Octavian Report: Is this the lowest you’ve ever seen volatility in the market?
Boaz Weinstein: On June 9th, the VIX touched 9.45. Since the beginning of the VIX — January 1990 — or roughly 7,000 days ago, I think this is the second-lowest level.
However popular, the VIX is not the only way to talk about volatility. It would be fair to say across markets, implied volatility and realized volatility are as low as they have ever been in anyone’s career. There have been brief moments where levels were similar, but the environment today is perplexing. Equity markets have rarely been this expensive and it has never been less costly to protect the downside — a surprising combination.
In 2016, there were enough events along the way — notably the energy-led selloff and Brexit — so that when you average it out, it was kind of a 50th-percentile year with an S&P realized volatility of roughly 13. In 2017, we’ve gone to effectively the lowest ever with realized volatility dropping to seven. This is a far more surprising post-election result than the rally in equity markets. Even though plenty of notable managers were calling for a stock drop in the event that Trump would become president, the rally wasn’t a total shock. Realized volatility back to 1963 lows is a true bolt from the blue, given the significant amount of economic and political uncertainty that comes from a new administration plus all of the unknown-unknowns, to coin a phrase.
Some of it is technically driven. There are sellers of volatility that look at it as an attractive carry trade since the credit market offers so little carry at present. Others, such as volatility control funds, sell volatility as it goes lower to keep a constant amount of exposure. So yes, these entities are to some extent depressing volatility. Now, there’s that famous quote: “No matter how much tornado insurance you sell, you’re not affecting the odds of a tornado, but if you sell enough portfolio insurance. . .” That said, this dampening effect can reverse if a significant event causes volatility to rise, since some of these funds will be falling over themselves to cut their positions in that scenario.
I think the energy selloff last year is a good example, where so many people were early in liking energy bonds that had fallen from 100 to, say, 75. Venerable funds with long-dated capital were set up to take advantage of the energy opportunity. Finally, when oil fell enough that the dip in energy bonds was not viewed as a buying opportunity, some of the buyers actually became sellers, especially as a lot of risk these days in credit is held in daily liquidity mutual funds, ETFs, and so forth.
I think with volatility it’s the same story. For now, there’s probably a lower chance of a breakout in volatility, but if there is one, it will be much more severe because you have all of this short interest.
OR: What is on the top of your list for potential triggers?
History has shown that investors, ourselves included, are not good at all at spotting regime shifts in advance. You can see it in the way the VIX almost always spikes on a large rise, but comes down gradually. People don’t see the event ahead of time, and when you consider that at present there is a large divergence between the calm in markets and the almost unprecedented amount of political and economic uncertainty, I think even without a catalyst in sight, owning portfolio insurance and owning volatility are incredibly compelling.
OR: How far out can you go with exceptionally low volatility?
Weinstein: In the U.S. the phenomenon of low implied volatility really is only short-term out to three months. After that, the levels become less attractive. Eventually, out to two to three years, implied volatility is actually over double the level of recent realized volatility.
The most undervalued long-dated equity volatility is in Asia, particularly in China, Japan, and Korea, thanks to an incredibly successful campaign by the banks to sell bonds that are linked to the price of equity indices. They are made to look a lot like a generic high yield bond — they pay coupons every six months and are issued at par by well-known banks — but their ultimate redemption at maturity is tied to whether the Nikkei or Hang Seng China Enterprises Index or Kospi have declined. The success in placing these structures with small institutions and high net worth investors is also symptomatic of the global problem of low yield in fixed income. Investors in Japan, for instance, are yield-starved given near-zero percent rates for JGBs and an aging population. So it’s no surprise that the structures sell well given the optics. But if you decompose them, it’s apparent that the investor’s yield is coming almost entirely because they sold out-of-the-money puts on stocks. I think there is a suitability question for these products and in a bear market I fear that these same sellers of volatility will be the ones buying it back at peak.
The tenors of these bonds can range out two to five years, and that has really suppressed long-dated volatility. Even though in almost every environment for the past decade (including 2008), the U.S. was less volatile than, say, the HSCEI, one can buy long-dated Asian equity vol at only a tiny premium to where the equivalent S&P vol is trading. This corner of finance may be new for some Octavian readers, and I think it’s really worth paying attention to, because it’s one of the places where I see great complacency in markets.
OR: Your fund has focused on the apparent disconnect between the credit market and the equity market; capital structure arbitrage, more or less. Can you talk about that and about how it’s a way of playing the volatility?
Weinstein: It is not hard to find people saying, “Equity valuations are high. There’s not much equity risk premium. Credit valuations are high. There’s not much credit risk premium.” In late June Goldman Sachs put out research suggesting that CCC-rated debt doesn’t even offer enough spread to cover defaults — much less enough to cover market to market risk and illiquidity premiums and the like.
We have been in this world before. High yield with a five-year spread of 350 basis points is low, but by no means unusual. The range has been 250 to 2000, and with default rates having been quite low for the past 25 years, I don’t think the current low spread is particularly extreme — especially compared to even lower equity volatility. Credit curves are very steep, so an investor in the five-year sector has some decent chance for price appreciation as the five-year becomes a four-year and so on.
That said, I do see great complacency in a part of the high yield market — particularly with companies where the equity has suffered greatly. We are tracking over 100 companies globally who have seen equity declines of 60 to 70 percent minimum over the past year and have a junk rating, yet their debt is still trading at a price in the mid-90’s or higher. Often the credit and equity markets are in synch, but occasionally one market is leading the other by a few months. If we look at the few credit blowups that actually have occurred of late, the equity market was signaling great stress and investors ignored the signs. Notably, Banco Popular in Spain and Noble SP in Singapore both recently saw their debt collapse months after the equity had collapsed.
OR: What are your favorite names?
Weinstein: Hertz is a good example. The stock fell from $50 to $9 in under a year, but the three-year debt still is in the mid-90’s despite unsecured debt being nearly 10 times levered. A stock that can have such a fall despite bearish sentiment all year long is a sign that the analysts’ models are failing to keep up with an even bleaker reality. And once the stress becomes as great as it is now, further disappointing results in my view will lead to a sort of “tripwire” where the debt can suffer an even greater decline than the equity as it quickly makes up for lost time.
Other companies that more or less fit the same description are Frontier Communications, Windstream, Community Health, Supervalu, New Gold, SM Energy, Dynegy, Avon Products, and JC Penney. Of course, an alternate possibility is that in some of these cases the debt market has it right and these stocks have been oversold.
OR: How do you think this portfolio — or volatility in general — would react to a change in interest rates?
Weinstein: People have been worried about higher interest rates for so long. Though that doesn’t mean they’re at all prepared for it. It’s also been a “Chicken Little” call for a number of years. So few hikes are priced into market expectations compared to the dot plot; someday there may be a day of reckoning, but it is likely still far off and maybe the market’s going to continue to discount that outcome until the bitter end.
OR: Can you talk about your career as a value investor and your closed-end thesis and how it’s been playing out?
Weinstein: I think discounted closed-end funds (CEFs) are the best long opportunity at present, and also fairly simple to understand. It’s a rare corner of the market where retail investors can get an edge over institutions: most institutions don’t realize that it is a large enough market to matter to them.
There are approximately 540 tickers on the New York Stock Exchange of different CEFs, totaling $240 billion in market value with about an even split between equity and fixed income. They are generally managed by top tier firms like Blackstone, BlackRock, PIMCO, DoubleLine, and dozens of others. Because of some peculiar dynamics around the Bernanke taper tantrum in 2013, investors went from being large buyers of closed-end funds to sellers. That downward pressure moved the closed-end funds from trading at a premium to net asset value to a deep discount to net asset value.
Although CEF discounts have narrowed in the past year, it’s possible to buy a few dozen of them at an average 10 percent discount without sacrificing quality. You go into it hoping the discount will narrow on its own, but one of the nicest points about this investment is that while you wait, you earn an above average yield, given the discounted price. If enough time passes without the discount narrowing, a dedicated buyer like Saba Capital might find itself the largest holder of the fund and then the “suggestivism/activism” side commences. Over the past two years many managers, from Alliance Bernstein to UBS, have announced steps that fully collapse the discount such as liquidation or open-ending their funds. We have found ourselves invested in the majority of these situations and, in many cases, the driver of the shareholder friendly campaign.
We currently hold about $1 billion of CEFs, and in the past few months launched an actively managed ETF (ticker CEFS). We view CEFs as a better way to own credit risk than CLOs or ETFs such as HYG or JNK due to the discount to NAV of the portfolio and the mechanism for narrowing the discount. Though most institutional fixed income investors have never owned a CEF, the largest individual holder is none other than Bill Gross who (according to public filings) still owns over $140 million of PIMCO CEFs. In addition, Jeff Gundlach, who currently is called the Bond King, has issued CEFs and frequently recommends buying other managers’ CEFs when at a discount.
OR: You’re a serious chess player. Did learning and playing the game prep you for your Wall Street career?
Weinstein: I wouldn’t have had as early start on Wall Street if it weren’t for chess. There was a Goldman Sachs partner obsessed with chess who I ran into while I was interviewing for a summer internship. Through that lucky meeting, I ended up getting a summer internship. So, I really do credit chess with getting me my first real trading job. I was never a world-class player, but I did manage to get to number two in the U.S. for the 15-16 age group once upon a time.
In terms of applications to trading or business, I think it’s a bit cliché. Like in From Russia With Love, where the SPECTRE villain Kronstein is playing in the world championships and uses his chess abilities to plot every move James Bond makes. Though the perception about chess players as the ultimate strategists certainly has helped me, I laugh about it because there are obviously so many other games — and I don’t just mean go, backgammon, blackjack or poker — that have their own strategic thinking and applications to a good risk/reward approach.
That said, I just returned from the National Chess Championships (where my daughter was just getting her start in the K-1 division). It is quite a sight to see thousands of children at that age able to concentrate so intensely and in total silence. There’s an ancient Indian quote: “Chess is a sea where a gnat may drink and an elephant may bathe.” I think this nicely sums up my sentiments and even after spending nearly 40 years playing, I still find some games and combinations to have great beauty. Just a couple of weeks ago for example, Levon Aronin beat the world champion Magnus Carlsen in spectacular fashion — so I’m still an avid fan and have been lucky to get to meet people like Magnus and Garry Kasparov.
OR: What’s your outlook on the hedge fund space in general and active management more broadly? There’s a lot of talk, obviously, about the decline and fall of both.
Weinstein: I think one of the advantages we’ve had during tough times is that our funds are generally invested in less-crowded strategies, including capital structure arbitrage, volatility arbitrage, and some niche strategies like CEFs. If an investor wants our profile, there are relatively few other managers they can turn to and there are no ETFs from which to get this exposure. If you’re doing something like long/short equity or fundamental credit that a thousand other funds are doing, it’s very hard to recover from underperformance and push back on fee compression.
In terms of the industry, its main challenge (aside from too many funds chasing too little alpha) is that the S&P as a benchmark for performance is just totally off-base. And I don’t recall in 2008 the press lauding hedge funds for losing half of what the S&P lost. So funds are sort of damned to be criticized no matter what. That said, someday markets will get choppier and tumble and investors will appreciate that most hedge funds do indeed . . . hedge.