volatility that took people out on this. And we’ve seen moves and volatility before. It’s the leverage that’s in these products. And I remember people argued with me, like, buyer beware, and you bought this thing. And as I can’t, but if I told you that this asset could go to zero, overnight, your risk appetite is going to be significantly less than what it is. And for the professionals in it, there are people out there saying these things, or events, they’re going to go wrong, and they’re gonna go wrong in a big way. Because there are a lot of orphans who made a lot of money when that happened, because they owned downside puts on those things, knowing that there’s a poison pill embedded in there that if you got to move over X percent, it was an infinite amount of vix futures you would have to buy and the fund couldn’t go below. I used to say your log normally bound by zero. But after watching crude oil last summer, you’re no longer locked normally bound by zero. So we could have negative vix if, if there’s no place to store your volatility like oil. The other thing is, I explained it to people who don’t know anything about volatility or fixes is my love for bacon cheeseburgers. And I always wish I could find a doctor, who would just tell me that here, take this pill. And you can eat three bacon cheeseburgers every day for the rest of your life, and it won’t have any bad effect on you. So I go through two or three years eating bacon cheeseburgers, and I have a massive heart attack and I die. And as I’m dying, I look at the doctor and I say what you told me that these bacon cheeseburgers weren’t going to kill me. And he kind of shrugged his shoulders and says I was wrong is the what a lot of those fix etps were in my opinion, people were told, Oh, you’ll be fine. Just don’t worry about it. And it goes back to wrote an article once about risk. And risk is a great thing. You take risk, and you get rewards. The dangerous thing is when you’re taking risk, and you don’t know it. And we’re seeing that more and more unfortunately, in the asset class I’m in in derivatives where there is this perception of no risk on the book, but we’re magically dripping out 50% yields out of products. And that can happen if you’re in the business of capturing the bid ask spread. There are market making firms which do really well. And that’s pure alpha. And pure Alpha exists by capturing bid ask spread, everything else gets made very efficient, even capturing bid ask for it gets made very efficient. But I think people need to be cautious of there’s something you’re generating that revenue flow, because you’re selling some sort of kurtosis, or fat tail events, somewhere in that portfolio exists.
Corey Hoffstein 42:47
After Credit Suisse, you made your way to the buy side and worked at harvest where you were a partner and portfolio manager. I think a lot of people woefully underestimate how difficult it is to bring product to market. It’s not just enough to be smart, you can’t do that if you build it, they will come it’s just not that easy. I’m curious as to what your framework was having moved from the sell side to the buy side for productizing, your knowledge that you had,
Dennis Davitt 43:15
all too often, there are people in the business that are smarter than me, that come up with great strategies. And they’ll sit there with not very much money in those strategies, because they have no way to communicate how great they are. I fancy myself to Chuck Schumer of derivatives, there’s not a microphone that I won’t talk to. And if my favorite subjects myself now, the ability to communicate what you’re doing on the fun side, coming from a bank seat is difficult. If you’re a pure form trader, it’s extremely difficult, you’ll find most people that are successful on the buy side of the hedge fund or the asset management community tend to be really from a sales background. Because the most important thing you do in running these businesses is it’s about distribution. It’s about communication. It’s about I always tell people like where do you really earn in this business, and it’s on the rentacar bus, you fly to places and you sit down and you talk with people and you develop a trust with that person, that you know what you’re talking about, and that they know what they’re talking about, and that they are smart to invest in you because you both understand what our common goal is, and there’s no investment drift. That sounds simple sitting here at my desk. But it’s not because you need to go out and not explain things to people to make them feel like I’m so much smarter than you and you’re just going to have to trust me that’s not going to work or make it so basic that I use these things called options and you have to trust me, and it’s very hard in the period of zoom. I’m fortunate that I had been on the road for seven years, talking with people and in the early days when I first went out I had the benefit of working with a guy who’s been an asset management salesperson for many, many years. And he introduced me to a lot of clients. And I explained to them what I was doing. After like, two or three months and about 20 meetings, I realized that I was taking the whole wrong tack that was doing with every single person would do, I would go in there and be like, Alright, I’m this derivative guy, and what do you want? And everybody wanted rainbows and unicorns, and 80% of the upside and 10% of the downside, they want to pay 35 pips for it. And then you have to look at them and say, That doesn’t exist. And they’ll say, well, the guy who was in here before you told me it does, and then you’re like, well, that guy’s a liar. Now you have a great relationship, you’re really building trust with them saying, what you want doesn’t exist. And the person who told you it does exist, that guy’s full of crap. So that was not the tack to take. But what I did do is I go in and and I would sit down and ask people, What do you hate? What’s in your portfolio that you hate? What’s the one thing as CIO when you have to go in front of the trustees and the board and explain the performance of this one asset class, or this one strategy that you’re invested in? That you just dread, like you hope the fund you’re invested in starts with the letters z, because they tend to go alphabetically through the investment. And if they don’t get to z in this meeting, you’ll have another quarter where maybe the guys that investment fund z will catch up? What are those guys do, and invariably came back seven years ago was long short equity, hedge funds, and hedge fund fund of funds. People didn’t like their fees, they didn’t like the transparency. They didn’t like their lockup periods. So I was able to then just craft stuff to say, well, I can use derivatives. To solve that problem. You have to be careful of not calling yourself a solutions person, because then you’re going to be solving for high net worth individuals concentrated stock positions, which is not something I do. But solving problems, like some of the problems you see now is, what am I going to do with my risk parity, bonds are at zero, those sorts of things. So hate is a very strong emotion. And people will get to what they hate, I find much faster. They know what they hate, they don’t really know what they love. So identifying like what the problems are in certain asset classes that they have. And then using options to do that, the volatility group, I practically have been thrown out of risk management conferences for preaching that volatility is not an asset class. It’s just one of many tools you can use to solve what you hate in your portfolio. So that’s my tactic for raising assets. While you’ve
Corey Hoffstein 47:44
recently taken it upon yourself to strike out on your own, which is a real opportunity to bring products to market that you truly believe in. You recently co founded Milbank, Dartmoor in Portsmouth to offer some of these volatility based strategies. And 2020 was a year that a lot of short volatility bets imploded for institutions, some of which you witnessed firsthand. So first and foremost, the number one question I want to ask is, why does your firm name sound like a law firm?
Dennis Davitt 48:16
The new firm Milbank, Dartmoor, Portsmouth, MDP. Our advisors and our backers on this are very fortunate to be partnered with Richard turbo and Mike Novogratz and talk about Richard. He’s like, What are you going to name it? Because he has a lot of investments, and he’s backed a lot of very successful people. And it’s always the he’s like, naming it is always the hardest part. And I was kinda like, yeah, I don’t know. I’m working on that. And he’s like, Yeah, you have to get a name. So went back, and I’m based in Asheville, North Carolina. So you think about some of the mountains and that’s to regional. And then I always joke if Ben ifer didn’t name his fund after his kids, then nobody has a right to name their fund after their kids. So I didn’t want nothing familial or anything like that. And then, one afternoon, my wife came up to me and kind of threw the iPad at me and said, Milbank, Dartmoor, Portsmouth, and I was like, well, like you said, what? Sullivan? Cromwell? What law firm in Manhattan is that and why do I care? And she’s like, No, jackass. Those are the three prisons where your great great grandfather slash uncle Michael dabit did time in England for running guns prior to moving over and becoming a leader in the socialist movement and the land league act with Parnell and other Irish revolutionaries, and formed a lot of peaceful protests and prison reform and stuff like that. So yes, it sounds in this country, very proper white shoe Wall Street firm. But if we were in England, it’d be the equivalent if I named my firm’s SingSing railway and Alcatraz. So that’s little bit inside baseball behind the name. It’s kind of morphed in my partner Mike McCarty and I, we just refer to it as MDP. And it works out that his name is Mike McCarty, my name is Dennis dabit. P is for a partner to be named down the line. So there’s a whole bunch of acronyms that you can pull out of that. That is the name as far as short volatility is concerned. My career Credit Suisse, I worked for a guy and I remember he came up to me, we’re doing very well in the index books, when I ran the index, part of the business and he said, You’re very good short volatility trader, you’ve made a lot of money being short volatility. And I kind of I don’t know what were rated on this podcast, but had a few choice words for him. Because I hated that I hated being considered a short volatility trader, I consider myself a type of trader that would take advantage of whatever the marketplace was offering me of the VIX is at nine, I want to be long volatility, whatever the statistical best bet in volatility right now to do. That’s what I want to do, which just happened to be in 2003. When the VIX was really high, we were not seeing movements in the underlying there’s a great deal of uncertainty, there was post September 11. So insurance premiums, for lack of a better term were very, very high. On the back of that having seen, like you said, firsthand, full disclosure, I worked at Melkite. I was there. I started in January, and then unfortunately, by March, they liquidated the fund. One thing I realized is that the current environment right now, there’s a dearth of short volatility, suppliers in the market. There’s, we mentioned the etps. Earlier, they were taken out and they were like, I always described to people as an enormous wet blanket on top of the volatility market, just laying there constantly dripping volatility in the marketplace, collateralized put selling, had a very difficult year last year, not so much for the sell off in the market, but for the rapid rebound in the market. And I know some people are very good, collateralized, put sellers who really had a struggle. I know some people who are very bad claros put sellers and lo and behold, they struggled also, I do feel that the short side of the volatility in the marketplace right now is kind of an interesting place to live. I feel there’s a need and a want for tail risk hedges right now. People are looking for, they’re saying, I need some sort of tail risk catch. And I go back to them, and I kind of shrug my shoulders and be like, Alright, when the VIX was at nine and 11. And I was pitching you a long vol product. You wanted nothing to do with it. And now the VIX is bouncing between 22 and 30. You want to go out you want to buy optionality here. So I think the short side of the market is where you want to live. I think a great analogy was made once like the VIX at nine, you’re trying to throw a football through a kid’s bicycle tire. When the VIX is at 35 You’re throwing it through a truck tire, there’s more room to be wrong. In this higher vix environment, the distribution curves that the tails are all fat. And they should be because there’s risk in the market. There’s uncertainty in the market. But it’s you’re getting compensated to take that risk. Kind of like I said, by cheeseburger thing before, now you have somebody saying, Yeah, you know, you can eat one cheeseburger a week, and you should really enjoy it. But there’s risk and if you eat three of them a day, you’re going to look like Dennis stab it. So don’t eat three cheeseburgers a day, just eat one and really enjoy it.
Corey Hoffstein 53:36
So as you survey the landscape of short volatility strategies, what do you see as being the key differentiator in the approach that you’re bringing to market?
Dennis Davitt 53:47
I think one of the things that I do that’s different than a lot of other people do is I make it like, slightly more complex, but not so complex that you can understand it. One of the things that people found in some of the short volatility strategies were a lack of liquidity when they needed to have liquidity. So staying in liquid products is very important. I also think looking at the relationship across the term structure is extremely important. I hate the term the Vala vol. But the volatility of term structure, which is I guess, in essence, the volleyball is really dynamic right now, and it provides you with some great opportunities. Without that aforementioned wet blanket of volatility dripping on the market, you will see the front end of the curve spike up a lot. And I think you need to balance that with how you structure certain things, the iron condor strategy, which much maligned which I think, at the time, going into the end of 2018, probably had close to $40 billion in assets, I think is a fraction of that currently. And I think this is a great time for that sort of strategy, but I think it needs to be spread out. Not all within one month. And then that’s something that I do differently that I haven’t seen other people do. But I surely haven’t seen what everybody does. I just think it works now, and provides a great opportunity and who you’re competing with, not even on an overlay strategy just more as a direct investment vehicle, versus high yield bonds in the fixed income area. Like once again, getting away from volatility as an asset class is listed options can provide you with a well constructed portfolio to compete with a fixed income instrument, you can target a certain mid to high single digit returns, that is not correlated to the market movement, and pull out of that with a limited risk and still have the liquidity where some of your high yield bond funds may not have the liquidity that’s needed, if you want to go take that money, that cash that you’re sitting on and put it to work in the equity market. If it were to sell off, right now, term structure is what I see. And I still believe that some sort of private equity structured, long term volatility is an ideal way to go. But it’s getting, you’re asking fixed income people to look at equity derivatives as a replacement. And now you’re asking private equity people to look at equity derivatives as a replacement instrument. And that’s a tough sell. But if you find the right person to do it, I think it’s great. I think there’s so much to be done in these products, the people just have to open their mind a little bit within their asset classes of how they’re used.
Corey Hoffstein 56:33
I want to go back to something you said very early on in the conversation about keeping a very narrow focus, sort of doing what you say you’re going to do. And I want to contrast that with the many degrees of freedom that are available. When you put on any sort of volatility trade long or short. There’s sort of the structure of the trade, the tenor of the trade, how you’re going to manage the trade throughout its lifetime. As you think about building this short volatility strategy, how do you balance that balance the need to sort of stay focused, but also give yourself the breadth to take advantage of the opportunities the market is presenting you at any given time,
Dennis Davitt 57:14
it goes back to the ball mageddon Do not put yourself in a leveraged position. I mean, options are leveraged by design. So adding leverage to a position is the one thing that’s going to take you out of the position, I also think being true to your marks to a certain I know that sounds silly and listed stuff, but really being true to like what you think their value and your ability to liquidate that position at any point in time is. So if you can stay liquid, I mean, going back to my SLF example, before getting out of that position. If that was some sort of structured CDs, or variant swap product that I had on SLF, I might not have gotten out of that position, because I might not have had the ability to get out of that position. So transparency, simplicity, in execution, which oftentimes, will people confuse with like, well, this is a simple strategy. And the simple thing can do it. The true genius is in simplicity. And saying this is the goal. This is what the client wants, how do I design this in a way that the client can understand it? And simple discipline? I mean, it made going back to your original question of like, what do I remember from being on the trading floors was, you have to do this, this is your job. This is what you’re hired to do. And I don’t think enough people take that approach nowadays. I mean, I think there’s a lot of there are funds out there that are free range chicken funds in whichever way the wind blows, they’re gonna go trade that asset or trade this asset, but, I mean, I personally will not ever trade Asian warrants. Because it’s not my expertise. Does that mean that at some point in time that we will have a strategy or something that trades Asian warrants? Probably, I’ll probably hire somebody who I know and trust and I feel comfortable with bringing into the firm and have them trade Asian warrants for us. Yeah, that’s the way to do it. But tight risk controls on that and understanding what they do. I go back to like I said, I’ve had many mentors in this business that have taught me a lot and that the discipline of staying true to the course or staying on the plan is paramount.
Corey Hoffstein 59:25
After 2008, sort of the commonly repeated mantra among product developers was no shorting no leverage, no derivatives. Short vol is sort of, I think a lot of people would consider it to be the antithesis of that mantra. This idea you’re talking about of using short vol strategies in some way as a PE replacement, a much more liquid PE replacement or bond replacement is really interesting to me. I’m curious as to what you think the willingness of the RIA or even the institutional community will ultimately be to accept Alterna have that sort of contain these features as a replacement for more traditional asset classes?
Dennis Davitt 1:00:05
Well, I think the RA community is one that I’m getting more and more exposed to. It’s another step in my career of 35 years, another reinvention. Because prior to starting MDP, I dealt only on the institutional side, at my previous jobs, large endowments large pension funds. I’ve still talked to large endowments large pension funds, and we’re talking a lot about short ball. I also have my flagship product, for lack of a better term is really a long vowel. It’s a hedged equity, but short vowel, I just think right now, there’s such a great opportunity in short ball, that’s where I think people should look to do it. If you ask me what the opportunity is, I mean, I still think you can use options for a lot of different things. But getting back to your question about the RA community, I think they are massively accepting of this, I think they are going back to what do you hate? When I talked to them, they’re sitting there with investors that have been sitting in cash, they don’t know what to do with their cash. And a lot of them are waiting for the pullback. But as they’re sitting on cash, they’re not earning anything on the cash that they have. So that’s why sometimes dumping that into the concept of owning a bond that pays them one and a half percent over 10 years, just gets a lot of the people the high net worth individuals that have those positions. It just puts them in a really bad headspace. I think from what I can gather, I mean, rates could go to zero, and they could realize a 10 or 15% return on their bond position. But that just that overall thinking scares them. And it’s been proven out like this year is a problem. Risk parity is a problem for see the breakdown correlation between bonds, the negative correlation between bonds and equities. What’s the replacement for that in the RA community, they’re much more open to doing it. I think it’s because they can also move. If they’re confident that they can move in and out of stuff quickly, they will do that. But the RA community vers the institutional community, I feel the RA community moves significantly faster, and is significantly more accepting. And it can be as simple as a lot of numbers. How many RAS do we have in the country? Verse? How many consultants do we have in the country, and even though we have 1000s, of foundations, and pension funds, they pale in comparison to the number of RAS and especially with more and more RAS becoming independent RAs and having the ability to look at new products. That’s another major thing is like the large wirehouses, it’s very difficult to get on their platform, if you want a 40 act fund with your strategy. They have all kinds of five years and x billion dollars in assets that you need to qualify, but independent RAs are looking for things to distinguish themselves. From the I am not going to mention any big wire houses because I would love for them all to love me. But there’s an ability to distinguish yourself by investing by having an offering by something like MDP, like what we do here, as opposed to the guy down the street who works at a more commercial wirehouse, who only has seven or eight different things that he can offer you.
Corey Hoffstein 1:03:15
Before we started recording, you sort of mentioned to me what you were seeing in the landscape today at this irony of Moneyball math. And I thought that might be sort of a fun place to end your view on something that was taken from this industry into baseball, the industry could sort of relearn from baseball,
Dennis Davitt 1:03:32
there’s a great book out there called the extra 2%. It’s not as popular as Moneyball. But it’s about the temper raise which I’m a big fan of and friends with Stu Sternberg, and those guys. But I was thinking the other day about what we were just talking about how the RA community is much more willing to accept derivatives and a package substituting out for a fixed income instrument or substituting app for private equity instrument, you need to look at what the goal is, for this asset class. The goal is to get us a 5% return with X amount of risk over a certain period of time. How do I do that? And that may be like using the guy who used to be a catcher to play first base, or putting four people in the outfield and pulling the shortstop out, or all of the mathematically driven stuff that they were doing in baseball, which has changed the game and I don’t know enough about baseball, really do it. I just liked the movie. But that approach that open mindedness and not being locked into, no, this guy is short. He’s got big thighs, he’s a catcher. Oh, you can only have a left handed guy play first base, or you can only take this certain approach because that’s the way it’s done. And that’s the way it’s always been done. And that is an old school approach to doing this and old baseball school approach to doing this Whereas in the IRA community, I think they’re much more like Billy Beane, and they’re much more like Moneyball. And they’re much more open to say, okay, that works. I’ll give that a try. And oh, by the way, it’s unconventional, but it’s working. unconventionality is cool when it works. I think there’s just so many people have a fear of doing something unconventional. And nobody wants to be the guy standing out in the crowd. Like, what do you mean, we’re not all going streaking today. So it’s probably not a very good example. But I think that the community there is accepting. I mean, I remember going to speak about my favorite subject myself, back when I used to row and it was a transition away from wooden boats into carbon fiber and fiberglass boats. And there would be people who swore that they had a row in these wooden boats, because they could feel the tension and they had different types of wood were used. And this wood was better than that wood in certain temperature. And along came these plastic boats, fiberglass, carbon fiber that were lighter, faster, cheaper, you can leave them out in the rain, the more durable, and they just suddenly, nope, you showed up the plastic vote and people thought you were crazy. And then you started winning all the races. And I think right now, I’m hoping that the financial community will start accepting some of these products. Now, on the other hand, we have an uphill battle, because some of our plastic boats have gone out there broken in half and sang, there’s a long list of derivative funds that have gone out of business and really left a lot of damages, even recently, and it goes back to long term capital management, which blew up on short, long dated vol. That’s myself of being an old timer. And when it talks about people, there’s a need for you almost wish there was a good housekeeping seal of approval for derivative strategies. Yes, this has no leverage. Yes, this is a liquid product. Yes, this is transparent. Those are the sorts of things people should be looking at when they invest in derivative products, and shockingly, is coming out of the era community.
Corey Hoffstein 1:07:08
Last question for you. I’m optimistic about the future. Here, we’re starting to see a lot more of the vaccines rollout with greater speed, keeping my fingers crossed about new sort of COVID strains not being an issue, Assuming all goes well, and the world is starting to return back to normal mid summer, maybe late summer. What are you looking forward to doing most?
Dennis Davitt 1:07:33
As I mentioned earlier, I’m in the mountains of western North Carolina. So COVID really didn’t impact us here like it did in other parts of the country where parts of the country been devastated. I’m looking forward to being on a crowded aeroplane. And I know that sounds crazy. But so I’ve been traveling recently. And I can tell you, anybody who says that travel is dead, and we’re going to be zoom conferencing. Going forward is nuts. I put out feelers to people saying, Hey, I’m going to be in town Do you want to meet? And it’s like, yes, like immediately Sure, we’ll meet at McDonald’s, we’ll do something like so there’s definitely a need, especially being a new fund. It’s really hard for me to go out and pitch what we do over zoom, unless you know me, but you need to build out that Rolodex of people. So I’m looking forward to sitting in the waiting room at a pension fund or an endowment, looking like the guy who’s there to fix the air conditioner, which most the time I tell them that I’m here to fix the air conditioner. And then just looking over at the guys in the great suits and expensive shoes and saying private equity hmm. And they all nod their head head, you know. So I’m looking forward to making fun of private equity guys, and waiting rooms of pension funds and endowments
Corey Hoffstein 1:08:51
of dentists. This has been fantastic. Thank you for joining me.
Dennis Davitt 1:08:54
It’s been a pleasure. Thank you. So you mentioned that
Corey Hoffstein 1:09:01
your flagship is your hedged equity strategy, but the opportunity right now may actually be in short, Vol. So how do you sort of meld those seemingly contradicting ideas? How do you effectively run a hedged equity strategy when it seems like buying protection may be prohibitively costly?
Dennis Davitt 1:09:22
It’s great question and buying protection has always been costly. I don’t know if I would say it’s prohibitively costly. Even with the VIX at 11. There are times where outright owning puts can cost you as much as 8% a year and that’s just way too much money for people to spend. I remember running back tests and you’d say if you bought puts, you could actually add to the volatility of your overall portfolio. And an example of that as the markets down six or 7% and volatility doesn’t expand and the value of your put goes down by $3. So now you’re down six or 7% then your equity portfolio and you’re down 1% on your hedge, and now you’re down 8%. In total, you’re now adding to the volatility of your portfolio on the downside, which is not anything anybody ever wants. And my days at Credit Suisse, we would deal with that. How options act can be conversely to what people think is going to happen. Another is that people buy calls and a stock, the stock goes up and stops just short of their call, the call expires worthless, I should have just bought the stock and not bought the call. What I’ve realized over time is to this is about as simple as it gets, when you own a putt, two out of three things stink, the market goes sideways, you lose money, the market goes up, you lose money. If the market goes down, you should make money. So what you’re really hedging is you own a putt, what are you going to do to mitigate the risk and two thirds of the scenarios, and how you finance that putt. So you rotate amongst different strategies depending on what the world is presenting to you. And when I was at Credit Suisse, I designed a product that people still use. It’s called the Credit Suisse fear barometer, a guy named Edie Tom who I worked with and I, we developed it there. And it’s just a measurement of skew in the marketplace. So skew is really high. That means puts relative the calls are really expensive. So what you can do is you can take advantage of that by buying a putt that is closer to at the money, and then financing that by selling an expensive downside putt. So you’re kind of as a hedge, you’re really just putting a buffer on your portfolio to the downside. And then there’s times when skew is really steep. And for the quants, as you all know, under a normal distribution curve, the area under that curve cannot be greater than one. So if you have a really expensive put, it’s almost like a seesaw, upside calls get incredibly inexpensive. So when do you sell the call to finance that? Well, if skew is really steep, you just don’t want to be short calls. So I mean, so much of what we did, and so much of the performance that we would get was really not what we did. But what we didn’t do. So in 2017, and really 2018 Right before Obamacare, and people forget, in January, the market was up six and a half percent. And that was because there was a fund out there that was overly short on ratios, upside calls. So to lower the volatility in the portfolio, the best way to do that is by using a volatility tool, or volatility product, which would be a listed option. The best option to do that is owning a put. So the difficulty in owning a putt, is in two out of three of the scenarios, you lose money. So how do you hedge out 66% of it, one of the ways you can do that is by selling a downside put in that high skew scenario. The other way you can do it is by selling an upside call, which he was not so Steve. And sometimes you do both. If you’re in a really low skew high volume environment, you can sell both the put and a call all the wild financing that put one of the things that is also Paramount is there’s no leverage in this portfolio. So for any call that you’re short, you’re long an equal amount of underlying notional against that call. And for any put that you may be short, your long a higher struck put within the portfolio. So this is the best way to approach an overall hedge a truly negatively correlated asset class versus the long equity position that you would have and you can do it on any index that has liquid underlying options.
Corey Hoffstein 1:13:50
If you’re enjoying the season, please consider heading over to your favorite podcast platform and leaving us a rating or review and sharing us with friends or on social media. It helps new people find us and helps us grow. Finally, if you’d like to learn more about newfound research, our investment mandates mutual funds or associated ETFs. Please visit think newfound.com. And now welcome back to my ongoing conversation with Harley Bassman as a fun bit of history trivia for our listeners. Our first interaction was actually about I think two years ago when I emailed you asking to join your mailing list. And as I recall it, I’ll admit I didn’t have the courage to go back and look at the emails. But as I recall it, I received from you a pretty pointed critique of some of the things I had written in my research blog, which I’m going to just paint over by saying it was a misunderstanding between us but as I recall it, the critique was mostly centered around the use of Sharpe ratios. And I’ve noticed that as a theme in your writing as well, that you find the concept for lack of a better word repulsive. Why are you So against Sharpe ratios,
Harley Bassman 1:15:02
let’s be clear, I did not call you personally repulsive. Although that did occur to me at the time. Sharpe ratios is one of those hot buttons for me, because it’s a marketing tool, it is not an investment tool. Now, when it was created, and you’re talking going back some of the macro asset allocation ideas, I forgot what Professor it is who did this Markowitz, he was right in the grand scheme of looking at equities versus bonds versus currencies. That made sense. But taking this macro idea, and then putting it into a micro framework is just foolishness. Because what you’re using as your measure of risk is daily realized volatility. Why is that a measure of risk? The fact that something has a small bid offers a big bid offer means that it’s gonna change the eventual outcome of the asset a year from now? I don’t think so. Okay, what do you care about is I buy something today? Where is it going to be in a year or two years or five years, and if it gets there by wiggling up and down a penny a day or five cents a day doesn’t make a difference to me. And this leads into this idea of reliance upon Sharpe ratio as a marketing tool, then leads to risk management processes, processes, where people look at your Sharpe and they allocate capital or risk for whatever you’re doing. And this encourages people I mean, if you put the carrot left, people go left, you put the carrot, right people go right. I have been at firms that are very Sharpe ratio driven. What this does is it encourages you to go find very liquid low volatility assets, and then lever them up 345 to one, as opposed to buying some less liquid asset and sizing it properly and carrying about two to maturation. I think it’s a dangerous tool because not only is it not described risk properly, it encourages you to add excess leverage. At the end of the day, you almost always see negative convexity and excess leverage at the scene of the crime.