115 Protection Against Black Swans & Building a Bulletproof Portfolio ft. Jason Buck of Mutiny Fund

Niels: Hey everyone, and welcome to another edition of Top Traders Unplugged, where today I’m joined by Jason Buck, who is a former soccer player, turned entrepreneur, trader, volatility expert, and who is a co-founder of the Mutiny Fund. Many of you will know Jason, of course, from his many podcasts, YouTube videos, and Real Vision interviews.

So, first off, Jason, thanks so much for joining me on TTU. I’m excited about our conversation today. How are you doing, how things where you are?

Jason: I couldn’t be better and I’m really excited today because I’ve actually been listening to you for years. So, it’s a true pleasure to be on. I think, even going back to 2015 when I think you had my buddy Bastian Bolesta on. I was just reminiscing on all the times I’ve listened to you on my headset. So, it’s definitely a true honor and pleasure to be sitting here talking to you today.

Niels: It’s absolutely great to have you here.

Now, as mentioned earlier, many of my listeners will be familiar with you from the great work that you do and the interviews that you’ve conducted. But, for those who are meeting you for the first time, why don’t we give them a little bit of a back-story to set the scene and the context for our conversation today. How did it all end up in this space for you?

Jason: Sure, so, you alluded to it previously, I’m primarily an entrepreneur. Going into the GFC in 2007, 2008, I was a commercial real estate developer. I also owned some restaurants and an internet service provider and other things, but the acute pain that I felt, from the great financial crisis (when liquidity dries up across the board on a macro sense), it doesn’t matter how good you are as an entrepreneur. If macro liquidity dries up everybody’s screwed.

So, that pain was so acute for me, for losing money for myself, family, friends, etc., I figured there had to be a way to hedge entrepreneurial risk. Everybody thought that was impossible, but I’ve been trading options going on about two decades now. I started trading VIX in about 2011, 2012, but I had this idea that there had to be a way to maybe hedge global macro entrepreneurial risk. That would be a superpower for entrepreneurs to have, if they could just go idiosyncratically long with their personal investments and their personal ideas, and then hedge out some of that macro risk. That was my focus for the last decade.

So, it really comes from this idea of being entrepreneurial. I’m an entrepreneur first. My partner, Taylor Pearson, is an entrepreneur first. So, we come from outside of the industry. So, I think we look at investments in a very different sense than most people. We really care about drawdowns most; what you can eat; eat what you kill.

We worry about things about things like MAR ratio: your long-term return divided by your max drawdown. I know [when it comes to] these things I’m speaking to a cohort here when we talk about those kinds of things because the CTA views of the world are very similar to the way that we view it. That’s really what it comes from. I’ve been an entrepreneur my whole life and the way I look at the investment space is from an entrepreneurial lens.

Niels: Yeah, looking at it from that side (and that’s obviously different from many of the people that we speak to), has the world changed when you look at it from that perspective? Now, the risks that you’re trying to hedge yourself against, have they changed to some extent?

Jason: I think [they’ve changed] a little bit. So, one of the ways I look at it is that over the last two decades we’ve had a real rise in derivatives. So, you know, as we talk about now: people going out the risk curve, and people selling volatility; you’ve had a rise in the derivative space (I would say) since at least 2000. So that started to really concern me in that are these derivatives the tail that’s wagging the dog?

So, part of that is that I go back to the Harry Brown’s permanent portfolio, from the 1970s, and that’s what I think about asset class diversification. Harry Brown had the four quadrant model of stocks, bonds, cash, and gold. I really started to wonder if cash provided that ballast against a stock market selloff, or are there too many derivatives in this space, where you could have these liquidity cascades (to steal a phrase from my buddy Corey Hoffstein), where the derivative space leads to more violent selloffs and you almost need derivatives on the other side to provide that ballast that cash can’t really provide for you.

So, that’s one way I look at it, from the entrepreneurial sense, is just watching the growth of the derivatives market and also the growth of volatility and the VIX instruments. That’s what we’ve really seen in the last decade or two that I believe has been a change to the market. Then hearkening back to my idea of… I was a commercial real estate developer, what scares me, now, about real estate is historically (especially individual real estate) was it was your home; it was your cave, and it wasn’t marked to market. So, you didn’t have to worry too much about it, but now we’ve had this over financialization of our world (which is part of that derivative process), and that now people are talking about selling fractional pieces of their home. That concerns me, as then we have to throw out the historical rule book of what home prices look like if, now, we financialized (created derivatives and fractionalized) even our home ownership.

Niels: Yeah. I mean, that’s a great point and probably a topic for a whole other discussion. So let’s dive into what we’re going to talk about today.

Now, many investors today have learned about the importance of diversification. If they look at their portfolio, especially if it’s put together by a bank or financial advisor, they will see all these many lines line items representing different kinds of investments. Of course the natural conclusion would be, “Look at all that great diversification that I have,” but some would argue that there’s really only one type of investment, namely volatility.

So, when you look closer, you’re either going to be long volatility or you’re going to be short volatility. So, why don’t we start there, perhaps, and maybe you can explain the importance of why seemingly diversified portfolios may actually be quite risky.

Jason: Yeah, When you sit down with a financial advisor they’re going to show you your pie chart of diversification and it always kind of makes me want to laugh a little bit because if you look at that pie chart of diversification it ends up being all long GDP assets. You have stocks, bonds, private equity, real estate, venture capital; all of these things are long GDP. What I mean by that is that when we’re awash with liquidity; when credit conditions are loose; all these things are going to do exceedingly well in a risk-on environment. When we’re in those risk-on, long GDP times, you’re looking at diversification in your portfolio.

The problem is that, although all of those things are implicitly short volatility (meaning that they are harmed by volatility in the markets), when we have any sort of selloff or an endoginous liquidity event (like March 2020), we see that the correlations of that uncorrelated pie chart go to one, and they all sell off at the same time, which really shows what the diversification is there (or lack of diversification).

So, when we look at the world, we think about those long GDP assets are implicitly short volatility. We need to really pair those with long volatility assets. So when those selloffs happen (when correlations go to one on our other asset classes), we have something that’s there that can ballast the portfolio, provide a comebacks return, hopefully, and then rebalance that back with those short volatility assets.

So, at the end of the day, we look at the world that’s both short volatility and long volatility, and that’s the two primary buckets that most asset classes fall into.

Niels: Yeah so, let’s focus, then, on the long volatility side (because, as you mentioned, a lot of the short volatility assets people are familiar with them, even though they may not know they are short volatility), but what does a long volatility asset look like? You’ve already alluded to why you should have them, but what do they look like?

Jason: Sure.

A couple of examples of long volatility assets (and I’ll dive into them as well) is you have an asset class just called long volatility, which is basically an absolute return, opportunistic way to trade volatility. You have your classical tail risk, which is your insurance (like put strategies).

One could argue that gold or Bitcoin provide, maybe, a little bit of ballast on long volatility. Then, close to your heart, you have (obviously) CTA trend, which is a great long volatility strategy as well. To almost steal a phrase from your writing cohort Katherine Kaminski, you have strategies that are either convergent or divergent, and most of those implicit short volatility strategies are convergent strategies; are mean reversion strategies; and the long volatility strategies are going to be divergent strategies (they’re going to break out and have some convexity to them that really provides that ballast).

So, I’ve referenced long volatility. So, what the heck is long volatility? The idea is it’s just a different way of trading the volatility space. The classical way is tail risk: you just buy, puts against, let’s say, the S&P 500, in a negative 20% drop, and it’s a fairly passive strategy. It requires some active management to do it well and to monetize it well, but otherwise just buying tail risk puts is a fairly passive strategy. It’s very similar to home insurance, car insurance, life insurance, those sorts of the insurance like products.

Now we’ve seen this space (and this is part one of the advancements) of long volatilities where we have managers that are looking to opportunistically trade the volatility space. So, they’ll be buying puts, but they also may be buying calls as well. So, they’re trading both the left and the right tails and they’re shooting for absolute returns over a business cycle.

What they would hope to do is carry flat to slightly positive over a business cycle while still providing those convex returns in a selloff. This is where the real advancement we’ve seen, in the volatility space, is on this long volatility way of trading. That’s much more opportunistic trading in and out of the markets and trying to maybe time those selloffs.

Niels: Yeah, and those three types of long volatility strategies (as you said, long volatility in itself, tail risk, and then CTA/trend following), I guess that it’s hard to know, for investors, which one they should have. Could you, maybe, describe… I know, of course, that you think you should have all of them, but can you, maybe, describe in what environment would they have their strong side in terms of diversification across long volatility strategies? Why do you need all of them?

Jason: Sure.

It’s great (as you know, I’m ‘D’, all the above), but I think CTA trend, for example, it always has a marketing problem. What do you call it? At one point (as you were part of) they were calling it crisis alpha, which it provided in 2008. When you have a sort of long protracted drawdown or recession, like you had in 2008, your CTA trend is going to do exceedingly well. It’s a great strategy.

But, if you are in an uptrend and you have a sharp, violent, endogenous liquidity event in a selloff, like we saw on March, 2020, your CTA trend can be caught on the wrong side. Not only that, they can get whipsawed as they try to get in on that trend and then it reverses in a violent V-shaped recovery. So, it’s not going to do as well in those sharp selloffs like we saw in March, 2020, where your things like long volatility and tail risk are going to do well there.

With tail risk you need to hit your attachment point. So, let’s just say you were buying negative 20% out of the money puts that are going to cover one for one in that selloff, well, you need that selloff to exceed that 20% threshold before you’re going to make money there. So, in any sort of selloff that’s 10% or 15%, you’re not going to monetize those puts, so you’re not going to do well in those environments.

Long volatility can be a little bit more opportunistic in trading the left and the right tail. So, it can maybe try to take advantage of smaller selloffs, trying to monetize them a little bit differently. It can also take advantage of melt up scenarios, like a ’99 type scenario when we have a melt up in stocks. If you’re buying the right tails of those calls (on the S&P 500, for example), you can monetize that melt up in a way that’s harder to do with the linear instruments that’s much more of a timing issue.

So, this is why there are a lot of different path dependencies to selloffs or different market or macroeconomic environments. So we view that you should try to take advantage of as many of those as possible through true diversification of your return drivers.

Niels: Yeah, now of course, people who listen to this podcast will have heard a lot about trend following, and CTAs, and the history, and all of that good stuff. In terms of the other types of long volatility strategies: so, long volatility, outright, and tail risk; how long would you say that they’ve actually been around as strategy? How big is the universe? You probably know all the players in that area. So, I’m curious to know how big is that “sub industry” or area of our industry?

Jason: Yeah, you’ve got a few issues when you’re talking about long volatility. One being the history that you alluded to is that you really can’t go back much longer than 10 years with any of these managers, for example. Quite frankly, if anybody tries to provide a backtest on volatility, especially in the VIX space (or VIX futures) beyond the last 10 years, it’s hard to believe those strategies because they weren’t really traded in size till about 2010, 2011 and 2012 (when you had a lot of VIX ATPs coming in the marketplace that were trading those fixed futures). So, the volatility surfaces are constantly changing due to the different players in the marketplace. So it’s really hard to think beyond the last decade with any sort of volatility manager, whether that be a long volatility manager trading options, or it’s other managers just trading the VIX futures.

So, that’s part of the difficulty with adding a long volatility strategy to any portfolio. You don’t have a long historical track record. I even think about the CTAs, which have a much longer track record, but there are not a lot that have been around since the 1970s. There are not a lot of people left that have traded in an inflation or stagflationary environment.

So, this makes it difficult when you’re actually constructing a portfolio to use any sort of historical precedence. When we think about the VIX space as well (or the volatility space), we actually look at it in three different buckets as well. We think about that there are just managers that trade options, which you could trade straddles on the S&P 500 and try to gamma scout that position daily to offset some of the theta bleed, or you could trade opportunistic strangles on the S&P 500, just going a little bit farther out of the money. But when you’re doing that, you’re just buying options. The best part about buying options is you can’t blow up. It’s just, it’s like Nancy Davis called debit card investing, it’s death by a thousand paper cuts. You know what your premium is, but you don’t know what your return is going to be in any sort of selloff.

That’s the most interesting bucket (we always believe) is just buying options because that that blowup risk is mitigated. The other ways to look at volatility are you have, we call it VIX arbitrage or volatility arbitrage, which is more of that pairs trade between VIX and S&P. VIX and S&P are going to be negatively correlated most of the time.

So, you can have a sort of pairs trade that would be similar to long Coke, short Pepsi. Due to the inverse nature you’re going to be, say, long S&P, long VIX; or short S&P and VIX. So, that’s the inter-market spread. You could also do what’s called a calendar spread where you could be shorter or long the front month VIX, and shorter along the back month VIX. You’re trying to ratio those out. You’re fairly market neutral, but you could still remain long volatility.

The other one we look at (taking a little bit outside look at the space) is we also view intraday trend following on the VIX and the S&P or other market indices around the world. We also view that as part of our long volatility space and our long volatility mandate as well.

Niels: Yeah, now you mentioned a term Crisis Alpha, and rightly Katie coined the phrase and it’s been fantastic. I was initially a big fan of it. I thought, “Yeah, finally, we’ve got something we can hold on to and investors can visualize what this is. There’s a crisis and here comes the alpha.” But I’ve realized that it’s not so easy because the definition of crisis is very different. Nowadays, everything seems to be a crisis. As you rightly alluded to, for the CTA world, we really need a kind of a longer term period of uncertainty and instability to really do well. Does crisis alpha help you? Because you’ve obviously covered many types of “Crisis Alpha”, how do you think about the term in terms of how investors would perceive it?

Jason: Yeah, I think Crisis Alpha is actually one of the best monikers for long volatility and tail risk, especially when you combine the two. What you’re referencing: we think about the world in two buckets of (like I said) short volatility and long volatility, but then we also think about the world in three correlations.

You have your long equity beta, which is correlated. You have as uncorrelated which is your CTA trend. Then you have [that which is] structurally negative correlated with your tail risk and your long volatility. But (like you said), sometimes if the market is moving too quickly or it whipsaws, that’s part of the uncorrelated nature of CTA, you can’t guarantee that Crisis Alpha, but when you have structurally negatively correlated things like just buying put options, you can almost guarantee that Crisis Alpha.

So, that’s the way we look at the world is through those three primary buckets of correlation. That’s what most asset classes are going to fall into. Part of CTAs being uncorrelated is sometimes they may move with the equity beta, and that’s hard for people to wrap their heads around – what uncorrelated, and structurally negatively correlated look like. The way we also look at it is, for a CTA to kick in (and especially longer term managers), like we said, you need that 2008 scenario where you have maybe a longer, more protracted recession, but a lot of times to get there, it requires a violent selloff.

So, this is why we look at this interim piece of long volatility and tail risk. It is to provide that convex return when you have a violent selloff, that then you can redistribute either to your equity beta or to your CTA trend managers. That is what is really helping the portfolio over the long term.

What I always worried about is exactly what happened in March, 2020. What if you’re in a certain trending environment in both the equity side and also the CTA side, and then you just have a liquidity event that’s a sharp selloff, that’s going against the trend? So, that’s what was always in the back of my mind, keeping me up at night. That’s why I really felt you needed to add this long volatility and tail risk piece for those liquidity events that come out of nowhere. So, that way you can monetize those, protect your portfolio, sleep at night. Then you had such a convex return that you now have a higher NAB point for your overall portfolio, that then you can redistribute to those other managers.

From there, if we have a K shape recovery, or V-shape recovery that the equities will do well; or if we have that protracted recession or we start really trending again, then your CTAs are going to do exceedingly well, but you’ve topped them up right at the most opportune time, which is the most important piece.

Niels: Yeah, now I know from personal experience that the narrative (I guess is the word I’m looking for), the narrative around trend following; trying to get investors interested in what we do when you don’t really have a great story and it’s all rules-based and very mechanical. That’s a challenge. I find the volatility space incredibly complex.

I’m just curious to hear some war stories. What are the main challenges that you guys face when trying to get people to embrace this? Or have you found some kind of magic formula where you say, “Yeah, we don’t actually need to go into the nitty-gritty of things,” but if we can just get them to understand this and say, “Yeah, that’s right.” Then that’s most of the hard work done.

Jason: Yeah, There are multi-steps of that process and you nailed it. Part of it is that historically I’ve been building these total portfolios, or holistic portfolios, for the better part of the last decade. The piece that was always missing for the retail investor was this long volatility and tail risk.

So, that’s what my partner, Taylor Pearson and I spent the better part of the last five years trying to come up with is how do we provide retail access to long volatility in tail risk, where they previously had no access to these sorts of strategies that can really protect their portfolios and manage their wealth over the long term.

So, part of that we knew was going to be a massive educational curve because these long volatility strategies are very difficult. To me, it’s the last bastion of active management. A lot of these other asset classes (those long GDP asset classes), you can just hit the buy button on an app, and it’s so easy to buy those.

But these long volatility strategies and tail risk are very difficult because the volatility surfaces are constantly undulating. It’s hard to find a cheap convexity in that search for cheap convexity. You need a team of quants, and a team of managers to really manage each of those positions in those different path dependencies.

So, this is why we view the ensemble approach to these as the most important piece, because those different path dependencies. We want to make sure we capture that selloff when it happens. But what you’re saying is part of that education curve is dealing with retail clients. We knew it was going to be a lot of hand to hand combat of educating those clients.

What we also knew is we couldn’t convince somebody (a sui generis) that they needed tail risk protection. We needed somebody that has read a Nassim Taleb book, or a Chris Cole white paper; somebody that’s actively searching for that ballast to their portfolio. Then we can bring them in house; educate them on the different strategies we use (the ensemble approach we use -why we do what we do), and then it’s a much easier sell because they’re already like-minded.

I think it’s impossible (as I’m sure you’ve tried to convince people to use CTAs that had never heard of CTAs), it’s an impossibility. You can’t really lead a horse to water, but if you’re at the same drinking hole, then you could say, “Hey, look over here, this might be a little bit better spot.” So, that’s part of the education curve that’s really difficult for us. The other part is we just, buy by constantly searching and tracking all of these different managers in our space, we just accidentally ended up at being experts on the long vol and tail risk space. We never really meant to be, but it’s just that there are not a lot of people tracking this space.

Part of it (I think that you referenced earlier) is even an aggregate, especially people that are trained in the VIX, is that you’re talking maybe a few billion dollars in aggregate is the capacity constraint. So it’s a very niche space and it takes a lot of education to really not only train our clients, but ourselves as well, to really understand exactly what these managers are doing.

Niels: So, I’m going to go a little bit off my own kind of a script here, because when you talk about this it kind of reminds me of something that I think is interesting (or at least I think it’s interesting), and it may actually be quite something that you guys have also thought about. When I started in this industry, a few decades ago, volatility was something we used to measure things. We were measuring managers, asset classes, whatever, through volatility or through its volatility. Nowadays volatility is a key component in many of the algorithms that we run. How do you think about that? Does that pose… And everybody’s doing it by the way. So does that pose a challenge, a risk? How do you think about that change when going from just being something we used to measure things to, now, something that kind of is one of the key components into our risk models?

Jason: Yeah, it’s gone from a risk metric to a player on the field. You have this reciprocity or feedback of volatility (which used to be a way where you just… it was just a simple risk metric on a sharpe ratio). Now, if everybody’s targeting volatility (especially at the portfolio level), now we’re going to get these feedback loops that really change the space. So, we actually viewed that as a benefit – the long volatility. So, if you have risk parity models, or vol targeting models, or even (as you’ve seen in your industry) it’s amazing to me how we’ve had compression in volatility where everybody’s trying to run a low vol strategy. Part of that is maybe moving away from commodities and more into the financial markets on the CTA side.
As you know, it’s an AUM grab. As people have targeted volatility, lowered volatility has specific targets at the portfolio level, trying to improve sharpe ratios then, to me, it compresses or subdues volatility until you have a breakout. So, you can never really get volatility out of your strategy or out of the markets where a lot of people are convincing themselves that they have a low volatility strategy and they can actually target it, until you squeeze that balloon and volatility pops up in other areas and then it surprises people.
It’s always fascinating to me, is how do you… and this may be a better question for you, is how do you target volatility at the portfolio level? People say, “The target is 10%,” and then you look at their backtest, and you take different slices of timeframes, and sometimes it’s 7%, sometimes it’s 15%. So I’m saying, “How are you targeting volatility when you don’t have a static volatility that you can actually target?”

Niels: That’s a topic that we talk a lot about on the podcast. I think most of us are against the idea of volatility targeting per se. I think if you look at most CTAs or trend followers track record, you will see definitely that there’s a big difference in our volatility over time.

I do think you can target risk, but that’s not the same as volatility. You can have some kind of idea of how much risk you want to take in your portfolio and you can adjust for that, but you can’t control volatility. I think your answer is pretty interesting and very insightful, that this might actually be a benefit for some of the strategies you employ. When volatility then explodes, then everybody is running for the “exit” at the same time. So that’s interesting.

Now, you mentioned another word (two words actually) that I think maybe people need to understand that a little bit better, and that’s path dependencies, because I think most people are used to thinking about sharpe ratio as the measure of risk adjusted returns. I think it’s an incredibly dangerous ratio to look at because it’s not path dependent, meaning you can have three different investments, and their equity curves, and they all look completely different, but they have the same sharpe.

Can you unpack that a little bit so that people kind of understand what you mean by it and the importance of understanding what it means, and maybe also what you use (you mentioned the MAR ratio), but what you use. If you don’t use the sharpe, or don’t put a lot of weight into it, are there other things that you think are better in describing the true risk of a strategy?

Jason: Yeah, A couple of things I want to touch on. Let me start back to what you said about volatility too. I absolutely agree with the way you guys look at volatility, [and that] is that position sizing is your best risk mitigation metric. So, when you put on that position size, obviously you’re going to position size accordingly to what’s going on in the volatility of the current environment, which I think is fantastic.

The other thing that has happened [is that] (what we saw clearly in March, 2020) when you have vol targeting strategies, and you have this endogenous liquidity event (some people call it VAR event, quite frankly), is people are de-grossing or de-leveraging their portfolios all at the same time. They’re all running for those exits, which is then spiking volatility, conversely.

So that’s why that March, 2020 event is great for us because we’re, as you have all these vol targeting type strategies that now are de-grossing or de-leveraging their book all at the same time and they’re selling off any asset class they can (where normally even gold would provide a ballast) it doesn’t matter. They’re just going to cash. So, they have to sell it even though they don’t want to. So, these are great environments for us. So that’s why we’re saying, you almost have these long periods, now, in risk-on environment (so very low volatility), punctuated by extreme volatility.

That’s in markets we moved into in a way, especially with what people will call central bank suppression (or whatever the markets were doing), a lot of people would say that it’s vol selling strategies. Whatever is happening is reducing volatility (maybe during a risk-on cycle), but that suppression leads to these violent selloffs or violent spikes in volatility.

When we talk about path dependencies, you just never know when a selloff is going to look like a priority. You don’t know if it’s going to be a violent, deep selloff, or if it’s going to be shallow selloff. Is it going to take one week? Is it going to take 10 months? We really don’t know. That’s why we try to find managers that cover a lot of different path dependencies. We overlay them into an ensemble approach.

As far as risk metrics, I think this is the most difficult, and nebulous and untalked about part of all of our industries is that the sharpe ratio is (as you point out), it’s essentially nonsense. I think CTAs have done a great job of trying to point that out over the last several decades.

So, the question is, what do you use? Do you use a Sortino ratio that doesn’t hurt your upside volatility? Do you use skew metrics? Do you use MAR ratio like we use for a return divided by drawdown? MAR ratio is a very crude metric and it only really works in hindsight. I say, my life goals over the next five decades to run a MAR ratio close to one, that would be the hero’s journey as far as I’m concerned, but I would never know that until five decades from now. So, it’s impossible to know.

The way we look at it in general, and in portfolio construction, is having different return drivers that do well in different macroeconomic environments and trying to pair those up accordingly. Then, if you add long volatility and tail risk, you’re almost truncating the left tail of that portfolio. So it’s not really focusing on the portfolio volatility, or any individual asset classes of volatility, because that can lead you to illogical conclusions. So, the way we also think about portfolio construction is that we actually call it stability through volatility.

If we have, actually, these volatile asset classes, but they’re truly uncorrelated return drivers, and we rebalance those frequently, that actually could create a much more stable portfolio, especially on the return to draw down metric versus the return to variance metric of the sharpe ratio.

Niels: Just a question, again, that just comes to mind when you talk about that, for example, in the CTA space, we all think we’re a little bit different, and we are actually, but we always end up with more or less the same correlation to our benchmarks. What about the volatility space? How different are managers, when you look at their correlation, yet you consider them as being long vol type strategy? How different are they?

Jason: You just hit on my other pain point of our education curve which is: one, what risk metrics do you use? (There are no good risk metrics for long volatility tail risk.) The second one is what do you benchmark against? (There are no good benchmarks for long volatility tail risk.) You have the Eureka Hedge and CBOE indexes, but those things are fraught with survivorship bias and they’re not great metrics to really benchmark against, and the space is constantly changing.

So, you don’t have a good benchmark. People will say, what about the VIX index? The VIX is just a number it’s not tradable. It gives people a false conclusions, fixed spikes or declines. So, you just don’t have good risk metrics. So, what do you do?

So, when we look at our ensemble approach, we look at what… The nice part about our long volatility strategies (and I said they are capacity constrained; they’re a very niche environment, but even within that niche), each manager has a very niche strategy they trade. So, we think about the different wrinkles of the way they trade and we overlap and overlay those wrinkles.

So, when we go out, we’re looking to cover as many path dependencies as possible, but we’re also looking for managers that trade slightly different strategies or have different monetization heuristics than our other managers. What’s been nice, as we try to use these correlations (and as we’re talking about this, correlations are terrible as well – if you use a classical piercing correlation, it’s just a time window analysis that can give you false conclusions), but over risk-on cycles our managers are fairly uncorrelated. Then, when the sell-off happens, our managers are extremely correlated, and then the correlations go to negative one to the S&P.

That’s exactly what we’re looking for because, during a risk-on environment, to try to have people hold long volatility or tail risk in their portfolio, during an entire risk-on cycle we’re trying to achieve a flat to slightly positive carry, just so people behaviorally will hold this strategy. To do so you need managers that trade very different strategies. So hopefully you can capture a little pops and volatility here and there. If we had the “Volmageddon” in February of 2018, we had some managers that were up double digits in that month. So, you want to capture that and redistributed across the year ensemble.

So, we’re always looking for managers that have a little bit different wrinkle, a very specific niche that they trade. Then we can (as I like to say), we play the orchestra not the instruments. So, therefore, I can really place those in different parts of our portfolio that’ll capture that path dependency, but also provide that (hopefully) slightly uncorrelated nature to the best of our managers, which also helps us with a little bit of a rebalancing premium over that risk-on cycle while we’re still holding all that convexity for a risk-off event.

Niels: Yeah, you know the solution to your problems about benchmarking and metrics and all of that you should do like Chris Cole has just done and create your own. Why not?

Jason: What’s interesting about his CWARP metric is it’s a “Coles Wins Above Replacement” portfolio and it’s taken from Moneyball. The idea is (basically) if I add this manager to my portfolio, does it improve my risk metric? So, if I’m starting off with my base portfolio being 60/40, if I add long volatility, tail risk, or CTA, does this improve the risk metrics of my portfolio? All of us have been doing this for decades. When we talk to clients we’re, “Give me your portfolio,” you put Dunn into that portfolio and it improves the risk metrics.

It’s the same with us. If you take long volatility tail risk, you put it with almost any portfolio (especially things that are long GDP or a pleasantly short volatility), it’s going to improve their risk metrics. Yeah, that’s the biggest part of what you’re referencing with Chris Cole’s work, and what you and I both do is, if you’re looking at your portfolio holistically, what does the team look like? That’s part of CWARP, is the whims of proper placement of the portfolio, as a team. This is what you have to think about when you’re looking to compound wealth efficiently or effectively over the long term. When you look at assets, in individual ways, you can be really distorted when you add them all together. That’s the problem with sharpe ratio. Actually, sharpe was originally built as a portfolio tool to measure the portfolio level, but now we measure individual strategies or individual managers with sharpe, and that was never the intention.

Niels: No, and that’s a very important point and that’s only really now coming into the narrative about that issue, even though we should all have been talking about that for a while.

Let’s stay with this then and say, okay, imagine that you’ve decided to incorporate long volatility strategies in your portfolio. How do you think about position sizing the exposure to long vol?

Jason: Historically, I think that Mark S Spitznagel, at Universa, has done a great job of talking about the classical tail risk hedge. What’s nice about a classical tail risk hedge, if you’re just buying (let’s say deep buy of the money puts with a negative 20% attachment point where you’re trying to truncate that left tail), it’s not going to cost you a ton of money. In any environment it can be anywhere from, let’s say negative 2% to a negative 6% bleed, depending on what environment you’re in on an annualized basis.

What’s nice about tail risk is the cash efficiency of it. So, what Spitznagel talked about is, if he holds (let’s say) 97% long S&P, then he can allocate 3% a year to tail risk. That, over the long run, is going to provide a much better compounded return over multiple business cycles, because now it allows you to hold more equity risk and sleep at night. Then, when that liquidity event happens, you monetize those puts, you rebalance back into your equity at a lower NAV point, and that allows you to compound wealth more effectively. So, that’s a way of looking at classical tail risk.

Now, if we add in these long volatility managers that are trading much more opportunistically, and we’re trying to be absolute return over a business cycle (or even during a risk-on cycle), you’re going to have to allocate a little bit more. So, we look at it more as a 60/40 portfolio. This is the new 60/40.

Historically bonds provided this negative correlation that had a positive carry. That was much like (or almost like) buying put options. It was a positive carry put option, which shouldn’t really exist in markets, but we’ve been in this anomalous market over the last 40 years where bonds provide that ballast for you. Now, will they provide it going forward? None of us know, but over a hundred plus years stocks and bonds have been much more correlated than they’ve been negatively correlated.

So, bonds may no longer provide that ballast you’re looking for. So if you pair your equity, beta (60% equity beta) with a 40% long volatility tail risk, and you get that negative correlation and you rebalance frequently, that’s how you compound wealth more efficiently or effectively over the long term.

What’s actually fascinating though, especially sitting in your seat (I think that has always interested me over the last few decades), is that you actually want those long GDP or implicit short volatility yards (as we said), so, it’s those convergent mean reverting trades. It actually should be 40% of your portfolio and those divergent trades should be 60% because of the huge left tails that you have in mean reverting strategies, and because your divergent strategies are going to have small losses and large right tails of gains. So actually, the proper construction is 40% short volatility, 60% long volatility, but everybody’s gotten so used to the 60/40 going the other way of stocks and bonds, it’s really hard to convince people that’s the proper portfolio allocation.

The other way, where I go a little bit far out on a limb as an entrepreneur is I like to talk about your holistic life risks, and especially Meb Faber has done a great job talking about this. If you are a financial advisor, you’re quadruple leveraged to the S&P 500. All of your strategies are long S&P 500; therefore your business is long S&P 500; your job, if you’re not managing that portfolio and your just an employee there is long S&P 500; and then usually your individual savings is long S&P 500. So, you actually are quadruple levered long equity beta. So, you really need a long volatility or tail risk hedge.

So, the way I look at it (as an entrepreneur in general) is that all of my businesses are going to be structurally long GDP. I want there to be a wash of liquidity in the markets. I want the good times rolling. I want real estate prices climbing. Every part of my life is essentially long GDP. So if I have any savings left over that I can’t put back into my business, all of those savings should go into a long volatility or tail risk piece. So, if a market sells off, and the rest of my life takes a hit, I have this Combax cash position that then I can use to either make payroll; buy out my competitors for pennies on the dollar; or buy up opportunistic real estate investments for pennies on the dollar. But that’s, maybe, a bridge too far for a lot of people to think about their holistic life risks.

Niels: I want to stay on the word holistic for sure, but just coming back to this 60/40, I couldn’t agree more, but in our world we’re still stuck at fighting around the 5% level. It becomes a problem. I just hope to get to the 40 level at some point for these types of strategies, but it is interesting. What I’ve always found actually quite surprising is (and I know that Meb talks about this as well) evidence-based investing, where you actually can present people with a lot of evidence. We’re going to talk about this in it shortly, but it’s almost like people don’t really believe it. For some (whatever) reason, it’s just not good enough to give them all this evidence. Anyway, we’ll see how that goes.

I do want to talk about (as we’ve transitioned a little bit more to the holistic approach and some of the new things you’re doing), have you guys found certain common mistakes that people make when they think about… Because [when it comes to] portfolio construction, I always think of people spending a lot of time picking the best underlying investment they can find. They spend a lot of time picking the best manager, etc., etc. It goes back to this whole Moneyball thesis, that actually what you need to do is that you need to look at the whole portfolio, and so on, and so forth. Are there some common things that you find that people do (in terms of mistakes they make) in order to not to get to the point where they actually need to be, and that point is, “How is this investment going to help me overall?” and not, “Oh, look at that guy. He’s done 15% with no drawdowns!”

Jason: Yeah, I think that Danny Kahneman, for example, and Amos Tversky brought it all to the forefront that we have a lot of these behavioral biases. I have the same as everybody else. I’m, I’m fraught with behavioral biases as well. So, I think we all are return chasers. We want the best portfolio and we can’t help but chase returns or be disgusted by drawdowns. I think it’s just part of our natural evolution.

What’s fascinating, and you brought it up before, I think that Eric Crittenden has done a good job of taking off the labels of these different strategies. How much would you allocate? The proper allocation to CTA, an uncorrelated strategy, is 40% to 60% if you’re holding 60/40, but as you alluded to, who’s willing to do that? So, that’s the real question is how do you fight for including these strategies?

So, everybody makes those mistakes. If I know if I’m prone to those mistakes as well, how do I behaviorally make sure I don’t do those mistakes? Part of proper diversification is that you’re always going to have part of your portfolio that is losing money, if you don’t, you don’t have proper diversification. It’s not only that you’re going to have part of your portfolio that is losing money, the news is going to be telling you’re an idiot to hold the part of that portfolio as well. Right now, if you told somebody to get bonds as part of their portfolio, people are like, “They’re at the zero bound; this is the worst investment of all time; or you’d be an idiot to hold them.”

It’s also what I love about CTAs, because who else would have rode that trend? Who would have rode the trend of negative in oil; who would have been long bonds through the zero bound; only CTAs. That’s the brilliance, I think, of what you guys do, and I think that’s also the difficulty. I think Jerry’s spoken of this as well, how do you? When the news and even all your personal intuition is telling you not to take the trade, you have to have the discipline to take that trade.

That’s, what’s fascinating to me always about CTAs. So, when we think about portfolio construction, I think it’s really difficult. What we found, actually, and what’s interesting is that the same biases that you see at retail level, you see at the institutional level as well. So, there’s no smart money, dumb money. Everybody is riddled with bias because even at the institutional level, it’s still human beings and individuals, and you see a lot of performance chasing there as well.

So, when I originally think about portfolio construction, my framework I use is the Harry Brown permanent portfolio. You have the four-quadrant model, everything’s on the axes of growth or inflation. You’re either in the growth or recession, or you’re in inflation or deflation. Harry covered that with his four quadrant model with just an equal weight each to stocks, bonds, gold, and cash. Those are your Global Macro quadrants. That’s the way you should think about portfolio construction. I think there’s a lot of modern nuances now that you can add to it. But that really, at the end of the day is, is the way to think about wealth for the long term. I think that’s really difficult for people to do. I think part of why that difficulty exists is because people are convinced that their savings are investment.

That’s part of the problem with our industry, or at least on the advisor side is that whatever your savings are leftover after consumption, those are your investments, and you need your investments to grow, and maybe put them in a stock market or a 60/40 portfolio. But no, these are savings and you need those savings to be there when you need it most, either when unfortunate circumstances hit you or retirement. You need those savings to be there and you just need those savings to outpace inflation. If you start chasing investment returns with those savings, that’s what leads you down a path of a performance chasing. So maybe that’s part of it too, is just the different words we use to describe how you should structure a portfolio that leads us to make a lot of these behavioral bias mistakes.

Niels: Yeah, I think that’s a great point actually. We’ll talk a little bit more about permanent portfolios and how you are thinking about it nowadays. Before we do, I’m going back, not because I want to suggest to people that the most important thing is to find the right manager, but since we don’t have that many people on the podcast that actually select managers, but you do, even though it might be within a certain area so far, I’m just curious in general (I think this might benefit a lot of our listeners), when you think about manager selection – just spend a few minutes talking about how you think about that. What are some of the challenges that you find with finding managers? Of course you can talk about whether it’s CTAs or whether it’s vol managers or whatever, but there must be some things you may be do differently compared to other people when they select managers. Maybe, if you have an example of a question that you really liked the manager to be able to answer well, to give you the confidence that either they thought about things or they have skin in the game or whatever it might be.

Jason: Yeah, confidence, wow, that’s a tough one.

I’ll start from maybe top down. Like we said, we think about the world as short volatility/long volatility. Then we think about the world in those three correlation classes of either a long beta, uncorrelated, or negatively correlated. So, we start structuring top-down that way. Then we start thinking of asset class buckets of whether it’s long volatility or commodity trend managers. Then we get into those buckets. When we dive down into each of those asset class buckets, then we start thinking about, okay, we have this ensemble approach, what kind of path dependencies do we need to fulfill? How do we diversify across these managers? So, then we start looking for different diversified managers within each of those sleeves that we’re looking for.

Part of the way we’ve done this is we’ve done a joint venture with RCM Alternatives out of Chicago. They’re probably one of the primary platforms for alternative investment managers. So, that really helps us source these managers, and we track dozens of them over time. The other thing I alluded to earlier is that we like to look for that wrinkle diversification, or that niche that they are all are part of, to try to diversify (even across that ensemble approach) within an asset class sleeve.

But then I may leave you wanting for my answer on this question.

Niels: I was just going to say, because what I’m trying to get at (because I think this is what a lot of people find especially difficult, and of course I’m incredibly biased and narrow in my thinking), when I talk to investors, usually we’re up against the same usual suspects. The peer group of trend fellows, who’ve been around for 20, 30, 40 years, is pretty small now.

Jason: Yeah.

Niels: So, I’m curious to get into the minds of someone who selects managers (even if you don’t, day-to-day look at just trend-followers, I’m aware of that), but I’m curious as to, if you were presented with five or 10 trend follows (let’s just keep it simple like that), what are some of the things that you think of would be important to you to make that choice? Because actually, I think it’s a really hard choice because to the outside world, we look very similar (to some extent. but I don’t). Of course, none of us are we have transparent, but we can’t give our rules away.

Even if we did, what are they going to do with that? They don’t know if a 40 day moving average is better than a hundred day breakout system. You don’t know. So, there must be something else that investors are looking for in order to say, “Yeah, I want to go with a Jerry,” or, “I want to go with a Dunn,” whatever it might be.

So, I was just curious whether you had some golden nuggets you could share to help me and my CTA colleagues to understand the mind of an allocator.

Jason: Sure. That’s a great way to start. I’ll give you a very specific example. So, if we’re looking at trend following managers, one way, I’m going to start looking at them (from the asset class sleeve) is that I’m going to look for short, medium, and long term lookbacks.

So, that’s what I’m going to start diversifying into those. Then, within those, I’m going to look at, okay, what are their trading heuristics; are they using classic Duncan; are they using moving average crossovers; are they using different breakout strategies; and what are their monetization heuristics?

So, then I can start differentiating within the short, medium, and long term what their different strategies are. I’m looking for that diversification, and I may be different because we’re building ensemble approaches and we’re looking at lots of managers. I’m not trying to pick the best manager because I don’t believe that exists.

So, now I’m narrowing down to try to find the ones that are doing slightly different things. So, I want to put them into an ensemble approach. Part of that too is (and you’re going to get some extreme honesty here) even if you guys have a multi-decade track record, that does not mean that next year you guys are going to perform.

You know this as well as everybody else. What’s even crazier is, your largest drawdown is always ahead of you. No matter what your risk metrics are, no matter how many decades you’ve been in business, your largest drawdown is always ahead of you.

It’s just the way that the markets work: [given] volatility in the arrow of time, your drawdown is going to be ahead of you most likely. So, these are the things we keep in the back of our head. Then the other piece to it is, okay, if I cannot guarantee that future performance is going to look like past performance (even though it says that on all our disclaimers), nobody really takes that seriously.

So, I can know, okay, these are your heuristics for taking trades, sizing trades. What kind of breakouts do you use? What kind of strategies do you use for monetization? I can look at all of those. So, I can know (at least) you’re sticking to your strategy. Then, what it always comes down to, for me at the end of the day, is position sizing.

That’s my best form of due diligence and my best risk metric. So, the same way when you’re taking trades, is you’re looking at a trailing ATR, and you’re trying to position size that individual trade accordingly. I’m looking (like I said), I’m playing the orchestra, not the instruments. I’m position sizing you guys accordingly because there are two reasons why. One is, like we said, we don’t know if you’re going to perform the way you have in the past. That’s part of it.

Then, the second part is I never put it past people to come up with creative ways to create a Maydoff-like scenario. So what we can do is that the best due diligence I have done to date is position sizing and getting an SMA (a Separately Managed Account), so I can see those trades in real time.

So, those are the only two key pieces I have. Now, there’s a whole other world of due diligence that we all go through, but that’s checking all the boxes, making sure there’s no fraud in the past. All of those sorts of things, if a manager is still in business, all of those things are going to line up.

Then, as you alluded to, they are going to do similar strategies. They’re going to have long track records. They’re going to have an amazing pedigree. They’re going to have gone to the best universities. All of these things are all check boxes that if somebody’s been in business for decades, they’re all going to look relatively similar.

So, the way I think about it is the way I can really mitigate my risk (because I’m actually not performance chasing, I’m not looking for the best manager), I’m trying to mitigate my risk through an ensemble approach. So, the best piece of due diligence I have, at the end of the day, is that position sizing and that managed account look through. But, that may be very different than a way another allocator looks at allocating to you guys.

Niels: I like that. I think that’s very insightful, but I also think it must be challenging because how do you get the historical position sizing from managers? Are they just going to open their books and say, “Yeah, here are the trades from the last 10 years that I’ve done?”

That’s hard, I imagine, especially if it’s a larger manager, potentially. So, I understand once you get your account up and running that you have full transparency, but I imagine also that that is a difficult type of due diligence. I think it’s very important. So I, I applaud you for doing it, but I imagine that it’s not necessarily the easiest thing to do.

Jason: It’s a perversion of our industry. I can pick your guys’ brain as much as I can to try to get you to open the kimono, but you’re never going to really tell me the secret sauce. But as soon as I get an SMA, I get to see the secret sauce in real time. I can reverse engineer 90% of it.

So, it’s about making the decision prior to, but then once you open the kimono with that managed account, then we get an idea. The biggest part of it, and why I believe in ensembles (as you know all too well) even with managers trading similar strategies (and maybe even similar lookbacks), we still have a large dispersion in the trend following space.

So, that’s the other point of actually taking an ensemble approach is I want to reduce that signal to noise ratio. So, the other thing that may upset managers, sometimes, is I actually don’t necessarily believe in alpha, because alpha is a time-window analysis.

Over a decade, two decades, somebody might be able to provide alpha, but then they maybe have negative alpha over the next decade or two. It’s impossible to know a priority. So, if I can create an ensemble approach, I want to get the beta return signal from that asset class.

So, if I’m looking to allocate to commodity trend advisers or trend following, that’s the other reason to take an ensemble approach by reducing that dispersion or signal to noise ratio. Everybody within that subset of trying to produce alpha, I can take a beta return signal from that actual asset class bucket or that asset sleeve.

Niels: Yeah, cool, alright, let’s move on. Let’s shift gear for a bit and move on to one of the new things that you guys are doing. You’ve kind of already alluded to it a little bit. I don’t know if you got the inspiration (I certainly was very inspired) from the paper that Chris wrote about the Dragon portfolio and what if you had to choose a portfolio to last you a hundred years? I think that’s incredibly interesting. Of course it helps a lot when you can create some narrative around these things. So maybe we just start from the beginning – how you think about this. I know you touched upon it already, but what I have it listed here in my little outline that now we’re getting into that phase.

From my point of view, if I understand Chris correctly and you guys correctly (and I hope I do, because I think it’s incredibly important), my concern today, (and I’ve voiced it a few times on the podcast) is that I think a lot of investors have built portfolios that more or less are only designed for “the environment we’ve seen in the last 20 years” – a deflationary type environment.

I think what you guys are doing is thinking of, “What about building a portfolio that can cope with different types of macro environments?” You already touched upon this in terms of growth decline, inflation, deflation environment. So, why don’t we start there and then you talk us through what you guys have done. I’ll intersect with a few questions, I’m sure.

I find this fascinating and I think a lot of investors really need to pay attention to these kinds of portfolio strategies that are coming out. By the way, going back to your point about the trend following mixed with stocks and what Eric Crittenden and his team are doing, which I think is actually a really good way of trying to get people to get much more exposure to trend. It’s almost, if you can’t beat them, then blend them. I think this is also a segue into what you guys are doing, so, let’s start.

Jason: Yeah, lately I’ve been calling it “a spoonful of sugar, helps the medicine go down.” It’s like we tried to hide the long volatility and commodity trend within a 60/40 portfolio, so then people will actually hold it. That’s part of that, when we talked about the educational curve earlier. How do you get people to buy in? Chris Cole’s Dragon portfolio is a fantastic paper. Obviously, we’re big fans of Artemis and Chris Cole. We actually allocate to them in our long volatility strategy.

So, we’ve all been good friends for years, but my partner and I, we’ve been building these total portfolio solutions for the better part of a decade. Even though I know how to trade options and volatility in the VIX instruments, there was never a solution for retail investors.
We had a lot of family and friends coming to us and said, “I’ve read a Nassim Taleb book or Chris Cole white paper and how do I do this? If you don’t have tens of millions of dollars, there was never a solution.

So, as entrepreneurs, we figured out there had to be a solution to this. The piece that was missing was this long volatility, tail risk piece. So we set out to create that opportunity for retail to get access to this asset class.

The problem is with the regulations and the business side of this space, it takes years to get these things off the ground. We started to work to launch the long volatility/tail risk piece in 2018, knowing that was going to be the hardest piece to build. Then once we had that piece, the second hardest piece to build was going to be commodity trend.

So, then we knew we’d build that piece and then it’s easier to overlay the stocks, bonds in gold and Bitcoin, etc. We’ve been working on it for years. So, when Chris’ paper came out in Q1 of 2020, it was great, but we’re also saying that we’ve been working on this behind the scenes, but it’s a rising tide lifts all boats.

So, we take a little bit of a different approach. Chris’s Dragon portfolio has, basically, almost equal weight to five asset classes with stocks, bonds, gold, trend following, and long volatility. Ours is a little bit different because, as I said, I have always been inspired by Harry Brown.

We take the four-quadrant model and so we use global stocks, global bonds, and then Harry Brown used gold, but instead of gold providing that ballast in inflationary times, we wanted to use CTA or trend following, commodity trend, in that bucket. Then, instead of cash, we use our long volatility and tail risk. So that’s the four quadrant model that we use.

So, you have global stocks for growth. You have your global bonds for deflation, you have commodity trend for inflation and you have long volatility and tail risk for that recession or, or sell off environment. So, we believe in ensemble approaches, I’ve been talking about, to each of those buckets.

So, that’s how we created this liquid portfolio. We use futures and options to cash out futures and options markets because then we’re allowed to cross margin these different asset classes and structure a portfolio that could provide a nice return to drawdown mix for our clients. Now, historically, we called ours the Cockroach portfolio because we’re trying to outlive, last and outlive everybody.

We think about multi-generational wealth first. How do we get this portfolio to outlive you and, hopefully, outlive your grandkids. Part of it is that we’re entrepreneurs. Most of our clients are entrepreneurs: [ages] 25 to 40 that have had their first liquidity event. To be an entrepreneur, you take very concentrated risks to actually build wealth and build savings. Then, to maintain that wealth and savings, you almost have to turn 180 and use diversification to manage that wealth over multiple generations.

So, this is what we’re trying to do for our clients. This is the liquid portfolio we built, but that’s not necessarily what kills multi-generational wealth is not necessarily that investment vehicle you’re using, but it’s things like war confiscation, etc., that can really kill multi-generational wealth.

So, we had the liquid portfolio and then underlying that we’re able to hold a segregated gold and a little bit of Bitcoin, as well, to manage some of that Fiat risk. So if we have some sort of extreme exogenous event: war, confiscation, diaspora, etc., we also want (underlying that portfolio), a little bit of segregated, gold, and Bitcoin to hedge some of that Fiat risk combined with that liquid portfolio.

So, that’s the lens we view of how you manage that wealth that you’ve concentrated to build. How do you diversify it properly to manage any sort of macroeconomic environment moving forward for multiple generations?

Niels: If we try and get people to visualize it, I imagine that 50% is offensive strategies and 50% is defensive, to say it in the football or soccer world that you come from.

I think that’s always been a great analogy, when you think about how to put together a portfolio. I think it’s a Diego that talks about a football team and how you put players on the pitch and all of that good stuff. I actually think that is, for a lot of people, an easy way to understand that each player has a role and you can’t have 12 players like Michael Jordan on the field because that’s not going to help, which is also another Chris Cole paper, by the way, when he makes the analogy to basketball and how they put together teams.

I imagine that in the offensive part is a lot of what we’ve already talked about: the long vole, the tail risk, the CTA trend, and then you have your gold and maybe your Bitcoin. In the offensive part (So, maybe I said offensive, before, when I meant the defensive part), in the offensive part; the offensive part is just buying kind of the, the underlying… or do you go into kind of some small illiquid stuff, private equity? How broadly do you want to diversify that part, so to speak?

Jason: There are a couple of ways to think about this. Part of (as you know) when you’re structuring portfolios, or creating strategies, is there’s a lot of regulatory burden, and then you have things like AUM burdens, etc., your assets under management.

So, initially, in the offensive part of the portfolio we use a combination of global stocks and global bonds, which you can get access to with the liquid futures markets. So, that’s what we start with. Over time, as assets under management grow, then we can add more strategies that are highly correlated with equities or bond markets.

So then, we can start to create much more of an ensemble within those buckets for diversification, but still sticking to highly correlated strategies within those buckets. If you were to add private equity, venture capital, real estate, one could argue they fall right into that equity sleeve. So that’s one way of looking at it, but they’re going to be illiquid strategies.

So, we built this liquid portfolio. One could easily, maybe, allocate 50% of their wealth to this liquid Cockroach portfolio, and then hold aside 50% for these private illiquid investments. That’s a really key piece of understanding that’s fascinating to me is that people don’t realize that the liquidity premium is almost just as important as volatility in our space. You have liquid and illiquid strategies.

Most people are in highly illiquid strategies, especially if they moved up the risk curve to private equity and real estate and venture capital. They don’t have the liquidity that these cash settled liquid markets provide. More importantly, in a selloff they’re illiquid, you can’t get your money out, but you also may be getting capital calls because now that manager feels it’s a target rich environment. So, you need to provide the liquidity for those capital calls.

So, that’s a nice ballast, actually, if you can provide a liquid Cockroach portfolio and pair that with an illiquid private equity, real estate, venture capital portfolio, you have a source of liquidity when you need it most.

That’s an interesting way to really manage wealth as well is we wanted to build that liquid strategy first, and then clients can pair that with their illiquid strategies that may require a much more nuanced approach to how they invest in those strategies.

Niels: Yeah, absolutely. Actually it’s funny, I think actually, you allocate to someone I used to work with when I worked for Jerry back in the nineties. I’ll call him Tom and then you probably know who I’m talking about. Tom used to say, back then (coming from the pension fund system), he always said, what people don’t really understand is that when you invest in a trend following strategy, for example, it allows you to own equities. I think that’s an interesting thing that I think people don’t really fully understand. It’s partly the liquidity side, but there’s obviously also the way that the performance tends to behave when there is a crisis. But I do think it’s a nice phrase.

Now, talk to me a little bit about something (which we also touch on unusually in our weekly conversations), and that is of course, okay, so, you decide that you want to do this, but how the hell do you go and put together a backtest of something where you want to build it for the next hundred years, and you want to do it in different environments, but the environment we’ve had has lasted for quite a long time. Some of the environments [where] we’re trying to protect ourselves we haven’t seen [before] (certainly not in my investment career, and, I think, in many other people’s careers). So how do you think about getting to a point where you could say, “Yeah, I think this is good. This gives me confidence in how these strategies will behave as the environments change over time.”

Jason: Yeah, that’s extremely difficult and I’m almost with Jerry on this where I don’t trust a backtest, but we all use backtests to give us an intuition pump (as the philosopher, Daniel Dennett tried to call it). So, we have to get an idea.

We can go all the way back to the Talmud for diversified portfolios, or to Jakob Fugger (in what’s now modern day Germany), in the late 1400s; you want different asset class return drivers for diversification. You can do rough backtests on things like stocks, bonds, gold, cash, with that permanent portfolio going back 100, 200 years. Once again, we have much more financialized markets these days.

We backtest our portfolio going back to the 1990s, but you have to use different proxies for these over time. So it’s never really accurate. Also, Chris Cole, backtested the Dragon portfolio a hundred years, but you have to use very vanilla strategies and make a lot of assumptions to be able to backtest that.

So, you can’t really hang your hat on a lot of these backtests, but it gives you an idea to think about how these different return drivers (or these different asset classes), perform differently over time. We talked about it earlier, I can’t find anybody that’s really traded stagflation. Those guys are long retired. It’s hard to find anybody in those strategies. Then, we talked about with long volatility strategies, you can’t really backtest beyond 10 years. So, it makes it really difficult to run that backtest. So you have to use proxies and (like I said) it leads to intuition pumps.

What you do think about is, (just in general terms), how do these return drivers perform in different macro environments? I think that was really the genius of Harry Brown. Now, we can use modern techniques to really diversify and create ensemble approaches within those, and use active managers that are trying to seek alpha, but we’re trying to get a beta signal from them, but that is really the difficulty with backtesting is that you use an intuition pump; you throw it out the window. It’s a weird, strong opinion (loosely held), is maybe the way to look at it.

You talked about Diego, actually, you’ll appreciate this, I argued with Diego when he was talking about the football or soccer pitch and the different players on the pitch; you have offense and defense is what he was primarily talking about. I said, your center and midfielders are actually your commodity trend. It goes back to that diversification. Those is your uncorrelated. They can go for offense and defense.

So, that’s how you really build that portfolio is thinking about offense, defense, and the transitions from that. This is why, also, we think about segregated gold or Bitcoin. What happens if the stadium blows up? You need something outside of that system, whether the markets shut down, etc. So, that’s the other thing is that we try to think much more about tail risk events; what if the market’s completely shut down? What, what are my options? Everything outside of zombie apocalypse is what we try to cover. We hope by doing that, we’re really just trying to build the least shitty portfolio.

I’m not trying to be the best portfolio in the world, but I’m trying to have the least shitty portfolio that can chug along in any environment we’re in. What’s interesting is if you backtest the 1990s, it’s much more important to traunch it out into five-year periods, to see how the portfolio performs over different five-year periods. If you have proper diversification, it should chug along nicely. It may not be absolute best, but it’s never going to be the worst it’s going to be in that top decile, the quadrant of returns, over individual five-year periods. That’s exactly what you’re looking for.

As I said, these are your savings. They’re not investments, they’re your savings that you need them to be there when you need them most. Part of that is you cannot sustain massive drawdowns because you have individual sequencing risk. That’s part of the lie that has been perpetuated is just buy and hold stocks for the long run and you’ll be just fine. That’s the ensemble of average of that, but we’re actually leading individual lives and you never know when you’re going to need that money most. So you want a very boring portfolio. That’s going to chug along in any macroeconomic environment.

Niels: Absolutely.

I’m mindful of the time, so, I just have a couple of other things, small things that I wanted to ask you about, and then you, if you have anything you want to bring up, feel free to do so. So just for me to understand fully the Cockroach approach. So gold and Bitcoin, you say in a segregated… but is it an overlay or is it part of the assets you hold.

Jason: That’s a great question. So I’m glad you brought this up. So the problem with a Cockroach portfolio like we have, or when people really love Chris Cole’s Dragon portfolio, what they found out is that it’s really hard to implement. And part of that difficulty is it’s really hard for retail investors to pull these different asset classes and cross margin them.

Part of the idea of targeting portfolio volatility is a fancy way of saying leverage, because everybody’s afraid to use the word leverage because they think people are going to freak out if they say leverage. What we do is, we have global stocks, global bonds, long volatility, and commodity trend.

We’re able to hold those. This is why we use the futures and options market (those cash sell futures and option markets), because at the FCM we’re able to cross margin them. So, it’s a very capital efficient way to hold these. We leveraged that portfolio to X.

So, if previously it was 25% each, stocks and bonds, now it’s 50% each. So, now we’re back to a 50/50 portfolio. So this is why I was saying about, now you’re holding that stock/bond allocation like people normally are, but now you’re also holding an equal amount of long volatility, tail risk, and commodity trend. So, that helps ballast that portfolio.

So you’re looking at a 50% each of those quadrants, as we hold that at the FCM, cross margined. Then, what you’re able to do as well, if you’re using these features and options markets, is you can actually hold segregated gold as part of your collateral. We use very low margins for trading futures and options. So part of that margin usage, instead of having cash or T-bills, you can hold segregated gold, and your certificate for that segregated gold counts as 90% collateral.
So, it’s just another capital efficient way of having the gold on the books as well. So, in our portfolio we use 20% segregated gold, and rebalance that over time as well. That allows you (in a capital efficient way) to have that gold on your books. More importantly, you’re having a segregated gold position that’s nobody else’s liability. There’s no counterparty risk there. Then we add 20% gold (and the Bitcoin position is 5%), you have a lot of issues there about how you’re going to hold your Bitcoin due to different regulatory environments, whether it’s domestically in the U S or Europe, etc.

So, you can start off with just holding it with the liquid futures markets. Eventually you can use cold storage, multisig, wallets. It’s just, we’re waiting for kind of the regulators to catch up to the environment we’re in.

Niels: I have a feeling they’re catching up pretty soon, pretty quick, given the last week’s kind of announcements coming out from left, right, and center, but maybe that’s a different story.

The product itself, when people want to invest, how have you packaged it or are you packaging it at the moment (so to speak), to make it easy for people to buy and put in their portfolios? What’s possible now-a-days?

Jason: One of the biggest hurdles that Taylor and I had to figure out over the last several years is what investment vehicle could we provide so we could offer retail clients access to this? So, technically, we’re a commodity pool operation or a CPO. So part of that CPO process is we’re allowed to take unlimited accredited investors. Now we did everything we could to figure out a way for non-accredited investors, but it’s just impossible.

So, this is the structure we figured out is we can take unlimited accredited investors. So even other managers in our space are going to be QEP or QP minimum. So that’s even a higher hurdle rate, but we kept it down to accredited investors. Part of that, in accredited investors, is that we have a hundred thousand dollars U.S. minimums.

So, this is how we tried to really democratize this investing style to get it as low as we could to provide that access point to retail. That’s exceedingly difficult to do. It took us years to figure this out. So this is what we came up with is, if we have accredited investors; a hundred thousand dollar U.S. minimums; that’s a direct access into this Cockroach portfolio that can holistically… and there’s a total portfolio solution for their savings. So, they can just hold that for the long-term and their savings will hopefully be there when they need it most.

Niels: Yeah, Will it be for U.S. investors, or also for offshore.

Jason: That’s an interesting question, as you’ve had to deal with as well. So, technically a CPO is a Delaware LLC. So, you could take direct investment from anywhere in the world. But who’s comfortable with that? So, South American, Asian investors are pretty comfortable with that; European investors, UK investors, not so much. You can also set up a Cayman feeder, which we’re working on as well. So you have all these other avenues or vehicles, and it really depends on each individual client and where they’re located and how comfortable they are with a direct investment into a Delaware LLC.

The other thing we were able to do, domestically, for U.S. investors is that they can invest in us through a self-directed IRA. So that’s just another tax efficient vehicle for them to have access to. Now, unfortunately it’s not set up for Canadian investors to do it with their retirement accounts.

So, we’re always working on all of those hurdles, but any investor anywhere in the world can have a direct investment. If then they require some sort of vehicle in between, we’re working on that as well. But as you know, you get those calls from a different country every day. A friend of ours said that they would love to see what a portfolio manager does on a daily basis. Do they want to see me in compliance and legal meetings all day? Because this is what our world looks like.

Niels: Yeah, it’s definitely not so easy. It’s also just timing, just getting peoples to say yes at the same time so that you can actually go and do these things. It’s a little bit of a puzzle, but it keeps us busy, which is good.

This has been great. Jason, I really appreciate that. I think one question that I have, and I don’t know if you’ve ever thought about this as well, because this portfolio sounds pretty Bulletproof in many ways, it really does. So, I commend you for that, but is there anything at all that you guys have thought about and said, yeah, these could go wrong if it’s just… If exchanges close and nobody can trade, neither can we. That I can understand, but then we’re all in the same bucket. But, is there anything else that you thought about, or do you really feel that this is pretty bullet proof?

Jason: You said it best. One is the obvious that is known, is that if markets has close down. This is also why we have the segregated gold for those sorts of scenarios, or for a true zombie apocalypse. As my partner likes to say, you need guns, butter and water. But outside of that, you asked the right person because, as long volatility people, we have a very quirky personality. So we really think about crazy tail risks. Actually this one’s not so crazy, but what really keeps me up at night is there are two things that I worry about. One, as you said, we’re looking at a backtest. At most I can back test the last a hundred years.

People don’t realize the last hundred years is an anomaly. Since the true advent of the industrial revolution, we went from a billion people in the workforce to 5 billion. So we had a five X increase in the workforce. In 2071, where they expect us to achieve peak population. So, the workforce may only increase 50% since then.

So, we went from this exponential increase in the workforce to now a linear one. So what does that mean for our economic models? We’re fairly uncertain. Another piece to that is that you have the dematerialization effects, of the worlds we live in, where we’re collapsing, supply chains.

Previously, I would have to go into a high-end boutique to buy, say a cashmere sweater, now I can go online and find somebody in Mongolia that can make that cashmere sweater and send to me directly. So in the store, it may have cost me $600 and I had all these middlemen and supply chains in between. Now I could buy that same sweater for $150 and it gets direct shipped to me. I still buy the sweater.

So, consumption continues at pace, but we have a decline in prices and we don’t have a lot of economic models that make up for that. The third piece of that is I think about the new EM, or the new emerging market which is actually the emerging metaverse. It’s not on a Countrywide basis. It’s that we’re all moving online into this emerging metaverse that we’ve had maybe sped up by the crypto environments or VR, etc.

That’s another dematerializing effect. So if we’re having a reduction in the workforce population dematerializing effects, I’m not sure we have any economic models in the textbook that speak to that. Now, I’m hoping that by holding all the world’s asset classes, and rebalancing frequently, that we should be just fine in that environment, but it’s impossible to know that apriori.

Niels: I think that’s a good point. Actually, it can be a little bit scary to even speculate about some of the things that could happen and how the world is changing at the moment. Narrative of course is very important. I was listening to someone, I forget who it was, but I thought it was quite funny. He talked about this thing about the cloud. We always think about, oh yeah, we’ll just put it in the cloud. But what he said, what it really is, it’s a bunker in Utah. But had they used that word; have they said, “oh, we’ll put it in a bunker in a Utah.” It wouldn’t have sold very well.

So it’s interesting. Anyways, that’s a digression.

Jason: If you said, “Yeah, I put it in a dozen cheap server farms in distributed locations around the world.” It doesn’t have a great marketing pitch as it always does. The way I also think about it is that the way we construct portfolios, with our Cockroach portfolio, is we’re trying to get out of the crystal ball game. Everybody believes they could predict the future. I don’t think anybody can. This is why I actually always love CTAs, I have a theory that when people are coming up in the financial markets, when they’re in their teenage years, they’re either inspired by Warren Buffet or they’re inspired by Market Wizards.

The Warren Buffet idea is that you can predict the future. You can pick stocks. You’re a genius. The Market Wizards, the CTA side is, nobody knows anything. I can’t predict the future. No narrative is going to help me. I have the epistemic humility to just take the trade. I’ve always been more akin to that side of the book. Epistemic humility that it takes to hold a lot of different asset classes and say, “I can’t predict the future. Nobody can, but if I do this right, I’ll be just fine.”

Niels: That is why you’re a good friend of the show with that attitude. Before we wrap up Jason, where do you want to send people to learn more about what you guys are doing?

Jason: Sure, the easiest way to find us is at MutinyFund.com. You can also find all our podcasts there on our website and all of the papers that my partner Taylor Pearson writes. We have a mutiny investing podcast that you can find on any podcast player. on Twitter I’m @JasonMutiny and my partner is @TaylorPearsonMe.

Niels: Fantastic, excellent, on that note, let’s wrap up this fascinating conversation. Jason, thank you so much for being on the podcast and for sharing your thoughts and insights with us. It’s been fascinating to hear your views on volatility and portfolio constructions and all of that.

To all of you listening today, I hope that you were able to take something from today’s conversation onto your own investment journey and if you did, please share these episodes with your friends and colleagues and send us a comment to let us know what topics you want us to bring up in the upcoming conversations with industry leaders in the world of finance and investing. From me, Niels Kaastrup-Larsen, thanks for listening and I look forward to being back with you on the next episode of Top Traders Unplugged. In the meantime, go check out the show notes for this episode and all the other resources that you can find on our website.

Until next time, take care of yourself and take care of each other.