Jim Grant Interviews Alan Fournier: "Pension Funds Are So Desperate For Yield, They're Systemically Selling Vol..."

In the latest installment of Real Vision's interview series featuring Jim Grant, longtime publisher of Grant's Interest-Rate Observer, the newsletter publisher sits down with Alan Fournier, the billionaire founder of Pennant Capital, to discuss one of the most widely discussed topics across modern asset markets: Volatility - or rather, the systemic risks posed by not only the paucity of volatility in modern markets, but how risk parity and low-vol targeting strategies have created imbalances that could lead to massive dislocations should volatility spike.

In the beginning of the talk, Fournier and Grant discuss how volatility has been artificially suppressed for so long that it's essentially become an asset class unto itself. Investors have devised all these new volatility targeting strategies - like risk parity, for example, that have generated outsize returns since the financial crisis. But many don't recognize the underlying risks. With so much money piled into the short-volatility trade, a large enough spike could trigger extremely painful selloffs in both bond and equity markets.

JG: And one would expect that if interest rates are going to turn, it might be kind of a noisy and dramatic turn.


Are you plugging in the interest rate aspect to this as well the bond market side of things?


AF: Well the thing that concerns me the most about this sort of overall technical setup, if you will, is that the reason people own bonds is they don't correlate with stocks. So if something bad happens in the stock markets, bonds rally, right? So risk parity, some stocks in a levered bond fund, it's been fabulous because that's been what we've seen for the last 15 or 20 years. Well if we get a turn, which is just driven by a normal business cycle and that correlation comes apart, who knows what happens? But there's a lot of money that's been dedicated to these kinds of strategies, whether they're vol targeting, risk parity. We're in sort of a spooky time.


JG: You use the phrase the setup, which I think is a wonderful way of expressing the notion of an overall context of things, how the forces are aligned or misaligned. And so many of those forces in this particular cyclical moment seem to be unusual if not unprecedented. Certainly the level, the nominal level and real level of interest rates is one of those forces. The positive preoccupation with the efficacy and with the certainty of outcome of passive investing must be another, right?


AF: Yes.


JG: And the peace and quiet in the markets as reflected in readings in both the MVE Index, which registers bond activity, and the VIX Index, which measures agitation in the stock market, those things are at record or near level lows. So Alan, how do you see the constellation of these forces?


AF: Well, we joke on a trading desk when we come in the morning if the futures are down-- like today they were down a bit this morning. But we joke about what time they're going to go positive during the day, and usually it's after the Europeans go to the pub or something at around 11 o'clock. By 2 o'clock they're positive.


And I just mentioned this because it's very unusual and something I've never seen in 30 years or so of doing this that sort of nothing rattles this market. And I think some of it is the vol being depressed.


JG: Now let's explain this. So volatility now, it's like a thing. It used to be stocks and bonds.


AF: It used to be observed based upon how options are priced. Now it's actually a source of income.


JG: Right. It's like an asset class.


AF: It's a bond.


JG: But it's movement. It's kind of capitalized movement, right?


AF: Right.

Toward the beginning of the interview, Fournier shared a story with Grant about how a high-net worth broker recently asked for meeting to pitch a suite of new "short volatility" investment products. After grilling the broker about the details of how the products are managed, he asked how the funds are protected in case of a sudden spike in volatility. The broker waved his question aside and said there products are all adequately hedged.

After doing some more due diligence, Fournier discovered that the broker was wrong. And it's not that he lied, Fournier surmised - it's that the broker didn't have an appropriately deep understanding of how the products work.

AF: Yeah. So I'm going to tell you a little story which is interesting, which is suggestive of the idea that we're pretty late in this tick-tock game.


JG: All right, I'm ready.


AF: Well a friend of a friend asked to come see me who is a high net worth broker at one of the investment banks. And he said, "Look, I know I can't help you in the stock market because you're doing your own thing in your fund and get that, but maybe we can help here with fixed income." I said, "Sure, come on by. Let's talk."


He comes in and I ask the question, "So what are people doing for income?" And he said, "We have this great product that sells vol." And I said, "Oh, how does that work?" And, well, it was a very basic explanation. Selling puts, selling calls, straddles, blah, blah, blah. And I said, "What happens if the market goes down?" And he said, "Well, there are ways they protect against that." I was like OK, and I just was very curious. So I said, "Send me the documentation." So he sends me the brochure with all the legal details and so forth, and there's really no protection. They're just selling vol and collecting income, which has been successful.

In the most unsettling excerpt from the interview – for mom and pop investors, that is – Fournier shared a story about a talk he gave to a group of pension-fund investment-committee members. Some investment bank trying to scrounge up brokerage business had taken the group of these investors on a tour of Washington, D.C., and Fournier was recruited to speak about his experiences in the hedge fund industry as sort of a keynote for the day’s events.

So, Fournier told a story that emphasized the risks of selling volatility.

Afterward, his audience sat there, stone-faced. As he would come to find out, many of their funds were running vol-selling strategies which – as we’ve explained time and time again – are much riskier than most investors realize.

And these are pension funds – purportedly some of the most risk-averse institutional investors.

JG: So when you sell vol, what do you do exactly? Do you sell puts on the VIX Index?


AF: Yes, and different tenors. And there are strategies that will sell vol at a level and buy vol further down and try to dampen potential crash risk and those kinds of things. But essentially you're just collecting income by being a house, selling puts.


So a few weeks later another investment bank invites me to come and speak to some pension investors. And they were taken them to Washington to sort of hear what was going on down there. And then they brought them up  to New York and I was sort of the end of the day, talk to a hedge fund practitioner kind of thing. And I sat there and I told the story about how this guy was trying to sell me vol, expecting some kind of reaction from them.


JG: And they said so?


After doing some more due diligence, Fournier discovered that the broker was wrong. And it's not that he lied, Fournier surmised - it's that the broker didn't have an appropriately deep understanding of how the products work.


JG: This is a group of--


AF: Pension funds, large European pension funds. And he said, "Yeah, but they have a strategy where, when you get a selloff, they sell more into the selloff." So if the VIX spikes from 10 to 15, you sell more. And then you continue to have this tremendous monthly pattern of income.


So as I was walking out of there I thought, my goodness, the central banks have succeeded in pushing people out on the risk curve. They're taking people that are managing the pensions of state pensioners and they have them in negative earning sovereign instruments. And now they have them-- they're so desperate for some yield, they're systemically selling volatility, which is remarkable.

In one of the most interesting excerpts from the interview, Fournier explains how a chance breakfast meeting inspired him to switch from long subprime lenders to short a few years before the housing crisis began.

The timely switch allowed Fournier to book winning trades on both the long side – he cashed in as home prices climbed toward their pre-crisis peak – and against during the collapse. He was inspired to change his position after learning from a subprime mortgage broker how the loans the broker was selling worked.

After their discussion, it quickly became apparent to Fournier that the whole subprime lending model was reliant on home-price appreciation, and the minute housing prices peaked, there could be a very significant credit event.

JG: This is where we have different lines of work Alan, because in the years 2001, '02, '03, '04, '05, '06, Grant's Interest Rate Observer deplored these queues of people lining up irrationally and uneconomically to buy the houses, the makers of which you were long.


It takes all kinds of people to make a world. I’m not throwing stones.


AF: We also got long subprime lenders. And we got to know them well. And early on it was clear that this was going to be a booming opportunity for subprime lenders. I mean, you were taking debt that was costing folks very high rates on credit cards and pulling equity out of homes. And so that was a natural arbitrage that created this big opportunity. And then using subprime to fund the purchase of second homes, driving up real estate prices. And I was actually at a breakfast with a company coming public that I ended up investing in where I asked them a number of questions about how these loans work. And it became very clear that the whole key to those loans was home price appreciation. And at that breakfast, I kind of logged this view, that, wow, when this turns, it's going to be a very significant credit event.


JG: Let me, if I may just interrupt to observe, how unusual it is for someone who has been long, a big theme, to turn around and successfully to change views and become short, successfully, that same theme. It's done sometimes at a bar in recounting fabulous fabled stories, but rarely in real life. Tell me about kind of the intellectual flexibility this requires. When did you decide to kind of jettison the bullish view on subprime?


AF: Well, it was a matter of first developing understanding of what was going on and how this reflexive process, classic Soros reflexive process was interacting with the real world. And it was very simple. Easy credit drive up home prices. The fact that home prices was growing up was making credit easier. And so it was a matter of how long that would play out and when it would end. We had the patience to wait. And we made some money in long side of some of the subprime lenders during this period. And it was really gaining the knowledge of what these CDO and CDS securities were that was an eye-opening opportunity for me.

So Fournier switched from being long doomed mortgage lenders like American Home Mortgage to shorting the mortgage-backed security products that would eventually slide all the way to zero.

Later in the interview, Grant asks Fournier for his thoughts on bitcoin.

In a heartening display of modesty and intellect, Fournier demurred, instead of offering a barrage of chaotic, unqualified opinions like some of his peers have tended to do.

“That’s something I don’t understand well.”


knukles Sun, 12/03/2017 - 20:30 Permalink

Exact same crap happened back during the dotcom bubble when plain vanilla utility income funds were jammed/stuffed with dodgy phone/internet/etc deals to boost performance.  Which worked until it didn't and Ma and Pa Kettle in Dubuque wound up fucked because they had been told the fund was utility dividend income .....Writings all over the place ... ain't to say however that this madness cannot extend much further and longer than anybody thinks.

CRM114 Sun, 12/03/2017 - 20:33 Permalink

The point is that the Pension Fund managers can't lose with such a risky strategy, in a relative sense, but they can if they don't produce yield now.You have to look in detail at the situation if the market does crash massively, which is not the same at all as the current situation. There are different rules.The logic: Many are worried (with good reason) about the underunding of pensions. If they don't produce yield now, the providers of those pension funds will look real bad, and they'll sack the mangers until they find someone who will produce yield. If the risk is uncovered, one of two things will happen. 1) The Government will perpetuate the ponzi as pension funds will be deemed TBTF. End of FM's worries (for a while); or 2) The market is going to be crashing so hard that getting sacked will be the least of the managers' worries. They will simply resign and head quietly off to the hills. There won't be a pensions industry left anyway. An analogy is the pensioner and the fund manager going on a hike.P: "Aren't we taking a rifle or pepper spray or something, in case of bears"FM: "Nope. If a bear appears, we run"P: "I thought bears chased runners?"FM: "Not a problem. I'm faster than you" 

auricle CRM114 Sun, 12/03/2017 - 22:01 Permalink

Great, organizing everyone to sell VOL when it spikes thus rendering its usefullness useless. Sounds like both fraud and collusion are occurring. If I were a regulator I would use this article to go make some arrests. In an ethical world, ZH would be getting finder fees for all the arrests that could be made from the crimes they uncover. 

In reply to by CRM114

The Alarmist auricle Mon, 12/04/2017 - 04:39 Permalink

Pension fund managers don't have to generate yield per se. They can ride the cap gains roller coaster in "low risk" bonds, which to date has been pretty much one-way ride (up) and realise gains as they sell to raise cash. Yeah, they will lose money when bonds crash, but the liability values will be moving in the same direction as the bond values. Key is to maintain an appropriate directional bias in the hedge of interest rates that drive the movement of liability values.

This whole thing about needing to generate income to cover the outflows is simply BS. Pension fund execs don't get it in general, which is why they are succeptible to strategies that generate more income for their consultants and brokers than for their funds.

In reply to by auricle

Magooo Sun, 12/03/2017 - 20:57 Permalink

Interest rates can never rise significantly - without causing 2008 on STEROIDS.   Regardless -  what cannot continue will stop - we will get our 2008 on STEROIDS.  And complete implostion of the global economy

buzzsaw99 Sun, 12/03/2017 - 21:01 Permalink

agree with his sentiment regarding bitcoin.i find it amusing that given enough time they all wax nostalgic for 2009. Now I think I'm going down to the well tonight and I'm going to drink till I get my fill And I hope when I get old I don't sit around thinking about it but I probably will Yeah, just sitting back trying to recapture a little of the glory of, well time slips away and leaves you with nothing mister but boring stories of glory days

TheMexican Sun, 12/03/2017 - 21:26 Permalink

People may or may not know but selling volitility or selling options is Madoff what was advertising. Even though the contract volume he needed to sell was far greater then the actual market volume. My guess is the current low volatility is hiding a lot of fraud. The SEC will not do their job and when the SHTF they will find one or two fall guys outside the banks. People will get hurt badly. The banks will pay fines and that will be it.

CashMcCall Sun, 12/03/2017 - 21:26 Permalink

Government employment is nothing less than wholesale corruption. In the town I live in, gov owns the water company and has this enormous infrastructure horticulture with thousands of trucks, endless zturn mowers, and government employees performing jobs that should be put out to bid. They are paying leaf blowers $50,000 a year. But that is just the tip of the iceberg. The State picks up the pension. Worse, the State has to backstop any pension fund losses by raising taxes to cover the pensions. This is insanity. When Meredith Whitney made her municipal bond call, she was 100% correct but for one missing element. She never understood that power of pure Socialism to go after the Taxpayer for endless bailouts. In a way, it is a form of QE in which all risk is backdropped by the Taxpayer. For taxpayers, it is akin to be trapped in a burning building. You are simply log fuel for the fire.  

Clowns on Acid CashMcCall Sun, 12/03/2017 - 22:21 Permalink

+100....Whitney was 100% correct. Few responsible people of Western thought factored in a completely neo Bolshevik response to the States deficits problem and in fact QE for the US (and European) Banks. No one would think that the criminal neo Bolsheviks woul;d be able to pull that off. Robert Rubin, Sandy Weill Llyod Blankfeld. Ben Bernanke, Jamie Dimon...et al.... are all criminals and destroys the socio-economic fabric of the US thru th4e debasing of the USD and concentarting legialative power within the hands of a few....criminals. Never forget these names and the others as well.

In reply to by CashMcCall

Grave Dancer 22 Sun, 12/03/2017 - 21:32 Permalink

RealVision seems like another permabear circle jerk.Is all the permabear hype about pension insolvency gonna turn out to just be the big nothing burger like Euro soverign debt was in 2009?  Or student loans?  Subprime car loans?  China hard landing?  So far all BS narratives where the shitstorm never comes. 

peippe Sun, 12/03/2017 - 22:04 Permalink

i've been worried about state pensioners since NEVER.State will print scrip for their former tools to use locally to survive. End of tragic story, pensioners remain fed & watered like the houseplants they are & were.

ds Mon, 12/04/2017 - 04:04 Permalink

Vols as a product sold by Pension Funds; great intel. Now time to work the algos to target at this growing class of sellers desperate for yields.