The most exciting rhythms seem unexpected and complex, the most beautiful melodies simple and inevitable.” – W.H. Auden
These are my thoughts on relevant investment topics. In our ongoing research of our own dilemmas, we recognize that the same issues are likely at the heart of struggles that we all face. With equal measure of frustration and excitement, we hope to contribute to the marketplace of ideas and discussion. And with the goal of interaction and feedback, please reach out with responses or topics of interest.
Michael Gelband’s Exodus Point launched in 2018 with $8.5 billion in assets. Expectations were high that the former Millennium Management executive would be able to take the skills he had learned at Izzy Englander’s hedge fund and replicate its performance, after a decade of running its fixed income business. The fund looks to be proving Read More
I am absolutely crazy about Pink Floyd, though maybe not quite as nutty bonkers about them as I was during my college years. But both then and now, when I hear their music, I just close my eyes and take in the beauty. The melody moves me.
I recall the night vividly at the Oakland Coliseum about twenty-five years ago; there were tens of thousands of people sitting far and wide across the vast auditorium; and all were frantically waiting. For being so immensely crowded across such a massive open space, the silence was eerie - almost deafening. Nor did it help that a deep blackness consumed the stage at the front and center, where the band’s instruments were believed to be. I could neither see nor hear anything but the crowd. Suddenly, and almost out of nowhere, fantastically bright bulbs illuminated the center of the stage from half a dozen perfectly chosen angles. The crowd began to roar, and cheer, and scream as a small and focused fireworks display leaped out of the stage floor, alongside Roger Waters:
Might like to go to the show.
To feel the warm thrill of confusion
That space cadet glow.
Tell me is something eluding you, sunshine?
Is this not what you expected to see?
If you wanna find out what's behind these cold eyes
You'll just have to claw your way through this disguise...
And on went one of the best concerts I have ever been to in my life. Pink Floyd aside, I’ve been quite a music nut throughout my life. During my academic years, my friends used to wonder how I was able to study with music in my ears, reading textbooks and memorizing for exams with my headphones singing was my favorite means of cancelling out all the other spotty noise. As long as I can remember, I’ve been completely transported inside by certain musical notes and wholly consumed by rhythm. In fact, when I first started building quantitative trading algorithms, I got an idea for “listening” to the price action through time and sales output. My hypothesis was that humans take information in through all of our senses, so why do we only “watch” the markets, why don’t we listen to them? Perhaps we’d hear something that our eyes wouldn’t see. Perhaps this was a means to extracting signal in the noise.
I hired a programmer to help me build “Audio-trader,” a construct I designed that would play high notes for buys (green ticks), and low bassy notes for sells (red ticks), the larger the block bought, the higher the high frequency, and the larger the block sold, the deeper the low. A 100,000 block sold would output a deep bassy thud - BOOM. When some big player wanted out, you felt it. The first test run failed because of the sheer magnitude of small trades, 100 lots going back and forth -- buy, sell, sell, buy, buy, sell, buy -- created an abrasive cacophony of indistinguishable noise. So I infused a filter; no sounds above a minimum transaction size threshold. When we tried 1000 lots, we started to “hear the music” of trading.
As it turned out, there was no real signal to be found. The ears provided no greater edge than the eyes at processing market data. Nonetheless, it was an interesting and creative attempt at finding the rhythm in trading. Today, almost twenty years since my “Audio-trader” debut, and soon after tossing, I am humbled to admit that I think I may have actually done it; I have finally found the music in trading.
It is not, however, the transformed audio output of the ticker tape, nor does it even classify as sound. Its only relationship to the musicality of Pink Floyd is the intensity with which its rhythm moves me. This rhythm that I speak of is the natural movement of securities. Stocks move, up and down, oscillating, gyrating, and sometimes shaking or exploding. What’s interesting is that many do so to a particular beat. There is, unquestionably, a rhythmic behavior that manifests itself in the movement of different securities, unique to specific stocks or sectors or classes, and to be experienced much like our favorite song.
Put in a different way, no matter what type of stock we are looking at, and no matter how we decide to classify its relative existence, be it growth or value, momentum or range bound, when we look at it, we are looking at its movement, aka its variance. All assets, really, are merely expressions of volatility; in fact, the uniting force behind any investment is simply that it moves. As the extreme opposite example, when we sit in cash, we see no movement, just the stillness of a placid lake somewhere in the Midwest. But when we purchase an asset with that cash, we exchange the stillness for movement; we trade silence for rhythm.
Volatility is Everything
I would even go so far as to say that whatever asset we buy, we are really just buying one thing -- volatility. When we exchange that fixed level of cash for something that we know will fluctuate, we try to make assessments and decisions based on how much fluctuation we want. Our choice of “risk” parallels our acceptance of the width, or outer boundaries, of such movement, which we translate into the variance, and higher moments. While risk averse investors may choose less movement, or easy listening, risk seekers may choose higher movement, or rock and roll. Either way, we are all just choosing a beat we can live with.
But so what; what does it help to know something so basic; that going from a fixed amount to a fluctuating amount is merely introducing volatility? This seems painfully obvious. And it is. But the reason I hone in on it is to expand on the depth of its character. People use the word "volatility" in reference to its academic standing - the so called “standard error,” expressed in symmetric units of deviation from the mean. But this nomenclature, unfairly, locks volatility into a box. Volatility is bigger than that.
The Volatility of Volatility
For starters, and perhaps as the most important aspect of volatility with respect to financial assets, is that volatility too has volatility. To say otherwise would be, quite literally, an insult to its very name. Formally, volatility can be homoscedastic or heteroscedastic; it can stay at the level it always was, or it can change to an altogether new level. When we choose a “known” volatility, we are believing in -- albeit, somewhat unsubstantiated -- a homoscedastic future. Whereas it is quite possible, and actually, quite likely when it comes to financial assets, that our choice is heteroscedastic, that the volatility we select is not necessarily the volatility we get.
Volatility, as measure of change, or more aptly, turbulence, would be easier to deal with if there were just one type. But the “volatility of volatility” infuses additional dimensionality into our risk analysis. It is not just that stock A is more volatile than stock B, and it is not just that stock A’s volatility is more asymmetric (i.e. more negatively skewed) than stock B’s volatility, it is that, with time, this assessment may completely flip, when at a later date, stock B beats stock A across both of these measures. And yet, we accept this. Imagine you bought tickets for an acapella concert, because you just needed to relax, and after sitting there for twenty minutes, the show unfolds into an amalgam of heavy metal and punk rock. SoCal Vocals had transportation issues, and Guns n Roses has made a surprise appearance. That’s not what you wanted, and certainly far from the gentle mood you were aiming for.
So what would be the best way to deal with this headache infusing clamor? If it’s a bad concert, you get up and you leave; and perhaps turn on some jazz on the car ride home to help unwind the frustration of that horrible experience. If it’s an asset in your portfolio, you need a different solution. The hedging market offers a range of variants for “lowering volatility” including, first and foremost, diversification, purportedly lowering correlation by the introduction of some other different thing, or else volatility normalization methods, such as risk parity. But, as explained in my prior post, these approaches face dangers, and worse, dangers that, at the worst of times, cause the intended hedge to become additional risk, to compound the volatility (or head banging metal) you were seeking to avoid. Welcome to the Jungle.
Can the Music Save Our Soul?
The more perfect association lives in the world of the danger itself, i.e. volatility; or said differently, if you can’t beat ‘em, join ‘em. Volatility is the ultimate asset class because, as established earlier, it lives inside everything. It is expressed in every form of investment. And to state the obvious, in order for a defensive solution to be robust, it must defend whatever comes at it. A sling shot is useless against an oncoming tank. Accordingly, and in an almost circular fashion, if everything is volatility, then volatility is both a natural and ubiquitous defense. More so, the requisite level of volatility with which to build the defensive arsenal must simply be commensurate with the volatility expressed by the offensive.
Said simply, the ultimate hedge against the overwhelming short exposure (both intended and unintended) to the thing that can hurt us most, volatility, is to get long volatility, and more precisely, in coordinated relation to the volatility that we fear. To go back to the musicality of asset variance, I consider portfolios comprised of different musicians. The Metallica portfolio trades metals, with extended electric guitar jams blowing out the speakers as gold and silver gap to new lows. Metal has negative skew. The Pink Floyd portfolio slowly and methodically acquires some deep value names, waiting ever so patiently for a drum cage solo that coincides with a concentrated long term position turning around into growth territory. Soft Classic Rock has positive skew.
Yes, I am extending an analogy much further than perhaps I should. Apologies for pushing the boundaries of poetic license. But the broader point that I’m trying to convey is that there is rhythm within the movement of what we hold, a beat that we call volatility. And it is our jobs to understand that beat, to assess it across all of its particulars, and then, above all, to counter it. In my next post, I shall expound further on volatility, the long and short of it.
Chief Investment Officer
Logica Captial Advisers, LLC