Chris Cole - Volatility Is The Instrument That Makes Us Face Truth | #134

Episode Summary

Executive Summary: Chris Cole of Artemis Capital argues that volatility is not just a risk measure but the central asset class, because most portfolios are implicitly short volatility and rely on stability, mean reversion, and liquid markets. He warns that low rates, buybacks, passive flows, and leveraged “short vol” structures have created dangerous reflexivity and fragility, while long volatility can protect portfolios during regime shifts.

Main Topics: Cole’s origin story and path into volatility investing (Priority: 5/5): Cole explains his unusual transition from cinematography at USC to options trading, CFA study, bond structuring at Merrill Lynch, and eventually founding Artemis Capital after trading VIX products and compounding capital during 2007-2009. Volatility as the only true asset class (Priority: 5/5): He argues that many strategies are effectively bets on stability or change, and that most institutional portfolios are dominated by hidden short-vol exposures through value, credit, and mean-reverting strategies. Short volatility, reflexivity, and systemic risk (Priority: 5/5): Cole describes a global ‘snake eating its own tail’ dynamic where low rates, yield-seeking, buybacks, and dynamic risk strategies reinforce one another and can unwind violently. Liquidity deterioration and passive investing (Priority: 5/5): He says liquidity has worsened despite rising markets, with shrinking volume, lower free float, and passive dominance reducing the role of active investors who provide liquidity in drawdowns. Catalysts for a volatility regime change (Priority: 4/5): He highlights inflation, rising rates, credit spread widening, and any economic slowdown as possible triggers that could expose leverage and break the stock-bond relationship. How Artemis implements long volatility (Priority: 4/5): Cole says long vol is not simply buying puts; Artemis uses machine learning, domain expertise, and structured convex trades to create positive carry and convexity across different regimes. Behavioral and philosophical framing of volatility (Priority: 3/5): Cole frames volatility as truth, uncertainty, and nonlinearity in both markets and life, using analogies from film, comics, sports, and event-time thinking.

Key Arguments: Most portfolios are implicitly short volatility because they assume mean reversion and stability; value, credit, and many institutional strategies depend on this. Warren Buffett is described as the greatest short-volatility investor because his strategy is fundamentally a bet on mean reversion and can experience large drawdowns. Volatility can spike in both left-tail crashes and right-tail rallies; it is not only a fear metric tied to market declines. A roughly $2 trillion global short-vol ecosystem creates reflexive feedback loops where low volatility enables more risk-taking, which suppresses volatility further until the system breaks. Explicit short-vol funds may fail first, but the bigger risk is the larger, more sophisticated implicit short-vol complex embedded in risk parity, vol-control, and corporate buybacks. Liquidity has worsened even in a long bull market because share buybacks reduce float and volume, and passive investing diminishes active liquidity provision. The market is fragile because stock-bond diversification may fail if inflation or growth shocks make the two assets correlate positively over a multi-year period. Long volatility can provide valuable convexity and diversification, especially when paired with equities or used to target second-order moves rather than small daily fluctuations. Effective long-vol investing requires systematic selection, execution, and timing; it is not simply buying puts and waiting for a crash. The best long-vol opportunities often involve being paid to own insurance or structuring trades that sell the first move to finance exposure to larger, nonlinear moves.

Data Points: Institutional portfolio short-vol exposure: 98% - Cole claims the average institutional portfolio is almost entirely driven by bets on stability and therefore short volatility exposure. Explicit short-vol strategies: about $60 billion - He estimates explicit short-vol strategies such as short VIX futures and naked option writing at this scale. Pension overwrite schemes: about $45 billion - Part of the explicit short-vol category, involving pension funds shorting puts or calls. Implicit short-vol strategies: about $1.4 trillion - Cole says risk parity, VAR control, and risk premium strategies synthetically replicate short-vol exposure. Share buybacks: about $5 trillion - He includes buybacks as a short-vol-like force because they suppress volatility and support prices via leverage. Corporate debt at low investment-grade tranche: over 50% - He says more than half of investment-grade debt is now in the lowest-rated tranches. Potential debt downgrades: $1 to $2 trillion - He warns this amount could fall to junk if the economy hiccups. Debt rollover need: $2 trillion - He says this amount of debt needs to be rolled in 2019 and 2020. Market volatility in the late 1990s: around 25 VIX average - He notes high volatility can coexist with strong equity returns. Weimar Germany hypothetical volatility: from around 19 to 2,000% - Cole uses this as a thought experiment to show volatility can rise dramatically in a right-tail hyperinflation scenario. February market move: down 4% - He cites February as an example where liquidity disappeared despite a shallow equity decline. Bid-ask spreads in liquid ETFs: 22 standard deviations - He says spreads blew out dramatically during the February stress event. Passive market share: 60% - He says the market is approaching this level of passive ownership, with some estimates even higher. Potential rise in Treasury yields for 2008-like bond returns: to -2% - He argues U.S. Treasury yields would need to fall this far to replicate 2008 bond performance. Long vol / equity combo performance: more than 2x the risk-adjusted performance of the S&P 500 - He claims a 50/50 mix of the CBOE Long Volatility Hedge Fund Index and the S&P 500 has strong historical results. Long vol / equity combo vs. average hedge fund: beat by over 90% since 2005 - Cole cites this as evidence that convex long-vol exposure can materially improve portfolio outcomes. Arthur's?: 2007-2009 exponential compounding - He says he compounded his personal and family capital during the 2007-2009 period, helping seed Artemis.

Pivotal Quotes: "volatility is the only asset class" — Chris Cole: Core thesis: volatility, not stocks or bonds, is the fundamental dimension underlying all portfolio exposures. "the average institutional portfolio today is almost 98% driven by bets on stability" — Chris Cole: He uses this to argue that most portfolios are implicitly short volatility and vulnerable to regime change. "the institutions would rather fail conventionally than succeed unconventionally" — Chris Cole: His comment on why investors avoid long-vol strategies despite their diversification benefits.

Implications: Listeners should view volatility as a portfolio dimension, not just a fear gauge. If low rates, buybacks, passive flows, and leverage persist, a regime shift could punish conventional 60/40 and short-vol strategies while rewarding convex, long-vol exposures.