Shailesh Gupta, Head of Structural Alpha, Simplify Asset Management

[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange, where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry.

[00:00:20] Of all the concepts focused on throughout the discussions hosted on the Alpha Exchange, the notion of carry is one of my favorites.

[00:00:27] In its most basic definition, carry measures the income or cost to holding an asset in the steady state when nothing happens.

[00:00:35] Underpinning the assessment of value in any option trading strategy is a view on the favorability of carry at a given point in time.

[00:00:43] Can I own options for free or at least at a meaningful discount to their fair value?

[00:00:48] Mr. Market makes this very unlikely.

[00:00:50] Can I be especially well compensated for being short optionality?

[00:00:54] These are challenging questions worthy of careful study.

[00:00:57] And in this context, it was a pleasure to welcome Shailesh Gupta, the Head of Structural Alpha at Simplify Asset Management, to the podcast.

[00:01:05] Our conversation explores areas of carry in the market, why they exist, how they can be harvested, and what can go wrong in the process.

[00:01:13] Shailesh shares his views on the pricing of interest rate volatility, where the vol risk premium has been especially high, and how it fits into product design at his firm's ETF platform.

[00:01:25] We also talk about risk, including the crowding episode in VIX products in 2017, leading into the XIV event of 2018.

[00:01:33] I hope you enjoy this episode of The Alpha Exchange, my conversation with Shailesh Gupta.

[00:01:43] My guest today on The Alpha Exchange is Shailesh Gupta.

[00:01:47] He is the Head of Structural Alpha at Simplify Asset Management, an ETF firm doing some really interesting things in the realm of derivatives.

[00:01:56] And the topic of this conversation is going to be carry.

[00:01:59] So Shailesh, it's great to have you as a guest on the podcast.

[00:02:03] I'm really looking forward to this conversation.

[00:02:05] Thank you, Dean.

[00:02:06] As Dean mentioned, I take care of the structural alpha strategies at Simplify.

[00:02:12] This concept was introduced by Bill Gross at PIMCO, and this was a significant element of PIMCO's outperformance over the decades.

[00:02:23] And it's basically a fancy word for carry strategies.

[00:02:27] So I think this would be a good discussion regarding where the institutional investors look at, how the institutional investors look at carry strategies.

[00:02:38] Yeah, I think this is going to be really interesting.

[00:02:41] Of course, you've got a background from PIMCO.

[00:02:44] And I said this to you when we spoke last time, Bill Gross would talk about carry in things like role yields in two-year notes circa, I don't know, 2012, 2013.

[00:02:56] I always just found that very interesting.

[00:02:58] So this is going to be fun to explore.

[00:03:00] Tell us a little bit about yourself, just with respect to your background in markets and how it leads into taking on this role at Simplify.

[00:03:09] Sure.

[00:03:10] So I started my career as a credit analyst, and soon I realized that to create some kind of unique USP or unique selling proposition, I should add something more quantitative.

[00:03:24] And I studied financial math at the University of Chicago, and immediately after that, got hired by PIMCO.

[00:03:31] And there, I actually really understood that the trading strategies have very different concepts as compared to what is taught in the schools per se.

[00:03:44] So a lot of learning on the PIMCO trading desk, so much so that we call ourselves PIMCO alumni coming from that school of thought.

[00:03:53] And take us through maybe some of the learning experiences from PIMCO.

[00:03:58] So first of all, give us the context of time during your time there, and then bring us inside the sort of thought process around carry.

[00:04:07] It might make sense first for us to, even before we do that, to define carry.

[00:04:12] But just tell us a little bit more about the time frame of your time at PIMCO.

[00:04:17] Sure.

[00:04:18] So this was from 2000, 2010.

[00:04:21] This was the time when PIMCO won the Fixed Income Manager of the Decade Award.

[00:04:28] And this was the time which included the financial crisis.

[00:04:32] And the thing is that most people try to enhance the returns in the financial markets through credit strategies.

[00:04:40] However, PIMCO was doing it through, as you mentioned, the two-year treasury or the corresponding futures.

[00:04:47] So the roll-down yield, you can achieve similar amount of enhanced yield without taking credit risk.

[00:04:55] And that way, when the financial crisis hit, most of the portfolio managers, investment managers were underperforming while PIMCO was the last man standing.

[00:05:06] Let's step back a little bit and maybe put some definition around this concept of carry.

[00:05:13] Big, big picture.

[00:05:15] Give us some understanding.

[00:05:17] Maybe not the math of it, not just yet at least.

[00:05:19] But give us some understanding as to what it means when professionals like yourself invoke this term.

[00:05:27] What kinds of risk exposures are taken?

[00:05:30] And broadly, what set of circumstances do they tend to thrive in?

[00:05:35] And where do they become vulnerable, these strategies?

[00:05:39] Sure.

[00:05:40] The technical definition would be something like expected return when the markets are unchanged.

[00:05:48] Markets can go down.

[00:05:49] Markets can go up.

[00:05:51] But what happens to the portfolio when the main market variables are unchanged?

[00:05:56] Does the portfolio gain or lose?

[00:06:00] That concept, probably easy to understand.

[00:06:03] Like, for example, you own a property.

[00:06:05] And if it is just sitting there, its value can go up, its value can go down.

[00:06:11] But you put it up for rent, then you're collecting your income.

[00:06:15] So that asset is generating income, generating returns, while the market can be unchanged, so to say.

[00:06:23] So that's pretty much the basic concept.

[00:06:26] I was thinking about this as I was laying out some of the topics we might address.

[00:06:32] And I was thinking about some of the areas in which the man on the street, you, I, others just running their daily lives, would be exposed to carry or at least have to make decisions that have some carry consideration.

[00:06:49] And one of them I just was thinking about was you'll get a message from your friendly home heating oil company.

[00:06:57] And they'll give you a choice.

[00:07:00] You could pay month to month or they'll give you the one-year contract.

[00:07:04] And there's, in some ways, different considerations there, right?

[00:07:07] You're sort of exposed in some ways to the month-to-month changes versus kind of locking something in potentially at a higher rate.

[00:07:15] I think there's, in some ways, some element of carry, at least from a consideration standpoint there.

[00:07:22] What else just in terms of what we experience as folks just running our daily economic lives?

[00:07:28] Are there non-market examples of carry?

[00:07:31] I would extend the example that I gave about the house, that you're collecting income that is your positive carry.

[00:07:39] And if you buy insurance on that property, that would be sort of the negative carry or the negative monthly bleed, so to say.

[00:07:49] So net, you have a positive carry portfolio.

[00:07:52] But now you have a smoother ride, so to say.

[00:07:57] That asset value can go up or down.

[00:07:59] But in case there is a crash in the property values, the insurance comes in.

[00:08:04] So those extreme events are covered.

[00:08:07] And then you have a nice, steady cash flow.

[00:08:09] So the whole point of carry is to stabilize the portfolio, reduce the market risk, and maximize the running yield or carry per se.

[00:08:21] So I think that is probably the easiest way to think about from a practical day-to-day life perspective.

[00:08:29] And it's a rare thing, but in the current circumstance, many homeowners find themselves in a positive carry circumstance.

[00:08:39] Perhaps let's strip away things like insurance, which are very real considerations.

[00:08:44] But just the idea that, at least for now, you can earn 4.5%, almost 5% in a money market account.

[00:08:53] And because you had an opportunity to refinance your mortgage at such a low rate, you might be locked in for 20-odd years at 3%.

[00:09:02] And so in some ways, just your mortgage is positive carry.

[00:09:06] Would you concur with that?

[00:09:08] Yeah, absolutely.

[00:09:09] I mean, if you have cash sitting in the bank, one can deploy efficiently.

[00:09:15] Even just the risk-free rate T-bills gives you regular income.

[00:09:19] But technically speaking, from a financial markets perspective, we should look at excess carry, excess over the risk-free return, so to say.

[00:09:29] So let's get into some practical examples, how it is used in the financial markets.

[00:09:37] Like the most popular carry strategies are known to be in the currency markets as the recent events brought forward, the issues with the yen carry trade and so on and so forth.

[00:09:49] What is happening over there is that interest rates in the U.S. are much higher than Japan.

[00:09:57] So if you do a currency trade where you are long the U.S. dollar versus the Japanese currency yen, so effectively you are investing in the U.S. people kind of a rate and financing that by borrowing in the Japanese rate.

[00:10:15] So on a financed basis, you can earn an extra return through this trade.

[00:10:22] So, you know, it seems like a free money kind of situation, but that trade would have a lot of currency risk.

[00:10:31] So this is the original carry trade, so to say, historically over the last 20, 30 years, a lot of academic research has been done.

[00:10:43] So in these kind of trades, carry one should think of as a tailwind to a trade idea per se.

[00:10:52] If somebody wants to be long U.S. dollars and you have that position against the Japanese yen, so you have a nice tailwind of the interest rate differential.

[00:11:05] So carry for a financial market perspective sort of can be a tailwind or a headwind based on the direction of the trade.

[00:11:13] And when we think about carry, and I'd love to explore the currency side of this, because as you know, there's been a not small amount of academic research looking at currency forwards and whether the discount for the higher yielding currency is worth it over time.

[00:11:30] And it turns out there's both a risk premium in there, but also the potential for something to turn around on you quite quickly.

[00:11:39] And I was hoping you maybe could just contextualize this for us or comment on this first.

[00:11:44] When I think about carry, I feel like we're in some ways implicitly saying you're kind of short vol.

[00:11:50] You're long the steady state, as you alluded to before.

[00:11:53] What's your return if nothing happens?

[00:11:55] And of course, that can be upended if something unwelcome does happen, right?

[00:12:01] If there is a drastic or sudden change in the profile.

[00:12:05] When you think about this concept of carry, how does it fit into your view on it?

[00:12:10] Yeah, I mean, one can think of carry sort of like an option stream.

[00:12:16] If you're collecting some premium from the options, then obviously in a bad scenario, there should be a negative outcome.

[00:12:22] Even if the carry trade is done in a plain vanilla contract, like for example, the currency.

[00:12:28] Like, for example, let's say, look in terms of outside the US.

[00:12:33] Like as a US investor, you want to put in a currency bet of, say, British pound.

[00:12:39] So, you know, okay, the currency can go up, currency can go down.

[00:12:43] If it has a positive carry, probably there will be a lot of demand for that kind of trade or that trade kind of becomes popular.

[00:12:51] The problem with any popular trade is that when it starts going in the wrong direction, positioning can cause the price actions to be severe in the other direction.

[00:13:05] There is no free lunch in the market.

[00:13:07] So if you are getting positive carry, then you also have a large market risk in the other direction.

[00:13:13] Maybe not fundamentally, but just based on the structure of the market.

[00:13:18] When we think about the existence of carry, the idea that in a steady state, there's return to be kind of peeled off, even if nothing happens.

[00:13:28] How would you frame out the reason?

[00:13:30] If you just use the term music to my ears, no free lunch, because I think if we're honest about markets, it's difficult to truly manufacture something from nothing.

[00:13:40] And so that's pretty intellectually honest.

[00:13:43] What are the sources of carry?

[00:13:45] In other words, what are the elements or the components of markets that allow it to exist?

[00:13:52] So the free lunch concept we considered from a steady state position or something like a currency carry, which has been a known concept for several decades.

[00:14:01] So obviously the payoffs kind of get neutralized, the steady stream, get balanced by tail risk on the other side.

[00:14:08] But let's dig deeper into other forms of carry so we can find, if at all, we can find some free lunch.

[00:14:17] So the main concept there was when the trade becomes popular, it also has large tail risk.

[00:14:24] If we hold on to this concept, we can apply to various situations, then we can find out carry versus the risk, so to say.

[00:14:34] So like currency we discussed, and another popular carry trade is just credit, right?

[00:14:40] Like if you buy credit securities, you get extra spread, extra yield as compared to the risk-free rate or the treasury rate, right?

[00:14:51] And we know this is a popular strategy that used by fixed income managers in general and investors.

[00:15:00] 60-40 portfolio is known to be the optimal portfolio over long horizons.

[00:15:07] So in that scenario, if you earn, say, 50 to 100 basis points of extra yield on your portfolio, the credit losses on an average are much smaller than that.

[00:15:19] So effectively, you are kind of getting a free lunch in the sense that you're collecting a spread, but your expected loss is much lower.

[00:15:29] But again, this is a very popular trade that almost every fixed income manager is overweight credit.

[00:15:36] So in that case, when there is a credit event like COVID crisis, the credit spreads blow out and all the portfolios, which are overweight credit, start underperforming, so to say.

[00:15:49] So again, so now we find an area which has more than fair value risk premium, which was not there in the currency market, but that risk premium is compensation for the tail risk that kind of strategy has.

[00:16:06] Yeah, it's so interesting.

[00:16:07] Yeah, it's so interesting.

[00:16:07] And certainly in credit, as you point to, you're getting compensated for default risk and defaults do occur, even occasionally in securities that have a very high credit rating.

[00:16:18] But you're more than compensated for bearing that risk is your main point.

[00:16:23] Perhaps the pricing is the result of the potential for things to go occasionally horribly wrong, a la 2008, where you get these giant blowouts in credit spreads.

[00:16:36] And I think you're pointing to the market tends to be all one way when something works pretty consistently.

[00:16:43] I was hoping you could comment on this, Shalash.

[00:16:46] Some part in the FX world of carry gets dictated by the promises of central banks.

[00:16:53] And specifically, I'm remembering the 2015 Euro-Swiss peg, where the Swiss National Bank basically just decided that its currency was too strong.

[00:17:06] It was suffering as a result, and it just drew a line in the sand and said, we're here to prevent our currency from rallying too much against the euro.

[00:17:15] I think it was 120.

[00:17:17] And they held that peg for a while, and the market truly believed it.

[00:17:21] And then suddenly, the S&B just decided to undo it with no notice at all.

[00:17:28] But it took an asset that was almost zero vol, because it was basically pegged, to an enormous vol in one fell swoop.

[00:17:36] Exactly.

[00:17:37] As I mentioned, there is no free lunch in the currency market, or all the excess juice has been sucked out.

[00:17:45] It's sort of an over-researched market.

[00:17:48] So that's why, as I mentioned, the credit has alpha opportunities, which are not the opportunities are much smaller in the currency market, just because it is so popular.

[00:17:59] So now we go to the next level, credit, which has alpha opportunities, but again, it is a popular one.

[00:18:06] So I think from currency to credit, if we can find some section of the market which has the alpha opportunities, but actually is not very popular, that would be the holy grail of investing, that you have alpha opportunities, but the trade is not very popular, that you don't have sort of structural risk for that.

[00:18:29] And for that, we should consider something like mortgages.

[00:18:34] Like in the U.S. bond market, around one-third is treasuries and one-third is credit, but another significant portion, close to one-third, is mortgages.

[00:18:45] Like almost every homeowner in our country has a mortgage against it, and these mortgages get packaged and are available to investors as mortgage-backed securities.

[00:19:00] So they don't have credit risk, but they do have extra spread over treasuries or the risk-free rate.

[00:19:08] So in that case, you would get collecting extra spread, but again, there is no free lunch or hour, there is extra yield, so there is extra risk.

[00:19:19] The risk there is the convexity risk, convexity in terms of the interest rate sensitivities of the portfolio.

[00:19:27] The interest rates go higher, the security or the portfolio loses money, and interest rates go lower, the fixed income portfolio makes money.

[00:19:38] But the convexity risk is such that the impact of higher yields is more as compared to the lower yield,

[00:19:48] and this asymmetric risk needs to be compensated and is compensated healthily in terms of extra spread that mortgage-backed securities have.

[00:20:00] Well, we brought some of this by way of example into the conversation earlier on the average homeowner who's had the benefit of that just incredible rally in the bond market

[00:20:11] circa 2020-2021 as a function of COVID and the emergency measures and so forth.

[00:20:18] And so that was the taking advantage of that embedded optionality.

[00:20:24] And so, of course, the homeowner is effectively long the vol.

[00:20:28] A partner of yours at Simplify is Harley Bassman.

[00:20:31] He's the creator of the Move Index.

[00:20:33] We find the Move Index for a couple of reasons, maybe one of which is the election, but it's in the 130s, which is super high.

[00:20:40] Walk us through how someone should think about the opportunities to essentially earn carry through exposure to MBS

[00:20:51] and how the Move Index at high levels kind of figures into the economics of that.

[00:20:58] So homeowner is long the option, and they are paying a healthy amount of premium for it.

[00:21:04] And that gets percolated in the market in the sense that banks and investors which own the mortgage-backed securities

[00:21:13] tend to hedge the convexity risk by buying options on treasuries.

[00:21:20] Mortgages are effectively yield-enhanced versions of treasuries for the extra convexity risk.

[00:21:26] And banks which want to neutralize that interest rate risk end up buying options on treasuries.

[00:21:34] So options on treasuries tend to trade rich.

[00:21:38] So if you have a yield-enhanced portfolio, which is enhancing the yield by selling options on treasuries,

[00:21:47] would on an average collect as extra premium while one can choose the options in such a way that,

[00:21:55] as you mentioned, the Move is elevated.

[00:21:58] Move Index consists of option volatilities up for short term, I think around one month or so.

[00:22:07] Interest rates are very volatile right now with the election cycle and Fed in motion trying to figure out

[00:22:15] where the resting place of the final Fed rate is going to be.

[00:22:19] With all these uncertainties, the interest rates are very volatile, but they are also very range-bound, right?

[00:22:26] So we don't expect the interest rates to just keep going up like the equity market

[00:22:30] or we are no longer in a secular decline interest rates, so to say.

[00:22:35] So if the interest rates are range-bound and very volatile, that creates opportunity on selling deep out-of-the-money options

[00:22:45] and enhance the yield of the portfolio.

[00:22:48] We are currently doing that yield-enhanced meant for T-bills.

[00:22:54] We are doing that yield enhancement to the typical bond market portfolio.

[00:22:59] And we also have products which are making available the mortgage-backed securities,

[00:23:06] the current mortgage securities as compared to just the mortgage index,

[00:23:10] which has historical mortgages where the interest rates were very low, so to say.

[00:23:15] So with the deregulation in the ETF market, we can bring forward these strategies which were traditionally available

[00:23:24] to only institutional investors, and we can make these strategies available to everyday investor in the ETF form.

[00:23:33] Well, I want to explore that a little bit more and kind of the way in which these products come to be

[00:23:40] and how you're able to deliver them in an ETF package.

[00:23:44] I want to talk first a little bit more about volatility, the pricing of it over time, let's say.

[00:23:52] And so I'll just sort of tee this up in saying that the VIX has been as high as 80.

[00:23:58] It's been as low as 9.

[00:23:59] Each of those in large measure is justified by the level of concurrent volatility.

[00:24:05] In other words, when chaos hits circa November of 2008 or March of 2020,

[00:24:12] the S&P is moving 5% plus a day, and you can easily justify a VIX of 80 and vice versa.

[00:24:19] It gets super quiet in 2017, realized is 6, and the VIX clears the market at 9.5 or so many, many days.

[00:24:27] It's below 10.

[00:24:28] And I think what you're talking about here with the move is that, yes, it's high.

[00:24:34] It's been high before.

[00:24:36] But you're, in some ways, I think, and I want you to correct me if I'm not framing it the right way,

[00:24:41] you're saying it's, I don't want to say higher than it should be,

[00:24:44] but that there's a pretty healthy spread between option prices in the treasury market

[00:24:50] and the extent to which there are large delivered moves.

[00:24:55] And therein, that kind of vol risk premium is pretty healthy right now.

[00:24:59] Is that fair to say?

[00:25:00] Yes.

[00:25:01] The move index is high, and that is helping the mortgage spray,

[00:25:06] mortgages to deliver extra yield,

[00:25:09] or one can monetize the yield by selling treasury options per se.

[00:25:14] So the main risk is basically if you take a position and hedge the convexity risk on a daily basis

[00:25:23] for every small little move, then all the extra juice goes away.

[00:25:29] But if you are willing to take a view that, okay, interest rate is going to move around quite a lot,

[00:25:34] but they are range bound.

[00:25:36] So if you don't sort of delta hedge or pay that hedging cost,

[00:25:40] then you can monetize the whole spread of mortgages or the extra yield from an option portfolio.

[00:25:49] And of course, the thing that's so interesting about volatility,

[00:25:52] these are just clearing prices.

[00:25:54] They're impacted by the economy, various components of uncertainty,

[00:26:00] the election being a prime example right now.

[00:26:02] But they're also very much a function of the trades in the market.

[00:26:06] Sometimes there's just a lot of folks doing the same thing

[00:26:09] that could cause vol to clear the market high.

[00:26:12] In 2006, 2007, effectively, every portfolio was some net seller of vol.

[00:26:18] And so that tended to push risk premium levels down.

[00:26:22] What would you say?

[00:26:23] Are there frictions in the market or trades in the market

[00:26:27] that you think are in some ways responsible for this spread

[00:26:33] in interest rate volatility versus what's actually being realized?

[00:26:37] Traditionally, investors for yield enhancement get into structures,

[00:26:42] which are short volatility.

[00:26:44] And then dealers need to hedge that volatility.

[00:26:47] You know, it causes the moves to get exasperated.

[00:26:51] So that's why if we can take some macro view around what is the fair value of interest rates

[00:26:58] and around that put in a range, like, for example,

[00:27:03] if the inflation stabilizes over long horizon at around 2%, 2.5%,

[00:27:08] or somebody may say 2.5%, 3%.

[00:27:11] So 2.5% I think probably would be a reasonable median expectation for long-term inflation.

[00:27:17] And if you believe the neutral Fed fund real rate would be something around 1%, 1.5%.

[00:27:26] So on a long-term basis, probably 4% would be a reasonable estimate of where the interest rates

[00:27:34] should be.

[00:27:35] So around that, okay, so very unlikely that the 10-year rate is going to go below 3% or go above 5%.

[00:27:45] And that's effectively how the market has been trading over last year or two years, so to say.

[00:27:51] So keeping that in mind, one easy way to trade that market would be just buy bonds when the interest rates

[00:27:58] are 5% and just sell them when they are 3%.

[00:28:01] But we may continue to stay around 4% and the interest rates may never reach 5%.

[00:28:06] So you're waiting for that opportunity.

[00:28:09] Or you can get into an option position that you, if the interest rates do go to 5%,

[00:28:15] you get long bond position.

[00:28:17] And if they don't, you keep collecting the premium.

[00:28:20] So effectively, you are monetizing the high rate of movement, range bond movement in the interest rates

[00:28:28] and taking advantage of the high move index, so to say.

[00:28:34] And so what you and team at Simplify have done is take this concept, this risk premium that's

[00:28:41] especially evident in the rates market, and bundled it, attached it to other exposures,

[00:28:48] and then delivered that as a package into an ETF vehicle.

[00:28:52] I'd love to learn a little bit more about how that process comes to be.

[00:28:56] And then one or two examples of how the Simplify ETF holder is essentially getting exposure to this

[00:29:05] interest rate vol spread through your products.

[00:29:08] Yeah, sure.

[00:29:09] So as I mentioned, we are doing that yield enhanced.

[00:29:14] We offer yield enhanced T-bills, we yield enhanced Ag portfolio, and yield enhanced treasuries through

[00:29:22] current mortgages.

[00:29:23] I'm not sure if I'm allowed to mention the ticker, but I think investors can check our website,

[00:29:30] www.simplify.us.

[00:29:33] And you can find these different products, and obviously you can schedule a meeting to

[00:29:38] discuss more details.

[00:29:40] And I would also mention that this concept we are also using to benefit the equity investors

[00:29:50] or specifically investors interested in generating income through the equity market.

[00:29:56] So we mentioned the VIX a little bit earlier.

[00:30:00] So VIX is a product which catches a lot of attention, but it's a funny product in the sense that if you

[00:30:08] look historically, long VIX ETFs on an average lose 50% of their asset value every year.

[00:30:16] So theoretically, short VIX strategies should be making money, but you see the history of short

[00:30:22] VIX ETFs with the big one known to be the XIV or the Volmagadan event,

[00:30:27] that the long track record of short VIX ETFs is also not very good.

[00:30:34] So if the long VIX strategies are losing money and the short VIX strategies are losing money,

[00:30:40] so who actually makes money, right?

[00:30:42] So that becomes a nice little conundrum.

[00:30:46] And that brings us to think about these carry strategies.

[00:30:50] Then one can consistently make money through carry strategies.

[00:30:54] But the important thing is the position need to be small enough corresponding to the risk attached

[00:31:00] to the underlying investment that the currencies are giving you carry,

[00:31:06] but they also have a lot of risk.

[00:31:08] So one can't really have too much of a currency risk.

[00:31:11] Similarly, short VIX is not a popular strategy right now as it used to be in 2017 or 2018 when

[00:31:21] the Volmagadan event happened.

[00:31:23] So a lot of alpha opportunities in shorting VIX and the risks are not as high as it used to be.

[00:31:31] However, VIX is a very volatile product, right?

[00:31:35] So the volatility of VIX itself is around five times the equity market.

[00:31:40] So effectively, one needs to take a very small amount of VIX exposure that even if you take 20-25%

[00:31:48] of short VIX exposure, which gives you the volatility of like a stock market level of volatility.

[00:31:55] So that's why we have constructed a product where we take a very, very small amount of short VIX exposure

[00:32:01] so that the beta of the portfolio is of the same order of magnitude as the equity market.

[00:32:08] So keeping that small exposure allows you to weather the storm and when actually that exposure is

[00:32:15] hedgeable, you know, using options, VIX options and S&P options, so to say.

[00:32:21] So that is, I think, the key of investing in carry strategies is the position size is very important

[00:32:28] that if you have a small amount of position, then that can kind of add to the fringes,

[00:32:34] but all the pennies add up over long horizon.

[00:32:37] And that concept, we are kind of applying that to one of the most high-risk, high-return environment

[00:32:44] of VIX, and we are able to generate consistent return in that portfolio, along with the opportunities

[00:32:53] presented by the move index, you know, through the out-of-the-money interest rate options that

[00:33:00] I mentioned. So combining these two things, that gives a very robust portfolio.

[00:33:07] And that's why in the carry strategies, one, the positions need to be small,

[00:33:11] and the portfolio needs to be well diversified to be able to achieve consistent results.

[00:33:19] You make some important points there. So I just wanted to pick up on a couple of them and see if

[00:33:24] we could drill down a little bit. The first thing you said, and I've said this as well, I find it

[00:33:29] so fascinating that both the VXX and the XIV have effectively gone bankrupt. And I always say,

[00:33:38] how do you want to lose money, either fast or slow, right? One of them just sort of defeases out

[00:33:42] over time. It's a long, slow bleed, but it's painful. The story of the long VIX future ETF

[00:33:49] is a tough one over time. And then, of course, we know, as you described, the XIV meeting its

[00:33:56] death date, I think February 5th of 2018. So that happened really, really fast. There's been other

[00:34:03] equity derivative-centric periods of just sensational losses, COVID in March of 2020,

[00:34:10] 2020 being one of them. And one of the things, Shelesh, and this is where I wanted you to reflect

[00:34:15] on, one of the outcomes of that 2020 debacle in equity derivatives was a really persistent and

[00:34:22] high vol risk premium in 2021. The VIX is always going to be above realized. There'll be some

[00:34:29] marginal spread there on average. But 2021, it spent a lot of time in excessive spread territory.

[00:34:37] Probably the results of fear and just capital destruction. And so the question I'd love to hear

[00:34:43] your thoughts on is the kind of time variation of these risk premiums. They're not always the same.

[00:34:49] There's a risk premium on average, but it goes up and down over time. You seem to be arguing that

[00:34:55] the interest rate risk premium is kind of especially high right now. How should we think about the time

[00:35:01] variation of the vol risk premium in the land of VIX and S&P vol?

[00:35:06] Right. So the risk premium is effectively sort of the insurance business, right? So when hurricane

[00:35:13] comes or there's a disaster, insurance companies making the payout, but subsequently the insurance

[00:35:21] premiums go up. So, you know, ultimately on an average over long horizons, insurance companies are in the

[00:35:27] business of making money. So they will charge enough premium that they make up for the losses,

[00:35:32] so to say. So that's pretty much happens in the volatility risk premium market. And this year is a

[00:35:38] very good example that when the yen carry was going bad in, you know, earlier this year, that the VIX

[00:35:47] spiked almost as much as at least intraday, as much as during COVID times. And if you compare

[00:35:55] all the VIX products, you'll see year to date, most VIX strategies, both longs and shorts,

[00:36:02] have a negative performance for the year. And in that pack, our short VIX strategy is probably

[00:36:10] the only one which actually made money this year, so to say. So the two things over there,

[00:36:15] keep the position small and hedge appropriately, the extreme risk events and diversify it along fixed

[00:36:26] income and equity risk premium, so to say, then that way you have multiple sources of carry. So

[00:36:34] the risk in one doesn't overwhelm the portfolio on an overall basis, so to say.

[00:36:39] Yeah. That's really interesting. So sizing, of course, very important. In some ways, implicit

[00:36:45] in sizing is, I think, another main focus you're alluding to, which is just trying to cover off the

[00:36:53] real tail. I think the VIX went up 65% on August 5th. And so having some protection against, you're

[00:37:01] always exposed, but having some protection against something as seismic a move as that, even if you have

[00:37:07] to pay away some of your carry. Is that what you're referring to?

[00:37:12] Absolutely. I would take a little bit of a philosophical view here that our brains are sort of

[00:37:20] wired to manage the stock market risk, right? So the stock market on an average goes up, but has

[00:37:27] periods of negative performance like COVID or the financial crisis. So if an asset has more

[00:37:36] extreme risk profile, our brains are not able to process that and we might end up taking bad decisions

[00:37:45] per se. So that return distribution needs to be sort of normalized. And that's what you do by hedging

[00:37:53] the tail risk and make the distribution closer to normal, which one can process better and make better

[00:38:01] trading decisions under times of stress.

[00:38:03] The other thing you're referring to is just that you can get some diversification in carry. So

[00:38:12] in a crisis event, it's generally the case that all vols go up, gold vol, rate vol, credit spreads

[00:38:20] widen a lot, equity vol. But there's certainly not a perfect correlation. And so August 5th was much,

[00:38:27] much more a VIX event than anything else. Rate vol went up, but nothing on the order of what happened

[00:38:34] in the VIX. So I think that's some part of you're referring to as well. As you got a little philosophical

[00:38:40] there, I was hoping to ask you something just back to this XIV blowup. I'd love to get you to reflect

[00:38:46] on this. So this was a very interesting period. Realized vol was just so low in the S&P.

[00:38:52] The Sharpe ratio of the XIV in 2017 was three plus. I mean, that's just extraordinary.

[00:39:00] And of course, you'd have this circumstance whenever something does so well, it gets popular

[00:39:07] and it makes its way into the retail community. Sadly, there was a famous Wall Street Journal

[00:39:12] article about a gentleman that worked at Target and was getting rich effectively being long XIV,

[00:39:19] short VXX or whatever the permutation of it was, but basically short vol and really not appreciating

[00:39:26] how toxic it could become. Folks like you and I, we watch this and you can kind of see the accident

[00:39:33] waiting to happen. But day after day, June, July, August, now it's November and we're still realizing

[00:39:40] five in the S&P. And so the VIX is trading at 10, realizes five. Boy, that's a gigantic spread

[00:39:47] actually, even though the VIX is 10. What's the balance between earning carry when it gets

[00:39:54] dicey and it feels crowded, but it's working. It's working day after day, even though it feels

[00:40:01] like the margin of safety is withering away. You're right. I know as we agree that taking a

[00:40:08] gauge of how popular the strategy is, the more popular the strategy, more is the risk. So the strategy

[00:40:15] is generating high level of returns and it is also has very high risk in that environment. It's very

[00:40:22] tough to take the other direction because you will have, you know, extreme bleed. So as I mentioned,

[00:40:28] the only solution is just, you know, you keep reducing the position. You should have sort of a

[00:40:33] very well-defined, okay, you know, you're making three, four, five sharp ratio trade, but it is also

[00:40:41] has a lot of tail risk, you know, so if you can hedge the tail risk, you hedge the tail risk. If you can't,

[00:40:47] then you should reduce the size of the position. See, that is also related to product design for ETFs,

[00:40:55] right? So like, you know, our VIX strategies pays monthly dividends. So effectively, it is designed

[00:41:03] as 10 to 15% annualized dividend, which effectively means that as the strategy is making money,

[00:41:11] you're taking money out of the strategy. You're sort of delevering it further. But earlier products

[00:41:17] used to have the segment of the market is getting more risky and more and more of your capital is

[00:41:24] getting exposed to that risk, right? So like XIV, I remember my recommendation was to buy XIV in 30s.

[00:41:33] And I was out of that position at 60 that, you know, double my money, take my money out. And then

[00:41:39] subsequently it went to 150 and then down to 10 in one day, so to say, right? So you have a sense of

[00:41:47] fair value, make your money and get out of the way of the freight train, so to say.

[00:41:51] It's a great point. The XIV product is designed to effectively take the same bet that's making money

[00:41:58] and restack it again and again and again. And what you guys are doing is saying, okay, look, let's

[00:42:04] have a systematic way via the dividend of taking profits along the way. I think that's interesting.

[00:42:10] I'd love to just finish the conversation, which I found very interesting. We'll go back to Bill Gross.

[00:42:16] And we've talked a lot about volatility in the context of carry trades. And some part of Bill Gross,

[00:42:24] I read the book by Mary Childs on PIMCO, and I think he had a nickname in the market called

[00:42:30] the Strangler, short something like 60 to 70,000 strangles in the S&P circa, I want to say 2014,

[00:42:37] just gigantic size. So those are vol trades. But carry also exists in the yield curve itself,

[00:42:44] the rates yield curve, by virtue of just the shape of it. And Gross has made commentary around that too,

[00:42:52] around just capturing steep yield curves and roll down. Can you walk us through how that works,

[00:42:58] how people should think about that, and maybe put it in the context of the current yield curve

[00:43:04] environment in which we live? Sure. So actually, in fact, I would extend that argument further to the

[00:43:10] Wix curve and the similarities of the yield curve and Wix curve, so to say. So in the decade 2000-2010,

[00:43:18] that at the time, the yield curve used to be very steep. And that steepness was extreme in the front

[00:43:26] end. We were coming off decades, previous decades, there was a fear of inflation spike,

[00:43:33] so to say. So inflation spike is sort of, you know, one can think of from a modeling perspective,

[00:43:40] like the Wix spike, so to say. Whenever there is a chance of a spike getting priced in,

[00:43:45] that causes the curves to be not only steep, but very convex, you know, with a lot of steepness in

[00:43:51] the front end, so to say. So I learned to trade the yield curve and the convexity in the yield curve

[00:43:57] during the PIMCO days, and I used that concept to design this Wix product. So the difference is,

[00:44:03] yield curve is a 30-year curve, while the Wix curve is a six-month curve. So whatever happens to a yield

[00:44:10] curve on a 30-year horizon happens in the Wix curve at warp speed in six months times. So now Wix,

[00:44:18] on an average, continues to trade steep, but the yield curve is flat. So now we are kind of checking

[00:44:24] the movie in the reverse direction, so to say. So now the yield curve is flat, but it used to be

[00:44:30] steep. And in those steep yield curve environment, what Bill Gross showed me was that you can replicate

[00:44:38] or achieve higher yield than the whole bond market just by positioning in one-year, two-year treasuries,

[00:44:46] because the roll down in those strategies in that curve was so high. Like, think about this way,

[00:44:54] to make money in a bond portfolio, you buy a treasury, two-year treasury, and the yield goes down,

[00:45:02] the price goes up, right? So if the yield curve is steep, as time goes by, the yield of the

[00:45:09] bond will be rolling down the curve. So effectively, nothing is changing,

[00:45:14] and your price goes up. That's that original definition of carry we discussed, right? So the

[00:45:20] extreme steepness of the yield curve was giving that extra tailwind to the strategy. On top of that,

[00:45:27] if you buy a 10-year treasury at 6%, and if the Fed rate is 4%, you'd get extra 2%. On a financing

[00:45:36] basis, extra 2% juice, so to say. So steep yield curves give many ways to make money,

[00:45:44] and the compound effect of both the roll down as well as the financing creates extra normal performance

[00:45:52] for a fixed income portfolio on a total return basis. And that was the bread and butter of PIMCO

[00:45:59] in those days. Unfortunately, now the yield curves are flat to inverted. However, there are some

[00:46:06] portions of the yield curve which are still steep, and we can have that roll down kind of,

[00:46:13] you know, we can design strategies, but that becomes a little bit more technical. And those products

[00:46:19] are sort of on our drawing board. And actually, some of those strategies we are employing in our

[00:46:26] ag age or the bond portfolio, the ag-like bond portfolio that we have, the details can be found

[00:46:33] on our website, or one can schedule a call to get more details. So basically, with the flat yield curve,

[00:46:40] it's not so obvious to which strategies to make, but it's still possible to create positive carry

[00:46:48] strategies in the yield curve.

[00:46:51] Well, let's finish with this. You are a brainy bunch at Simplify. One of your founders, Mike Green,

[00:46:59] Harley Bassman, yourself. What's in the lab, just in terms of where you want to take this idea of

[00:47:06] structural alpha? Are there areas of investment?

[00:47:09] So I would like to add that along with the brains, we also have the tools. We are one of the rare ETF

[00:47:15] provider which have the ISDA. ISDA is the agreement between the bonds, so we can put in institutional

[00:47:22] quality trades which are not available to everyday investors. We can put those strategies in ETF form

[00:47:31] and make it available for everyday investors. So I think having the capability as well as the tools

[00:47:38] give us unique opportunity to provide the best in class strategies.

[00:47:44] Are there new areas of structural alpha that are on your radar screen for product development?

[00:47:51] Yeah. I mean, one of the areas which is kind of unexplored is we have a lot of treasury issuance

[00:47:57] and there is a lot of demand from pensions to hedge duration, but there's a mismatch that the demand is

[00:48:05] in the interest rate swaps while the supply is in the treasuries. Threatically speaking,

[00:48:10] you can buy a 30-year treasury or a 20-year treasury and hedge the interest rate through interest rate

[00:48:17] swaps. And you hold that portfolio till maturity, you have a risk-free profit. And that risk-free profit

[00:48:26] can be super used to enhance the return of any beta product. That alpha can be portable to any beta.

[00:48:34] So you can effectively outperform any beta product using those structural opportunities.

[00:48:40] The question is finding enough demand. These concepts are kind of complicated. So we need to first

[00:48:46] demonstrate it within our products enhancing value. Then we can find enough traction in the retail

[00:48:55] community versus it. It's like bringing the original stocks plus concept from the PIMCO days to an ETF

[00:49:03] format and accessible to individuals. So really interesting stuff. Shalesh, I've really enjoyed

[00:49:09] the conversation. I appreciate you taking the time today. Thank you very much.

[00:49:13] Shalesh Sankar

[00:49:13] Thank you, Dean, for putting this together. It's good to bring institutional concepts to retail investors

[00:49:19] and make the market more efficient for everyone.

[00:49:23] David Morgan Fantastic.

[00:49:25] David Morgan You've been listening to the Alpha Exchange. If you've enjoyed the show,

[00:49:29] please do tell a friend. And before we leave, I wanted to invite you to drop us some feedback.

[00:49:34] As we aim to utilize these conversations to contribute to the investment community's

[00:49:39] understanding of risk, your input is valuable and provides direction on where we should focus.

[00:49:44] Please email us at feedback at alpha exchange podcast.com. Thanks again and catch you next time.