Logica Capital January 2023 Commentary

Feb 22, 2023, 5:02 am

0
Logica Capital commentary for the month ended January 31, 2023.

Summary
January started the year off with a bang; major indices gained between +6.2% (S&P 500) and +10.6%
(Nasdaq 100). We saw minimal deterioration in VIX/Implied Volatility despite the large move in the
S&P. Realized vol continues to trend downward, while factor rotations remain a major story.

Gates Capital Management Reduces Risk After Rare Down Year

[Exclusive]
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name
Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have
produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second
half of 2022, outperforming the 3.4% return for Read More

Commentary & Portfolio Return Attribution

“Appear weak when you are strong, and strong when you are weak.” 
– Sun Tzu
While January seemed to give us a broad, blasting upward market, we saw a significant factor rotation
and some dispersion beneath the surface. As mentioned above, the Nasdaq 100 strongly outperformed
the S&P 500, as did the Vanguard Small Cap ETF (VBR), and even the equally weighted S&P 500 ETF
(RSP). At the same time, the SPDR Energy ETF (XLE) returned a paltry +2.8%, paring its gains from a
huge run – and being the strongest area of the market – over the past year. Concurrently, and to
illuminate the contrast, the Dow was up only +2.95% in January.
On a related note, an internal strategy that we run/track which picks “anti-momentum” (overly beaten
down names) returned an astounding +26.5% in January, highlighting “junk” as the strongest
component of the market’s rally. As readers may recall, we implemented this LFB module (“Logica
Focus Bottom”) after Q1, 2020, and participated in the aggressive rally in oversold sectors like the
airlines after the Covid-19 meltdown dragged them down almost beyond recognition. That said, our
portfolio construction model did not trigger engaging the LFB module in January, and so we did not
deploy that exposure. However, we clearly see its results, and so more acutely understand the market
dynamics that took place in January.
What this all translated into for our strategies is that both components of our Sector & Single Stock
Calls – our momentum “LFT” module (+3.0% as a standalone), and our diversified “LFD” module
(+5.2% as a standalone), underperformed the S&P 500 on the month. 
Elsewhere, our Macro Overlay performed positively on the month, continuing to provide value after a
decent Q4 2022.
“Don’t expect to build up the weak by pulling down the strong.”
– Calvin Coolidge
As touched on above, January saw a fairly dramatic rotation out of the energy complex alongside other
recent strongholds (Utilities, Health Care and Consumer Staples). These sectors all performed
relatively well in 2022 but were actually down in January as investors rotated into the most beaten
down names/sectors (Consumer Discretionary & Communications) which generated double-digit %
returns. 
On this point, we draw further attention to the powerful run that the energy complex (XLE) has seen
over the past couple of years, enabling it to “catch up” to the remainder of the S&P 500 (note the chart
below is S&P relative to XLE, wherein the ratio more than chopped in half from 2021 forward).
Looking even more carefully at the chart below, we can see a small upward tick in January. And more
broadly, while we appear to be back to somewhat “more reasonable” levels as of recent months, the
“ideal” level is of course anyone’s best guess:
 “Life comes in clusters, clusters of solitude, then a cluster when
there is hardly time to breathe.”
– May Sarton
Moving over to the picture on Volatility, we note that realized volatility continues to trickle downward,
but certainly did not “collapse” alongside the strength of the market rally:
From Logica’s perspective, VIX/Implied Volatility provided a decently favorable environment in
January, as it didn’t fall quite as much as one would expect given the S&P 500 run upward and the
historical relationship between IV and S&P moves. Looking at this relationship (monthly) in the chart
below, we note that IV held “above average” relative to its expected decline for a similar magnitude
move. As always, this can be interpreted with a narrative, backed by the inflation story not yet over
and/or by the supporting empirical research, which demonstrates that Vol tends to be “sticky”, or
cluster, and so it will take more than a short time to move to a very different level. Of course, both the
reasonable narrative and the somewhat reliable characteristic behavior of Vol might both be the reality,
and deeply intertwined, such that it’s hard to separate what is quantitative from what is qualitative.
Relatedly, and despite the slight downward move in realized vol, we still see implied volatility levels as
extremely low relative to the magnitude of the cumulative S&P 500 drawdown. And though it is an
arbitrary level overall, it’s interesting to see that IV has come down to a very similar level to the early
days of the cumulative drawdown that began in early 2022! One might dare to say that in terms of IV,
nothing happened at all year-over-year! Not sure we can say the same for the equity market.
Further, in January, vol-of-vol was extremely low, as measured by the CBOE VVIX Index5, which
printed its single lowest close of the “post-Volmageddon” era.
 “Excessive optimism sows the seeds of its own reversal.”
– Alan Greenspan
On that front, and again updating a prior chart, below we see that the skew compression trend has seen
a slight tick upward in January. This relentless drop in skew in 2022 was particularly challenging for
our long volatility peers who rely on an “attachment point” via OTM puts to provide protection. Not
only was implied volatility across the volatility surface lower than expected in 2022 given the
magnitude of the S&P 500 drawdown (as discussed above and plentifully in numerous prior letters),
but in particular, the moneyness shape, or vertical slice of the volatility surface (as is popularly referred
to as the “option smile”), got significantly flatter in 2022 as well. This trend reversed in January 2023:
at-the-money (ATM) implied volatility was punished a bit more than out-of-the-money (OTM). That
said, we don’t believe that this short term differential has any real significance outside of the somewhat
extreme levels that things had reached. To some degree, and as discussed last month, the compression
of skew seemed overdone, and the mean reversionary tendency of markets was likely eager to reveal
itself. In this sense, it’s not so much that ATM was punished, but that OTM offered some of the
expected recovery after its outsized beat down.
Finally, taking a closer look at the daily movement of our strategies for the month of January, we see
what we’d generally expect, with LAR participating mildly, and LTR holding ground in the market’s
gain, while remaining net short, with bundles of convexity in the waiting.
Logica Capital November 2022 Commentary
Dec 21, 2022, 7:39 am

Summary
November brought us several fascinating storylines, from spectacular collapse(s) in the crypto space, to
a historic equity/bond day in traditional markets. Concurrently, we experienced a fairly predictable
relationship between implied volatility (IV)/VIX and the S&P 500, with perhaps slightly more
volatility crush than normally expected. Logica’s strategies fared well, all things considered, due to
several factors we discuss below.
Q3 2022 hedge fund letters, conferences and more

Gates Capital Management Reduces Risk After Rare Down Year

[Exclusive]
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name
Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have
produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second
half of 2022, outperforming the 3.4% return for Read More

Commentary & Portfolio Return Attribution

“It’s not whether you get knocked down; it’s whether you get up.”
– Vince Lombardi
At long last, the star of the month was our Macro Overlay, which contributed about half the total return
for LAR and buoyed LTR in November. In fact, one of the most historically anomalous S&P 500/Long
Bond days occurred on November 10th (after the CPI data was released) when the S&P rose +5.5% and
TLT also rose 3.8%. Below we visualize the S&P 500’s top 15 up days since July 2002 as compared to
the TLT return on the same day:
Ignoring its unusual relationship to the equities market, TLT was unusual even on a standalone basis, as
this was its 7th biggest up day since 2002, where 5 of the other 7 were in March 2020 or late 2008.
Interesting times, indeed.
The rest of the book performed about as expected, with Single Stock Calls coming in slightly lower
than the market, but still outperforming considerably for the year.
With respect to the volatility environment at large, November 2022 (the red dot in the green box below)
was nearly in line with expectations of the long-term S&P 500/VIX relationship, landing almost spot
on the best fit curve, albeit slightly below it, as we have tended to experience all year long with S&P
upside moves:
Similarly, with respect to the current YTD drawdown in the S&P 500, we see more of the same of what
we’ve been describing all year long: a measured drawdown with lack of IV upside reaction given the
extent of S&P downside, and then alongside that, larger than normal IV crush during equity market
upside. November did nothing to change this phenomenon, as we can see by the black dots below:

Relatedly, we see the CBOE VVIX Index tracking at multi-year lows. The VVIX Index, outside of
some mathematical gymnastics, can basically be thought of as “volatility of volatility,” or, how much
implied volatility itself (VIX, in this case) is bouncing around. If implied volatility is not bouncing
around (as represented by a lower value of VVIX), there are typically fewer trading opportunities for
those that scalp Vega, as Logica does.

Our VVIX explanation is somewhat simplified for the sake of clarity of communication, and we
encourage readers that are so inclined to take a look at its full methodology for themselves:
https://www.cboe.com/us/indices/dashboard/vvix/
“Instead of connecting with new things, widening our worlds, algorithms have shrunk it to a
narrow chamber with mirrored walls.”
-Olivia Sudjic
Looking at the chart above, the fascinating data for 2022 is not only that VVIX, aka VolofVol, is
relatively low, but that it has spent the year getting substantially lower. What this demonstrates is an
ironic feedback loop; while VIX itself has been generally unresponsive, it has gotten increasingly
LESS uncertain about its own unresponsiveness! If we imagine IV to be consensus opinion, it’s as if
earlier in the year, the consensus had some uncertainty about how panicky to be, then leaned on the “be
less panicked, stay calm” side, and then, as the year marched forward, became increasingly certain
about its decision to be more calm.
So now the question is… why might this be the case? As with many other areas of the market, we see
the all too familiar behavior of a “feedback loop,” which said in slightly different words, is the hyper-
familiar concept we all call “momentum”. But whether dubbed a “feedback loop” or “momentum”, the
backdrop to this behavior is that the market is getting more and more familiar and/or comfortable with
its decision, and an increasing number of players are joining in on that decision path. In terms of
VIX/IV, this agrees strongly with the supply/demand dynamics over the course of 2022, wherein the
VIX has made a lower high at each successive new S&P low, following a large S&P down leg (refer to
our September letter illustrating the S&P down legs and successive deeper bottoms in January, June,
and then September, corresponding to lower highs on the VIX for each, respectively). To tie this in, the
lower highs represent quicker selling into the further S&P drops as a result of increasing distrust of
Vol’s payoff; if it didn’t work in January, then June’s move becomes the next opportunity to get out
quicker, and then when that 2nd leg demonstrates greater weakness (because it looked back to the first),
the 3rd leg down in September is sold out even faster. In other words, the feedback loop of Vol’s
unreliability begets quicker selling, and the related “momentum” of unresponsiveness. Similarly, this
behavior occurs at smaller timeframes; as mentioned above, numerous smaller Vol pops during the
month have been rapidly unwound by faster sellers, which lead to quick Vol crushes shortly thereafter.
And so VolofVol contracts.
But then for the next, even more valuable question, what does this suggest looking forward? Well, from
our perspective, this is great news. Why the excitement? Because if we look at the long-term behavior
of momentum, and really, almost all feedback loops, we generally find negative skew on the horizon;
that is, they go, and go, and go… until they don’t. At which point – precisely because of how long
they’ve been going, and how many participants have jumped on the train — the reversal is often
sharper and more extreme. Further, this ties into the natural results of the supply/demand dynamic
described above, for as the sellers sell out, there is of course less and less inventory remaining. The first
lot sold out in January, the second bunch sold out even quicker in June, etc… and in viewing the year-
to-date path, we get the contraction of VolofVol, which effectively equals greater participation in the
new sentiment, i.e. all agreed on the unreliability and unresponsiveness of Vol.
We analogize this slow capitulation of sentiment to a coiling spring, which as one pushes down, gets
tighter and tighter, but as soon as it faces a sufficient release trigger … well, that’s when, with little in
its way, it can leap sky high. That’s when the negative skew of all the selling momentum begets the
positive skew for those persistent holders. From this perspective, Vol is not dead, it is merely sleeping;
there simply has not been enough uncertainty, or panic, in 2022 to wake it up. We described this
concept as “bounded uncertainty” in a prior letter, identifying the narrow bands of uncertainty
surrounding rolling inflationary numbers and Fed related decision-making. The point being, we believe
that if there is an actual unbounded uncertainty event (a shock like COVID-19, ’08 GFC, 9/11, etc…),
humans would panic just the same, and Vol would inevitably do what we all expect it to do. Vol would
again be wide awake. But then – breaking news — all those participants who unloaded their inventory
and moved on to seemingly greener pastures undoubtedly become the aggressive bids that fight to buy
the breakout – ironically, to own the unknown.
At Logica, we don’t want to fight to own the unknown, we want to constantly carry inventory precisely
so that we don’t have to aggressively overpay at the worst of times or chase the breakout. We prefer to
fight against the bleed of sleepy Vol given the absolute unknowability of tomorrow, and the shock
events that do not obey investor sentiment.
Separately, every so often in our letters we have been keeping track of a couple of products/indices that
use volatility as a hedge for long positions: one product through VIX Calls, and the other using S&P
500 Puts – and both of which use OTM options as their long volatility component. We continue to see
these products not only fail to provide benefit, but through the end of November, actually detract from
a standalone S&P 500 Index investment performance. The point here is not to demean these products
and/or their construction, but rather to highlight the incredible difficulty of long volatility given the
behavior of this year’s declining market as compared to other recent crisis periods – and especially with
regards to out-of-the-money (OTM) protection, as these 2 products employ.
“The opposite of a true statement is a false statement, but the opposite of a profound truth can be
another profound truth.”
– Neils Bohr
Similarly, we observe the lack of “pop” of OTM options by visualizing how steep the “moneyness
slope” is in relative terms. A steep slope would indicate that OTM implied volatility is dramatically
higher than ATM, i.e. high skew. A flatter slope, of course, would indicate that OTM implied volatility
is not popping enough to cause its IV to be much higher than ATM, i.e. skew compression.

Bringing everything together: the fact that 1) Implied Vol/VIX in general hasn’t been very responsive
in 2022 and that 2) the moneyness slope (or, skew) has dramatically flattened, starkly contrasts with the
biggest crisis events, where we typically see two opposite outcomes: all strikes along the moneyness
continuum see their implied volatility rise dramatically, and the rate of increase in OTM IV outpaces
the rate of increase in ATM IV (skew steepens). One of the many reasons that we consider ATM “safer”
than OTM is that the reliance on skew, and the additional concern about its steepness vs. shallowness,
introduces an additional dimension in the management of risk. More specifically, it introduces basis
risk into the already difficult problem of managing downside market behavior. Downside markets are
hard enough to calibrate — imposing further complexity is, to some degree, just adding risk to that
calibration. For example, one might get both market direction AND IV gain totally correct, but lose
more on skew compression, thereby not accomplishing the core objective. Broadly, this all translates
into why Logica loves ATM, because of its greater path independence for as many as possible
downside paths.
Finally, taking a look at the daily movement of our strategies for the month, we can see that LAR kept
pace nicely with the S&P upside, and LTR was able to minimize losses (while holding significant
protection and negative Delta tilt at all times).

Logica Capital January 2023 Commentary

Feb 22, 2023, 5:02 am
0
Logica Capital commentary for the month ended January 31, 2023.

Summary
January started the year off with a bang; major indices gained between +6.2% (S&P 500) and +10.6%
(Nasdaq 100). We saw minimal deterioration in VIX/Implied Volatility despite the large move in the
S&P. Realized vol continues to trend downward, while factor rotations remain a major story.

Gates Capital Management Reduces Risk After Rare Down Year

[Exclusive]
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name
Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have
produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second
half of 2022, outperforming the 3.4% return for Read More

Commentary & Portfolio Return Attribution

“Appear weak when you are strong, and strong when you are weak.” 
– Sun Tzu
While January seemed to give us a broad, blasting upward market, we saw a significant factor rotation
and some dispersion beneath the surface. As mentioned above, the Nasdaq 100 strongly outperformed
the S&P 500, as did the Vanguard Small Cap ETF (VBR), and even the equally weighted S&P 500 ETF
(RSP). At the same time, the SPDR Energy ETF (XLE) returned a paltry +2.8%, paring its gains from a
huge run – and being the strongest area of the market – over the past year. Concurrently, and to
illuminate the contrast, the Dow was up only +2.95% in January.
On a related note, an internal strategy that we run/track which picks “anti-momentum” (overly beaten
down names) returned an astounding +26.5% in January, highlighting “junk” as the strongest
component of the market’s rally. As readers may recall, we implemented this LFB module (“Logica
Focus Bottom”) after Q1, 2020, and participated in the aggressive rally in oversold sectors like the
airlines after the Covid-19 meltdown dragged them down almost beyond recognition. That said, our
portfolio construction model did not trigger engaging the LFB module in January, and so we did not
deploy that exposure. However, we clearly see its results, and so more acutely understand the market
dynamics that took place in January.
What this all translated into for our strategies is that both components of our Sector & Single Stock
Calls – our momentum “LFT” module (+3.0% as a standalone), and our diversified “LFD” module
(+5.2% as a standalone), underperformed the S&P 500 on the month. 
Elsewhere, our Macro Overlay performed positively on the month, continuing to provide value after a
decent Q4 2022.
“Don’t expect to build up the weak by pulling down the strong.”
– Calvin Coolidge
As touched on above, January saw a fairly dramatic rotation out of the energy complex alongside other
recent strongholds (Utilities, Health Care and Consumer Staples). These sectors all performed
relatively well in 2022 but were actually down in January as investors rotated into the most beaten
down names/sectors (Consumer Discretionary & Communications) which generated double-digit %
returns. 
On this point, we draw further attention to the powerful run that the energy complex (XLE) has seen
over the past couple of years, enabling it to “catch up” to the remainder of the S&P 500 (note the chart
below is S&P relative to XLE, wherein the ratio more than chopped in half from 2021 forward).
Looking even more carefully at the chart below, we can see a small upward tick in January. And more
broadly, while we appear to be back to somewhat “more reasonable” levels as of recent months, the
“ideal” level is of course anyone’s best guess:
“Life comes in clusters, clusters of solitude, then a cluster when
there is hardly time to breathe.”
– May Sarton
Moving over to the picture on Volatility, we note that realized volatility continues to trickle downward,
but certainly did not “collapse” alongside the strength of the market rally:
From Logica’s perspective, VIX/Implied Volatility provided a decently favorable environment in
January, as it didn’t fall quite as much as one would expect given the S&P 500 run upward and the
historical relationship between IV and S&P moves. Looking at this relationship (monthly) in the chart
below, we note that IV held “above average” relative to its expected decline for a similar magnitude
move. As always, this can be interpreted with a narrative, backed by the inflation story not yet over
and/or by the supporting empirical research, which demonstrates that Vol tends to be “sticky”, or
cluster, and so it will take more than a short time to move to a very different level. Of course, both the
reasonable narrative and the somewhat reliable characteristic behavior of Vol might both be the reality,
and deeply intertwined, such that it’s hard to separate what is quantitative from what is qualitative.
Relatedly, and despite the slight downward move in realized vol, we still see implied volatility levels as
extremely low relative to the magnitude of the cumulative S&P 500 drawdown. And though it is an
arbitrary level overall, it’s interesting to see that IV has come down to a very similar level to the early
days of the cumulative drawdown that began in early 2022! One might dare to say that in terms of IV,
nothing happened at all year-over-year! Not sure we can say the same for the equity market.
Further, in January, vol-of-vol was extremely low, as measured by the CBOE VVIX Index5, which
printed its single lowest close of the “post-Volmageddon” era.
 “Excessive optimism sows the seeds of its own reversal.”
– Alan Greenspan
On that front, and again updating a prior chart, below we see that the skew compression trend has seen
a slight tick upward in January. This relentless drop in skew in 2022 was particularly challenging for
our long volatility peers who rely on an “attachment point” via OTM puts to provide protection. Not
only was implied volatility across the volatility surface lower than expected in 2022 given the
magnitude of the S&P 500 drawdown (as discussed above and plentifully in numerous prior letters),
but in particular, the moneyness shape, or vertical slice of the volatility surface (as is popularly referred
to as the “option smile”), got significantly flatter in 2022 as well. This trend reversed in January 2023:
at-the-money (ATM) implied volatility was punished a bit more than out-of-the-money (OTM). That
said, we don’t believe that this short term differential has any real significance outside of the somewhat
extreme levels that things had reached. To some degree, and as discussed last month, the compression
of skew seemed overdone, and the mean reversionary tendency of markets was likely eager to reveal
itself. In this sense, it’s not so much that ATM was punished, but that OTM offered some of the
expected recovery after its outsized beat down.
Finally, taking a closer look at the daily movement of our strategies for the month of January, we see
what we’d generally expect, with LAR participating mildly, and LTR holding ground in the market’s
gain, while remaining net short, with bundles of convexity in the waiting.