Opportunities in Option Mutual Funds with Russ Kellites

In the ever-evolving world of finance, change is the only constant. Like the shifting tides of the market, options trading has transformed from monthly expirations to weekly and even daily strikes. It’s like going from a leisurely stroll to a thrilling daily marathon in the world of trading. Alongside these shifts, hedging strategies have also had to adapt, especially after the rollercoaster ride that was 2018.

On this episode of The Derivative, we’re taking you on a journey through the financial landscape with none other than Russ Kellites from Alpha Centric Funds. From the intriguing story of San Francisco’s economic landscape to the evolution of computer science and AI, to the transition from Goldman Sachs to starting a fund – we’re covering it all — SEND IT!



From the Episode:

Portfolios of Power futures with Tim Kramer

LJM – The Autopsy




Check out the complete Transcript from this week’s podcast below:

Opportunities in Option Mutual Funds with Russ Kellites


Jeff Malec  00:07

Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go analyze the strategies of unique hedge fund managers and chat with interesting guests from across the investment world.



Hello there. It’s back to school season and we’re back with a great lineup the next few weeks battling a little bit of a cold here and doing this intro so apologize. Might have been from the great trip to Philly. We had recorded the live panel event there as a pawns. We’ll put that up in a couple of weeks for you to hear yours truly moderating a panel with Tim Pickering of Auspice talking commodities. Cory Hoffstein of Newfound talking return stacking, and Brian Maloof of Campbell and company talking systematic macro has a lot of fun, check it out. Onto this episode, we’re back talking options trading and volatility and the like, with computer scientist or mutual fund pm Russ Kellites. We’re getting into rest his background as that computer scientists what’s going on in San Francisco. We talk Uncle Warren selling naked puts and then dive into the various options strategies Russ uses in his model to do all sorts of things like market participation, upside capture, and downside protection. Send it This episode is brought to you by RCMs outsourced trading desk, which does voice electronic DMA, all sorts of other execution services for groups and mutual funds, hedge funds to individual investors. 20 466 Because market is an open Saturday. So 24/7 Minus a Saturday is at twenty-four, six. Visit our rcmalts.com to learn more. And now back to the show.


Jeff Malec  01:43

All right, everybody. We’re here with Russ Kellites or Russell, what do you what do you prefer? Russ? I always call you. Sure. We’ll go with Russ. Thanks for being here. Where are you in your lovely home there? San Fran.


Russ Kellites  01:58

I am right in the middle of San Francisco.


Jeff Malec  02:01

So Is it as bad as everyone’s making it out these days?


Russ Kellites  02:07

Ah, you know, that’s a great question.


Jeff Malec  02:10

I get the same question every time from Chicago, right? We just had some woman snuck a gun into the White Sox game under a fat roll. She put a gun under a fat roll to get through the metal detectors. And then Chad, someone during the game. So we got our own problems here in Chicago. But sorry. So yeah, that questions.


Russ Kellites  02:33

You know, parts or parts are pretty bad. But the main kind of residential areas are really fine. In fact, the area I’m in is really perfect. We’ve got very few problems.


Jeff Malec  02:47

But have you seen people like wanting moving out and mass or is it contained? Is that just an admin?


Russ Kellites  02:54

I’m not really, you know, again, kind of, I think some of the areas that were sort of hard hit were downtown financial district, Soma, I think was hit pretty hard. We actually had kind of an odd incident the other day here, which is unusual. Someone was carjacked. Five people jumped in the car and drove down the street that actually, you know, we’ve got all these hills and this particular street just sort of ended. There was a staircase that it picked up down below. Well, they drove right off the end of the car careened off of that did a somersault it was probably about three storeys high, and landed on his roof.


Jeff Malec  03:48

Wasn’t like the 70s car chase movies in San Fran like that. We had the commercial real estate guy in the pot a while back, he was like he wouldn’t buy commercial real estate in San Fran Chicago or New York. So we feel your pain. But yeah, I’m fine. I’m still living here in Chicago. can’t scare me away.


Russ Kellites  04:07

Well, this made the news and everything. I’ll send you a link to it. Yes. After a vineyard,


Jeff Malec  04:13

but you went to school in New York, correct? That’s right. So where what was that like you grew up? California, went to New York or New York and ended up in California.


Russ Kellites  04:24

I was actually born out west I was born why we moved around a lot when I was younger.


Jeff Malec  04:31

Army brat Navy brat.


Russ Kellites  04:33

My my, my dad worked for Pan American son. up in Seattle a little bit. We were in California. We actually lived in Afghanistan for a couple of years. to Long Island, New York, where I mostly grew up and then I went to Manhattan for school. And I went to Columbia and I got a bachelor’s degree there I entered a master’s degree program that was all in computer science, focusing on AI, doing research in AI, and then went into the MBA program and got an MBA in finance and marketing. Nice.


Jeff Malec  05:14

And not to insult you right off the bat and call you all but right, what was it like back then with the computer science and AI versus today, right must be vastly different Are you think the nuts and bolts of it were pretty much the same?


Russ Kellites  05:28

Well, we were really kind of at the early stage of, you know, the building blocks of what you see now. So, you know, something I was particularly interested in was a natural language processing, which is, you know, the recognition of text words, etc. As opposed to, you know, computer programming and direct database access. So for example, you know, we would work on a zoology database where you could query the computer, you know, how many legs does a panda have? And it would answer a panda has four legs, which was, you know, really kind of pronounced step forward. At the time. You know, of course, now we take that for granted. And with chat, GPT, three and a half and four, and you know, some of the others, the computers have really gotten much more advanced than that.


Jeff Malec  06:32

Do you think it’s mainly the processing speed and what they’re able to do on the back end? Or is it they’ve made leaps and bounds on how it’s handled? Right? I’m sure you were dealing with much slower speed in order to run those queries and whatnot. Oh, yeah.


Russ Kellites  06:46

Yeah, I know that. The computers they call it is increased dramatically. We really were bumping up against the upper edge of what was possible because of, you know, computation speeds. And of course, now I’ve got more power in my iPhone than I do. And, you know, we use digital equipments. Dec. 20s. Back then. So it’s, there’s a huge movement forward,


Jeff Malec  07:15

the pod or pod last week on the power trader, and he was quoting that it’s 10 times the amount of energy is used for AI query than a normal Google search. Right? So and then it’s like something like 100 or 1,000x, I can’t remember to actually train the model. Right? So it has consequences, all this electricity reason, all this power, all the chips, we need all the materials to do the chips, all that




Russ Kellites  07:46

That’s right. Yeah. I mean, I, I listened to someone the other day, who was saying that chat GPT, four to 10 times the resources of three, and five will be 10 times four, etc. But, you know, the results that you get out of that are, you know, tremendous. I mean, some industry leaders are suggesting that the reduction in workforce utilization is something like 30%, kind of across the board for all these kinds of more sophisticated human resource intensive roles, you know, marketing and consumer, lawyers, communication, lawyers.


Jeff Malec  08:40

Yeah. So, what made you go down the finance path instead of the computer science path, something in there said, like, this isn’t for me.


Russ Kellites  08:53

It really wasn’t, we were bumping up against the edge of what was what was possible at the time when we spent, you know, tremendous amounts of manpower, getting to the point where we could build this sort of a database, and be able to access it through a natural language. But you know, the next, it looked like the next big movements forward, the next big leaps, were probably going to be 10 or 20 years off. And I, I just didn’t think there was a lot of return and spending a lot more, you know, spending the next 10 or 20 years making these very small, incremental gains. And finance numbers were really pretty interesting to me. So I went to business school,


Jeff Malec  09:40

and then out of there got into where it was at Goldman Sachs. Right. So you must have been doing some right to catch someone’s eye over there.


Russ Kellites  09:49

Well, I think, you know, I think large financial firms are really just kind of catching up to the US progress being made in the computer side. So they were looking for people that had technological capabilities, and were good with numbers and that sort of thing. And so


Jeff Malec  10:08

just like they’re looking for high end coders and whatnot today,


Russ Kellites  10:13

yeah, it’s really, you know, frankly, it’s been pretty consistent. And a good way for them to try and separate themselves to get some competitive advantage.


Jeff Malec  10:29

So take us through the backstory from God, entry level, or whatever level job at Goldman through the next stages to eventually starting your own fund, running your own fund.


Russ Kellites  10:41

Well, I moved around Wall Street a little bit, it was Goldman in Maryland, and some, some bolts, brackets and boutiques. And I guess my last, my last job at a large was a international investment bank. I was running the structured finance groups, and we were doing cross border, complicated trades involving derivatives and accounting and tax and things like that. And I’ve been, I’ve been trading from my own account for a long time. And, in fact, I was I was doing some options, strategy trades. And they were really kind of two components to it. One was picking a instrument stock. And the other was the structure around that stock. And it was involved, primarily buying what’s in calls. And my, my technique, or choosing stocks was working pretty well. But I wasn’t really making any money. But at the same time, we were approached by by actions, Goldman, who was doing large trades for Berkshire Hathaway. And you can go back and see this in the press at the time. But Warren Buffett was selling large, out of the money, put options on major indices, it was The s&p Nasdaq Russell, the neat guy, and he was doing something in Europe as well.


Jeff Malec  12:16

Not Uncle Warren. He’s great, famously like anti derivatives to the general public, even though


Russ Kellites  12:23

like he sold them.


Jeff Malec  12:25

But he’s you selling sorry, I meant he was selling puts.


Russ Kellites  12:29

Yeah, exactly. Naked. And so they were billion dollar trades, I think at the time. And so gold was the other side of these, but they were running out of there, the exposure they can take to war to Berkshire Hathaway. So they were looking to offload that. And so we did some analysis looking to take on that exposure from them. And it was, you know, around them that I realized, in fact, it wasn’t really, that I realized I was just on the wrong side of the trade. When I was buying, I really should have been selling and so I had to revamp that half of my equation to vote for focus on the premium collection, the premium writing.


Jeff Malec  13:11

And you’re saying from a flows perspective, or just you saw Warren selling earning premium and said that might be a better, better game?


Russ Kellites  13:20

Yeah, it was really that it was, you know, he’s obviously a really smart guy. And if that was the side of the trade that he was on, it’s a good reason to think it’s a good side of the trade for me to be on. Good way to


Jeff Malec  13:33

look into it more. Yeah. And so then set up all that or whatever firm you were and started your own.





Russ Kellites  13:41

Oh, well, so this was end of 2007 going into 2008. So there was it was, you know, there was this you know, financial meltdown. Yeah, hopefully you didn’t sell puts right by group was eliminated. So at that point, I just turned to the tray from my own account.


Jeff Malec  13:59

And then eventually said, Hey, this is good enough, I’m making progress in my models to roll it out to customers.


Russ Kellites  14:06

Right. So you know, I’ve been helping out friends and family in 2011. That turned into a hedge fund. In 2016, we turned the hedge fund into a mutual fund, which is, you know, the fund we’re working on now.


Jeff Malec  14:24

So, the idea behind the fund, and your overall strategy. So well, let’s back up is your how different is what you do today from what you were originally thinking up and designing for your original fund.


Russ Kellites  14:41

Well, so I developed a model to analyze what the best positions options trikes explorations, where to buy or sell back tested that and then ran it through an AI engine for further find that that’s really been, that model has really been the cornerstone for what we’ve been doing ever since. And that really hasn’t changed.


Jeff Malec  15:07

And that was that was it the entire universe of single name stacks. We started it


Russ Kellites  15:11

really just just the s&p 500 got


Jeff Malec  15:16

and ingest the entire universe of strikes and tenors,


Russ Kellites  15:20

right? Yeah. And the advantage of that was that there’s, there’s a lot of liquidity. The the premium options were really pretty consistent. And, you know, there were just a lot of strikes and explorations for us to work with. So that’s, that’s changed a bit. You know, we went from really kind of monthly expirations to weeklies, and now really pretty much daily. So they’re really strikes for every day of the week. And so that’s given us an opportunity to take more positions and further refine what we’re doing. And we’ve also refined our hedging strategy. A bit early, quite a bit, is a reaction to what happened to the market in 2018, where we hadn’t even called volume again, when the market dropped about 4%, but volatility spiked actually went up 100% over 100% on that small, downward s&p




Jeff Malec  16:29

Real quick backup, that’s interesting. I hadn’t thought of that of like, if you’re feeding this data into an AI model, there’s could be an argument of like, I don’t have enough data from monthly expirations to give the model enough to work with now you’re doubling it with with twice a month you’re quadrupling it with weeklies, you’re whatever the number is 16. And thing with 20 a thing with dailies. So now the model has even more and more data to work with and can be better refined. Right? So there’s some sort of statistical significance in there. Like the more data I have, the better,


Russ Kellites  17:05

that really hasn’t affected so much how the model works. I mean, we’re really looking at things like what you know, what the movements in the markets are, like the, you know, the volatile market, say versus the amount of volatility priced into the options. And the looking over the landscape of that to see where the mispricing is, is the greatest where we take the best advantage of that.


Jeff Malec  17:34

Now you’re you’re not an option guru unless you caught the ball surface.


Russ Kellites  17:38

I was trying to avoid lingo.


Jeff Malec  17:42

That’s the but yeah, like, right. And I think of those 3d Heat maps of Yellowstone or something, right? It’s like all these peaks and valleys and blue and orange and red. Right of like, that’s what the ball surface and you can say, Okay, this doesn’t make sense on this one slice, right? It should maybe be gently rising, gently falling. You could have some slope, but if there’s a big peak and a big valley on the bottom one slice, right, something’s amiss there.


Russ Kellites  18:10

Sure. Sure. heatmap tends to have a sort of a gradual gradient type pattern, but you still look at, you know, where the price is, you know, high when expiration versus low, and another expiration and take advantage of that.


Jeff Malec  18:28

And so it strikes me that it’s unintended, it strikes me that it’s not that easy, right, like so. Just because one is more expensive than the other doesn’t necessarily mean the ones overpriced, and the ones underpriced. There may be good reasons for that. So kind of how do you view that of like, okay, this is the market is pricing it there? Right. So in my, do I have a better model? Am I identifying just the mispricing or am identifying an opportunity?


Russ Kellites  18:57

Right? Well, we feel like if we’re taking into consideration, you know, kind of the known external factors that are affecting the market. And we we try and take a balanced approach. So rather than just kind of selling something out, right, we’ll buy another thing to hedge. So even if we’re wrong, you know, the we’re really trying to look more at the differential between those things rather than kind of the absolute of one thing versus another.


Jeff Malec  19:35

And that’s a good segue that is that way options instead of right, you could have run single stocks into the model. You could have run global stock indices, been long or short stocks or right. Did the Why did you settle on options because it’s cliche and gave you more optionality gives you more like you’re talking about I can, I can know that my last will be truncated here because I just spent premium I can And


Russ Kellites  20:01

we’ve found that the liquidity and consistent differential between the amount of risk embedded in the market versus the amount of risk of being paid for the, in the options, that differential tends to be pretty consistent in the broad indices, whereas it can move around a lot more with individual stocks with individual stocks, you get that idiosyncratic risk, you know, there, it’s just really hard to tell what’s, you know, what’s affecting any individual stock, it could be, you know, the CFO is about to step down, or, you know, he’s, he’s got some health problem that isn’t widely known, you know, earnings miss could come out or earnings beat could come out, there are just so many factors that can affect an individual stock, whereas, you know, the broad market tends to diversify all those videos and Radek risks.


Jeff Malec  21:00

I could argue that these days, like those top 10, stocks have mastered taking away all those idiosyncratic risks, right, that’s why they just keep getting bigger and bigger. If you’re a trillion dollar company, you’re not going to move 10% a day on some unknown risks, right? They’re going to telegraph.


Russ Kellites  21:17

Well look at look at in video yesterday, last couple of months. You know, they had a day, a month or so ago, where they were 30 40% or something. And then on earnings, they were up 10%. I think they gave a lot of that back. But you know, I’m your sixth largest company by market cap. Right.


Jeff Malec  21:39

But to your point being kind of isn’t worth it to try that. Like, if you’re right, sure, you’re gonna make some money. But if you’re wrong, you could be really wrong in that scenario.


Russ Kellites  21:49

Yeah. Yeah, you know, I’m sure there are people that, you know, look at the large companies and do the deep dives, and, you know, have a really good handle on you know, what to expect what’s gonna affect the stocks, but that’s just not how we we want to operate.


Jeff Malec  22:10

Right? You want to be the good barring the good type of boring, right? So we kind of buried the lede a little bit here, but let’s take a step back, Stan could step up 30,000 foot view, talk about the trading strategy? Overall, what you’re trying to accomplish? And then we can dive into some of the details? What would your What’s the 32nd? Elevator Pitch on what you’re trying to do with it?


Russ Kellites  22:41

Well, I think the, the principle underlying what we’re doing is really taking advantage of that differential that I met mentioned. So it’s the differential between the amount of risk in the market and the amount of risk you’re being paid for the options. And, and it’s really a lot like, you know, I draw the analogy to an insurance company, say like a, like a GEICO where, you know, if you have a car and you insure it with maybe Geico, you’re paying them say, $1,000 a year for insurance. But when they take all the people like you, and they add them all up in the average, and the cost embedded in that policy is more like, say, $800. And so they’ve got this $200 20% profit margin, it’s really the same thing with options and options is really the only financial instrument that I can think of aside from saving insurance policy, where you’ve got that positive, expected future value on a risk adjusted basis. So with stocks, you know, if you buy and I sell, if it goes up, you win, I lose vice versa. And it’s a random walk with bonds really the same thing. And when you take when you take out the default rate and the recovery rate, you’re you’re left with a risk free rate of return. But with options, you’ve really got that that profit margin built in. And so what we’re trying to do is find the best way to take advantage of that profit margin, find where that profit margin is, is the highest and, and sell those policies or where’s the lowest and, and violence policies.


Jeff Malec  24:15

It’s more like GEICO with less funny commercials.


Russ Kellites  24:21

You don’t have to get go.


Jeff Malec  24:23

The end. So the whole concept there is I need to be widely diversified. Right. So that is the index giving you enough of that diversification or you’re saying it’s not just the index but different strikes different tenors?


Russ Kellites  24:37

Well, you know, we think the index diversifies out a lot of that risk that idiosyncratic risk. So, you know, if if a hurricane goes through and you know, wipes out and videos manufacturing plant, that’s going to be a pretty bad event, but it’s the impact on the s&p 500 is going to be pretty minimal, you know, So we’ve really diversifying out that idiosyncratic risk.


Jeff Malec  25:03

And then how do you think about that the shouldn’t the option already reflect that pricing. Or you’re saying there’s a built in SKU that investors are overpaying for protection or something of that nature that kind of builds this mechanism.




Russ Kellites  25:17

And it’s really the latter. So there, there really are no natural sellers of options, just like there are no natural sellers of insurance policy. I mean, you know, they’re natural buyers of options, the market, the value of the US equity market is $30 trillion, or something, you know, it’s probably larger now. But so you’ve got all these insurance companies, pension funds, endowments that are long the market, so they need to buy protection to protect against downside, you know, so your retirement funds need to buy downside, so they can, if they’re up, they can still pay the the obligations, they’ve got all their their insured all the pensioners, so they’re natural buyers, but there aren’t really any natural sellers on the other side. And so that’s why you’ve got that that embedded premium that access, you know, risk premium.


Jeff Malec  26:20

The end, so talk a little bit, but it’s not always like that, right. So in a risk off environment that can get or vice versa, it can move around. So we talked offline, you have a bit of a construct of these for the markets, I was in one of four quadrants. Can you talk through that a little bit what those four quadrants are, and how you kind of view the, what makes them different and what you do different in each of them?


Russ Kellites  26:43

Sure, so So our models are attempting to look at the direction of really the two main components about where we’re working with the underlying market, and the volatility that’s reflected in that market. So the the s&p and the VIX for simplification purposes. So we’re looking at whether we see the market going up or down, and whether we see volatility going up and down. And so depending upon that, will modulate the amount of risk or the type of positions that we’re taking on, you know, when the markets going down will, you know, of course, try and take less market exposure, you know, probably less short s&p s&p, when exposure, maybe even go long, s&p puts similarly when the markets going up, we’ll try and take, you know, long s&p exposure, less short call exposure. And then when the volatility we see the volatility going down, we’ll try and take more short volatility exposure, you know, we try and hedge that, of course, and the opposite, we see volatility going up.


Jeff Malec  27:55

So I lost the four quadrants, and there’s some so one of the


Russ Kellites  27:58

four quadrants or you can say, kind of across the top, it’s what’s the market doing up or down? And then across the side of what’s volatility Do we go up or down? So you’ve got these two factors, times two is four dimensions.


Jeff Malec  28:15

Got it? So mark it up, Vall. Market up, fall down, right market down, ball up, market down, ball down? Exactly. And so that shifts how often monthly in real time and your model does it?




Russ Kellites  28:33

It really varies there, there are periods where we’ll be in one quadrant in the most, you know, the quadrant, where we find ourselves most frequently is market down volatility. And in general, you see those those two instruments inversely correlated. And that’s the case they’re inversely correlated that 80% of the time, but so probably about 65% of the time, it’s up market, down volatility, probably another 15 It’s up market, up volatility and the other 10 Each say and down market down volatility market volatility.


Jeff Malec  29:16

6515 1010 100 Good work off the top your head there. So 60% of market down volume. And to your I think you answered I was kind of saying as the you’re not just at the end of every month, saying where’s the market at and redeploying it’s looking at it daily.


Russ Kellites  29:35

Right. So you’d ask kind of what the frequency is. So, you know, overall, we tend to be in that market down volatility. We can be in that tech Quadrant for long periods of time. If you go back to 2020 from say, early March through, you know, middle well, even even the end of the year, we really shifted data that Quadrant for a couple of days, kind of towards the end of the summer, and then a couple of days in the fall. So that was kind of nine months of the year where we were one was really,


Jeff Malec  30:13

really not in 2020. With COVID, you mean 2019?


Russ Kellites  30:18

No 2020. Once we got through the big drop and gathering markets, as you know, we were, we were down with 25 30% of the market just just rebounded and really pretty consistently, came back.


Jeff Malec  30:33

And so in those sort of environments, and overall, let’s take a step back. So you’re trying to capture as much of the market upside as possible,


Russ Kellites  30:41

right, and avoid the downside, as much as possible.


Jeff Malec  30:45

And so that was seems like makes you different from some of these other right, so if I hear that upfront, I’m like, Oh, you’re kind of in this hedged equity bucket, right of like, participating in equities with a bit of a hedge. Right, but from what you said before the elevator pitch, it’s not quite like that. Because you have these other options, strategies that you’re trying to generate some income from, and generate some different types of returns than just owning the stocks and hedging or owning the index managing.


Russ Kellites  31:13

That’s right. The hedge fund equity funds that we say, really kind of have one approach, which they use consistently, really all the time. So they’re typically the best, you know, the vast majority segments are long and equity position, and then they’ll a lot and we’ll do a costless collar around that. So they’ll, they’ll buy put underneath, they’ll sell the call above, and they’ll sell another put down below to, to balance out the economics. And there is very large funds to do that. But again, it’s this sort of sort of one thing, and so they do well, within that, you know, the top part of that band, so when the markets doing up, going up, and they’re up, you know, say less than 5%, for the quarter, they’ll do, they’ll do pretty well and track the market. When the markets down between zero and 5%, they’ll typically be down to 100% of the market. So you really get kind of that 100% correlation between, say, you know, plus five minus five, or wherever they place their bands, where we’re, you know, we’re really doing really four things to add economics, five things really to add economics to our to our fund. You know, one of them is this premium capture that I, I mentioned, where we’re selling positions around the market. And so that’ll do well, as long as the market stays within a band, say, you know, up or down so that that contrasts really dramatically with the hedged equity, which are really kind of litter linearly correlated with the market within that, you know, plus minus 5%. So we’ll have economics, really, they’re pretty consistent from that strategy. As long as the market stays within, you know, up a couple percent down a few percent on what we’re doing premium collection, it’s really a weekly position that we’re taking. We take those positions three times a week. So Monday, Wednesday, Friday, we’re dealing with the three expirations. So we’re looking to minimize, we’re looking for a minimal amount of market movement over the course of a week. And since we’re putting those positions on three times a week, we’re really, we’re really rolling the positions constantly. So our you know, the average length of those positions is about three and a half days. So that market really has to move pretty dramatically for those positions to get hurt.


Jeff Malec  33:50

And then is that is it fair to just say that’s classic option selling?


Russ Kellites  33:57

Right? Yeah, it really is.


Jeff Malec  34:01

And but on both sides, right. So in theory, you’re a little bit hedge there, if one side goes, the other side is going to erode back


Russ Kellites  34:08

and it’s possible to lose money on both sides. So one side will, will be profitable. And that’s, that’s an important part of what we do. But it’s one part where there are option premium phones that do just that. And so they’ll do that and they’ll never, you know, 1015 to one, there was a fund that got hurt pretty dramatically in 2018. They were levered. I think it was 61. So they’ll take they’ll take a lot of leverage to get consistent returns which look really good until something dramatic happens and so that, that dramatic event, you know that you know, once in a lifetime event happens every couple of years now.


Jeff Malec  34:54

We will put a link we did all we call it an autopsy. It was the ljm fund. So we have a great blog post doing an autopsy on that funds demise. Right? Yeah, there were a couple put in the show notes of this. But yeah, like you can get in trouble in a hurry there.


Russ Kellites  35:11

So that was 2018. And there were a couple of 2020 that had the same sort of problem. So that’s one part of what we do. Another part of what we do is we look for some market participation, and our market participation component is typically around 40%. So that’s going to give us about 40% of the upside, and downside, flip through the entire range of the market. So the markets up 10%, it would be, you know, 40% of that 10%, the markets down 10%, same thing. But then we’re using our directional indicators to try and modulate that. So we’re trying to get a little bit more of that when the markets up a little bit less than that when the markets going down. And when the market has these large, these long term trends, we do a little bit better during those during those cycles when it’s when it’s vacillating. You know, on a daily or you know, by daily basis, we can get whipsawed and get get hurt on this position. So, you know, willing for the market to go up, we increase our participation, the market goes down, we lose a little bit more than we’d like.


Jeff Malec  36:21

And that’s accomplished via the options or via just holding futures, typically, just holding the future, right. And so sometimes that’ll ramp up to close to 50%, sometimes down to 30%. Right? in that band, right? It’s


Russ Kellites  36:38

it’s usually kind of 40% plus or minus 10.


Jeff Malec  36:43

And how did you arrive at the 40%? Target?


Russ Kellites  36:48

Oh, we were looking at the overall risk of our portfolio looking at kind of how much risk we wanted to take on. And that was, that was where we came out 40 plus or minus 10. And I think it seemed to be a good counterbalance to what other funds in our space, were doing it, we saw hedged equity funds, for example, that seemed to have kind of that 50% correlation. So that seemed like it would be a good counterpart to those funds.


Jeff Malec  37:20

And then you sort of mentioned it, but Is this your understanding, I think it’s mine of, right, some of the hedged equity products, they’re selling the call in order to buy the put. So that’s capping their upside. So if the markets up 50% A year, they might only get 10%, right? Who knows where that top upside call is, but


Russ Kellites  37:40

what their explorations are. So if they’re doing quarterly, they will be limited that 5% on a quarterly basis, if it’s annual, it would be limited on an annual basis. So we’ll do sort of a quarterly reset. And it’s, it’ll be like clockwork, so December 31st, I’ll put emphasis on that run through March 31, etc.



Jeff Malec  38:05

And I feel like a lot of those programs haven’t had a bad run, because they haven’t seen either this big up market where they got capped out, everyone’s like, what the heck, we only made 8% Why? Or vice versa? Like it goes through that short put on the bottom. And losses great be like, Okay, I only lost, right? If they’re down 10% Maybe they only lose eight. If they’re down 40, they might lose 38. So it seems like a


Russ Kellites  38:33

right. I mean, they’re their markets that can be really bad for them, like a, you know, like a market that just declines 5% in quarter, four quarters in a row. So there’ll be down 20% Down here when the markets down 20% In the year,


Jeff Malec  38:49

right? No, nothing hedged about the verb versus you guys, because you don’t have the full exposure, by definition would be some percent


Russ Kellites  38:59

effective. You know, depending upon the exact circumstances a slow grind down of, you know, 5% a quarter could actually wind up being a good year for us.


Jeff Malec  39:16

Well, I want to talk through some of these different environments and how you view so we were talking about? Yeah, so it was one was premium capture to market participation,


Russ Kellites  39:26

right. So the third thing we’re doing is an upside participation. So what we’re trying to do is set up position so that if the market does kind of ramp up, we can take a little bit more advantage of that those structure we’d like for that as a is a call ratio. What we’re typically doing there is we’ll use a we’ll call one by two, so we’ll be long one, called near the market. In short, two calls further out. Typically, those positions are about two months to expiration. The long is about 200 points out of the money And the short is 100 points out and outside of them. So that position will be profitable all the way up to 400 points above the market, we typically do those two to three months in exploration. And we’ll do them typically every other week. So we’ll have four to six of those on on at a time. So kind of every other week, going out for two to three months. And then we’ll stagger the strikes as well. So the first one might, the two month might be two endpoints about the market, two and a half might be 250 points below the market for three and a half, three months might be three or points above the market, etc. So even if the market does really accelerate through that, that first earlier set of positions, we can capture the economics on the longer data positions.


Jeff Malec  40:56

Do you view that as so it’s a bullish trade, it needs the market to move up in order to make in order to be profitable,



Russ Kellites  41:04

right. And so we’re doing those because we’re selling to and buying one position, and we’re doing those pretty inexpensively. We’re typically getting them for, it’s about $1 $1 to two, depending really upon the ball surface, what’s going on in the market? You know, we’ve we’ve actually paid up a little bit for some recently. But typically, they’re pretty cheap. So even if the market doesn’t ramp up into that lower long position that we have, the economic impact is pretty, pretty modest.


Jeff Malec  41:44

And then that’s a good example for people to try and understand. So I’m buying a for call it $1. What does success look like, though you’re selling it out for how much?


Russ Kellites  41:55

Well, we did, we did well with those, say in the third, second, third, fourth quarter of 2020, where we were buying them for $1. We were getting them for free, we start selling them out around $20. We were selling them all the way up into the 40s. I think the best we’ve ever done is 60. So you know the the economics can be pretty dramatic. But at


Jeff Malec  42:22

some point, if it goes through the upper strikes, it starts to come back down, you can go negative.


Russ Kellites  42:27

So what we’re doing is well, you know, depending on where the market is, and the time to expiration, etc, we’ll be we’ll be selling those out as they start to become profitable. Sometimes we sell too early. We rarely sell we rarely sell too late. We’re, we’re taking economics when we can


Jeff Malec  42:47

all right number is there a fourth and five originally, this is the old who was that politician? You said three things and could only remember two of


Russ Kellites  42:55

them. Yeah, what was actually fine. But so the four, what was


Jeff Malec  42:59

that guy, the Texas Governor Rick Perry. I think that’s what what


Russ Kellites  43:04

does he do that. So the fourth is downside protection. And there you know, there are a lot of ways we can print it against downside. When volatility gets cheap, we’ll be buying. But we can recombine those outright, we can buy them and in a vertical. So we’ll buy a put near the market and sell one further from the market to minimize the cost a little bit. We can do we can do calendars where we’ll say buy one for a month out and sell one for a month further out or do the opposite depending on what the market the economics look like. We like actually hedging by going long vix futures. So we’ll do that frequently, depending on what the the volatility space looks like. Sometimes we’ll actually even in fact, frequently we’ll go short volatility. And when we do that, so we’ll sell vix future. And when we do that, we’ll take an offsetting position. And so there are a couple of ways we there are three ways we can we can do that. We can sell volatility, say sell vix futures, and sell s&p futures against that. We’re modeling that there’s a certain relationship between how much the VIX moves against how much the s&p moves. And so we’re typically doing kind of two to four to one, so we’ll sell, you know, say $1 worth of vix futures, and we’ll sell two three or $4 worth of s&p futures against that. I’m expecting that the s&p, s&p will go up less than the VIX will go down.


Jeff Malec  44:51

And so that’s not necessarily part of the downside participation. But that’s


Russ Kellites  44:56

actually is in that you’ll see it Really earlier in the month where the market would actually move down a little bit, but we would make money on the the decline in the s&p and lose less on the decline on the short term and the short VIX. And so when the you know, when the s&p is down, you know, to win in Nixon’s down one, that would be a profitable trade for us. There were days actually when the VIX was high enough as a starting point, where both the VIX and the s&p went down because we made money on both sides of that trade. So the third way we, we we do that is calendars that will be short or long, the front month and then the opposite on the back month. So for example, we might be short $1 of the VIX, 30 day, and long $1 or dollar 10, or dollar 20. The VIX 60 day.


Jeff Malec  46:00

And that’s the view that as long Vega and short fit like what’s it’s totally dependent on the curve.


Russ Kellites  46:08

It really depends on the curve. And what we really like to do is when you’ve got the right volatility structure, we like to take the opposite. We’re long the front month and short the back month. And so that would be you know, what you call a long Vega. Of course, if we’re short, front, long back or be short. And then the third thing we do is we will go short volatility, but we’ll certainly just short a vix future. But we’ll go. We’ll go long vix calls against that. And we typically do that in a pretty high ratio. So we’ll be long vix calls, you know, two to one, three to one, four to one, currently, it’s five to one.


Jeff Malec  46:50

And so in a min and a march 2020 thing that’s going to do much better than the short, does worse. Alright, so that whole bucket under downside protection is designed to be if the market and this happened with the front end March 2020. Right for the markets down sharply. These which we don’t get too far in the weeds, but we do here on this podcast. So it’s fine, but they have convexity. Right. So your your may be short, the last convex thing and long the more convexity. So the


Russ Kellites  47:23

right. So I think one of the key aspects of what we’re doing, which again differentiates us from many of the others, like you mentioned that the hedge equities will move around, you will change our portfolio based on where we are on that, on that quadrant on that on that four by four grid. And so for example, in March of 2020, we went from being you know, short vol short s&p to long vol to long vol long s&p, and so we were losing money on our longest position. But we’re making up for it in the long long vix futures position. And there again, it was kind of it was about a three to one that we had. So we were long $1 VIX, long $1 of s&p, but the s&p went down 25 ish percent. The VIX futures went up, or 400%. So, we raised 400 450. So we made, you know, 16 to one on our vix futures, where we were losing, you know, point two, five to one on the on the s&p.


Jeff Malec  48:39

And I want to circle back to that, because I think that’s important. But let’s finish out your five pillars here. So the


Russ Kellites  48:45

right so the last and this is, this is really something that’s, that’s critical for us recently, we’ve, we’ve been doing it for years, but it just hasn’t really added much to our economics. Because what we’re doing is in the derivative market, we don’t actually purchase positions, we post collateral against those positions on margin. And the margin rates on the instruments that we trade is, is really very favorable. So it leaves us with typically 70 to 80% of our nav in cash, the rest being what we post against collapse post against the posttest cap collateral against our positions. So that cash recently, starting really kind of last year, is now earning interest income for us again. You know, starting last year, it was in the 2% range, it’s gone up to four I think we’re getting, you know, four to 5% on our cash balance now. And so that just drops right to the bottom line. We’ve always done that we you know, we was profit for us back in the mid teens, but then of course with zero interest rates really didn’t have much worse.


Jeff Malec  50:03

So that’s essentially like the fun is a 9010 fund or something right or a 7525 Cash alts fun, right, and that 75 is income producing T bills tears,


Russ Kellites  50:17

and that touches on, you know, what we think is an important part of what we’re doing, which is, you know, we’re, we want to have a return, we want a positive return, we want to do well relative to, you know, what we look at really is not the s&p so much as a, as a is a balanced portfolio, like a 6040 portfolio of s&p versus that we’re not really just looking at the return itself, but we’re looking at the volatility of our returns versus the volatility of that, of that basket. And we think because of these five components that we’ve got embedded in our fund, we really compare pretty favorably on a volatility perspective, relative to that 6040 basket. Certainly, then, you know, the other funds,


Jeff Malec  51:06

right now would if I’m being critical, I’d say okay, but if I could just get the same, I could lower my volatility by just doing half the amount of s&p, right. And And could I get the same or similar volatility if I just did half? But would you come back and say, Well, yeah, but then you’re not getting the ability to flip the sign in a in a big down move, you’re not getting the ability in a flat market to earn some of this option premium, right. So help me understand that of like, Yeah, I think well, why don’t I just do 40%, s&p and get lower volatility and lower return, like your pillar to like, I could just do half the s&p and get nearly the same place,



Russ Kellites  51:46

I think you’d have to look at how the 6040 performs versus some percentage of the s&p and I imagine there’s a point there, where they, they equate equate, but the 6040 is going to give you a lower volatility, and the s&p itself will, whether that’s just s&p or some percentage, s&p. And we think that lower volatility is important, because it lets an investor or financial advisor, keep their investor in the fund when when times get really tough. So if you look back at times, like say, early, you know, early 2020, when the markets down 2025 30%, you know, there were countless investors that would call their financial advisor, you know, do it themselves, and just exit the market, because they, you know, they’d had enough pain, they don’t want to deal with it anymore. So they, they want it because of the volatility, getting out at exactly the wrong time. And the market turns around and goes up 3040 50%. So they turn around, get back into the market exactly the wrong time. It’s a lot lower volatility, we think less than investors stay and weather that storm a lot better.


Jeff Malec  53:06

And then, so talk through we kind of hinted on, like, how you would expect the strategy in some different environments. So right, like 2017 type, very little volatility, markets, just crawling, significant, you know, higher, higher, higher, higher market, I think we went 11 out of 12 months and six months without a 1% down move in 2017. So that kind of market, you’re probably in that most of the time in the market downfall quadrant and are expecting what to have that maximum market participation.


Russ Kellites  53:46

Yeah, that can be that can be a very good market for us. Because, you know, our market participation is doing well. If the volatility is low, there aren’t a lot of, you know, the volatility, volatility, if you will, you know, is low then we can do well with our, our premium capture, our upside participation could be kicking in, you know, we’re wasting money on our downside protection, but the other should more than offset that. And then, with high interest rates, you know, getting, say 5% on 70% of the portfolio can add three and a half percent to the bottom line. You know, before we do anything, so that can be that can be a good market for is it really kind of the markets that are difficult for us or where, you know, we kind of touched on this before, but it’s really kind of where we get where we get whipsawed. So, you know, we go from an up market to a down market. So we’re changing our participations and our structures. And then we went back to market and revert back to a down market. And so the whipsaws can really wind up eating or economics. You know, we had we had kind of a tough time in 2020 Oh, You know, we outperformed the market, but sorry, 2022 we outperform the market. But you know, not as much as we would like. And really, the reason for that is that our, you know, while we’re, we’re buying protection on the downside, as we entered the year, volatility was was priced pretty high. In fact, it was probably pretty fairly priced, maybe even overpriced. So as we were buying protection, there really wasn’t a lot of upside for it, there really wasn’t a lot of room for it to go.


Jeff Malec  55:33

And then I know you said, you’re wasting money buying protection, but I know you don’t really believe you, you’re wasting that money, right? Because in a right, so you have this slow grind upward, probably going to be good for the strategy, you’re going to almost max participation plus some option plus and to slow grind downward 2022 You send not that great, but to me, like, you’re only going to lose somewhere half ish, right of what the of what the market did, because you’re only participating 40%. So even if those options strategies don’t kick in, they’re not going to bleed enough to turn right into a full s&p loss or something. So I know, yeah, clients probably don’t like that if like, Hey, I can’t eat relative performance, right? It’s the old line of like, great, you lost me half, but I still lost. And then the third scenario would be a sharp, move downward. So in a sharp move downward, that’s where I come in. I don’t think you believe that you’re wasting money buying that downside protection?


Russ Kellites  56:33

Right? Well, right. I mean, I said ways that it was it didn’t it didn’t fall down to our bottom line. But yeah, just like an insurance policy. You know, when you’re writing your check to Geico, if you haven’t had an accident, you might, you know, it was, it was important that you had that position, but it didn’t really do a lot of good. But, you know, so a good market for us can be well, you know, a good example is, is early 2020, where, you know, we were coming into the year and had a pretty normal environment. That had been pretty, pretty calm. So volatility was, was, you know, was priced pretty low. The VIX was in, you know, 12 ish range. And so as the market started to turn, it was a great opportunity for us to buy protection very economically. And so we started buying those, those those vix futures as the pricing was around 16. And then the market just really started to drop the price of protection in the VIX really took off. And so, you know, the price of those positions went from, you know, 16 to, I think we started, I think we held on to them all the way up to 82. We added on the way up, but, you know, we sold some out at the top, which was a look, they expire at 82. So it’s, you know, kind of a four fold, increase in the value of those. So that can be a definitely good environment or as where, you know, you’re you’re kind of coming out of this, there’s this calm before the storm. And there’s an opportunity for us to to acquire some protection inexpensively. And then, of course, the market just, you know, flips and we can take take real advantage of that.


Jeff Malec  58:27

It seems like that’s the answer to a smart, smart ass like me, like, why wouldn’t I just do there’s plenty of things I could do to get less volatility, right? Why do I need to do all this? Like, well, because I can read, I can change the sign in a big down move like that a big spike down.


Russ Kellites  58:42

That’s true. And we do think we compare on our risk adjusted, so volatility comparable basis, we think we compare pretty favorably to, you know, the 6040 portfolio, which is really kind of a benchmark, you know, we could look at different scenarios and how long you’d have to be the s&p to outperform us, I think you’d still have more volatility. But in fact, I’m certain that the only way to return and lower volatility is by adding that that debt portion, which of course, you know, hurt you pretty dramatically in 2022.


Jeff Malec  59:21

Right? A lot of those logic is based on before bonds were super volatile, right? So even if they’re clipping along a nice return if they’re super volatile, it’s going to make that portfolio a little more volatile which which breaks a lot of that modeling thoughts on zero d T E.


Russ Kellites  59:46

It’s an interesting space. It’s not one we’ve really gotten involved in yet.


Jeff Malec  59:51

Like crazy meme stock option traders all that stuff.


Russ Kellites  59:55

Yeah, we it’s not our thing either.


Jeff Malec  59:58

Leave it to the pros have Have you seen the Walt Disney that there’s a movie coming out about the GameStop? stuff? And oh, yeah, it looks fantastic. Like it’s got Ken Griffin and all the fen guy from Melvin capital not themselves but


Russ Kellites  1:00:13

actors playing. Interesting story. Yeah.


Jeff Malec  1:00:17

So yeah, I’m gonna,


Russ Kellites  1:00:18

I’m going to try and get about crypto and SPF coming out as well.


Jeff Malec  1:00:21

Yeah, I’m sure they’re lining up paying to get that going. Great rise, but it’s been fun. Thanks for all the info. What’s your just quick before we go, like, What’s your thought on your run in the private fund, you know, each investor maybe on a, you know, outside your family and friends, you know, people personally and you’re explaining it to him versus mutual fund model, you don’t really know who’s buying it, or what their motives are questions are like, is that been hard for you? Or it’s recommended to recommend all fund managers do it?


Russ Kellites  1:00:56

No, it’s it’s interesting. I mean, I think I think the biggest difference between the, you know, the hedge fund and what we’re doing now, and you know, we’ve been doing this, since 2016. So, coming on seven years, is, is the daily price discovery. So with the hedge fund, we had an entire month to work on achieving economics 15 days, after the end of the month, the economics would come out a week or two after that investors would want to talk to us. And so then, you know, maybe they they’d subscribe or redeem, they would put in the notice at the end of that month, and so then the funds would flow at the end of the following month. So really, there was kind of a two month window for ebbs and flows in economics, the the communications around the fund, were a lot more sporadic. Here, you know, if we have a, if we have a good day, investors see it immediately. If we have a bad day investors see it immediately. You know, we’ll get calls from investors, or not from investors from phase asking, you know, you know, why wasn’t the fund up more, you know, why was the fund down or whatever it really kind of on a daily basis. And you’ve kind of managed to work with the financial advisors, so they kind of know what to expect. And they can moderate how they communicate with their investors a little better.


Jeff Malec  1:02:33

But it strikes me what you were just saying, like, it doesn’t make sense a lot of time to judge funds like this, and some other alternatives and options, like on a day to day basis, right? Like, if I sold this option with an expectation that it’s going to do X over the next 45 days. On day five, if it’s losing money, and I’m like, I’m out. Right, that doesn’t make a lot of sense, like being a distressed debt mutual fund wouldn’t make a lot of sense, right? Like, month two people are like, Oh, this isn’t working. Like we need time in order for it to play out.


Russ Kellites  1:03:05

That’s That’s exactly right. And that’s the point of kind of a low volatility. More likely correlated fund, it’s a long term investment, that lets someone put their put their money into it, and watch it grow over time. They’re looking for, you know, the the fast, profitable trade, then, you know, they’ve got to turn to the Kryptos and the memes and things like that, you know, that they can, you know, maybe make 50% in a day or whatever the crazy numbers are, of course, it works the other way as well.


Jeff Malec  1:03:38

Right. All right, the most important question, did you have all of your hair when you started this one?


Russ Kellites  1:03:44

I have a lot of it still is. Yeah.


Jeff Malec  1:03:47

Right? Because then we’d be really worried. Yeah.


Russ Kellites  1:03:50

I had as much hair as you. Whoa. All right.


Jeff Malec  1:03:53

So there you go. Folks, don’t be an option trader for living, you might lose your high res. It’s been five years. So you don’t have to exactly appreciate it. That is true, right? Like you’re, you’re looking at all this day to day you’re taking on this volatility, you’re analyzing it. Right. So the investor doesn’t have to do all that work. That’s right. Awesome. Appreciate it. We’ll talk to you soon.


Russ Kellites  1:04:16

Thanks, Jeff. Appreciate it.



This transcript was compiled automatically via Otter.AI and as such may include typos and errors the artificial intelligence did not pick up correctly.


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