Watch: Masters of Risk | Season 4 Episode 5 (Video): Beyond Diversification: Strategic Risk Insights for Modern Portfolios

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Stewart Webster   00:00:00

Welcome to a special edition of the Masters of Risk podcast coming to you from the 2026 Definitive Risk Conference hosted by S&P Global. This event brings together leaders from across markets, finance and risk management to explore how risk is being understood, measured and managed in an increasingly complex global environment. For this episode, we recorded a series of conversations with senior practitioners spanning valuation, derivatives, private credit, asset management and nonfinancial risk. Each discussion offers a distinct vantage point on today's risk landscape, how uncertainty shows up in different corners of the market and how firms are adapting in real time. Individually, these are focused conversations. Taken together, they tell a broader story about how risk is evolving across asset classes, business models and market cycles. This is Masters of Risk. Let's get started. Today, I'm joined by Karan Sood, CEO and Co-Founder of Vest, a fintech innovator reshaping outcomes-oriented investing through defined outcome ETFs and buffer strategies. Prior to Vest, he spent years at ProShares and Barclays Capital focused on options-driven strategy design and the engineering of defined investment outcomes. Karan, thank you for joining the podcast today.

Karan Sood   00:01:31

Yes. Thanks for having me, Stewart.

Stewart Webster   00:01:33

Absolutely. And I guess for our audience of the Masters of Risk podcast, can you talk a little bit about Vest and the type of ETF strategies you guys deploy?

Karan Sood   00:01:41

Yes. So you said it in your opening remarks, we are a defined outcome-based investment firm. The building blocks of what we incorporate into our investment funds are derivatives -- those are the ingredients. But what investors, consumers of investments perceive them, incorporate them into their portfolios as defined outcome ETFs. So we give investments that provide access to broad market, but with defined levels of downside protection, defined level of income, defined level of upside capture. So there's less surprises from your investments. We like to think about it as we are unlocking the power of derivatives for everyday investors.

Stewart Webster   00:02:29

Right. So you mentioned different capture ratios or different upside ratios, downside ratios. So I guess you're minimizing the upside ratio. And I guess you're also minimizing your downside capture as well. But are you still producing, I guess, a conex profile or.

Karan Sood   00:02:44

I guess the way to think about it is most investors think of investments, like, let's say, the most popular investment asset class in the world, U.S. equities. So you go along the U.S. equities with the very famous benchmark that you guys have built, the S&P 500. You go buy an ETF that tracks that S&P 500 Index. You get all the upside, you get all the downside and you get this very uncertain income profile, which is like once in a while, throw out dividends, sometimes the dividends in certain market conditions are high, sometimes they're low. And that produces a lot of uncertainty in customers, in clients, investors' portfolios, where in some years, you could get a massive amount of upside. Other years, you could get a decent amount of downside. So what we do is we trade those off. So as an example, one of our most popular ETFs that we manage provides S&P 500 exposure with 10% downside protection. So the first 10% of the losses are protected. So if the S&P 500 was down 1%, the fund over a 1-year holding period would be down nothing before fees and expenses. It was S&P 500 was down 11%. It's in that case that you'll start taking losses and the fund would be down 1%. You get upside up to about a 20% cap as an example. So if S&P 500 is up 15%, the fund is up 15%. The S&P 500 is up 30%, that's when you're like -- that's your give up. You're going to be up only 20% capped up at 20%. So that kind of a trade-off is fair. There's not like Alchemy up here. We're not producing a lot of upside and no downside. We're just moving and transferring risks around, and it has a high utility for investors because now you have something that's more predictable and has a profile which you can match to your specific outcomes that you might have. You might have a target, a savings bucket and you might say, I'm ready to take up to 20%, 10% kind of losses on this. And so we have an ETF for that. And one more aspect up here, I gave you an example of 10%. Of course, there are all kinds of investors out there. So we have -- at the most recent count, we manage more than 100 ETFs. It's almost for every risk profile, for every market exposure, there is an ETF. So we have 10% protection on the S&P 500, we have 20% protection on the SP 15%, 25%, 100% and you get different kinds of upside profiles corresponding to that. We have a version of that for income, where you have 5% income, 3% income over risk-free rate. We have 12% income and corresponding downside for those scenarios. So we -- as the term defined outcome means, we define the outcome. First, the investors engage with the investment with the defined definition in mind and all the other risk and returns settle where they may.

Stewart Webster   00:05:53

That's interesting. And I think it's a great strategy because you're actually making the returns more gradual, right, and more predictable in nature. And you mentioned that you're protecting against a 10% downside, right? And I would categorize that as a contraction, right? And multiple -- we have multiple contractions in a normal cycle, right? And any time that there's a 20% decrease, that's when you get into the bear market territory. But you're protecting investors from those contractions. Exactly -- and they're still able to participate on the upside and you're protecting them from periods of irrational exuberance, right? So any time that you're greater than 20% of return, chances are we're going to see a market pullback, and that's why you guys are selling off the higher end of that. Do you guys do that through derivatives? Or how do you guys deploy that fund level?

Karan Sood   00:06:38

Yes, you guessed it. So the building blocks for this are derivatives, right? So arguably, a lot of investors could do it themselves. But there is a certain expertise we have in doing -- having a very deep understanding of derivatives, having a deep understanding of the derivative market, the infrastructure, the market structure that's available for us to build these investments, do them at scale, get institutional level liquidity and pass that on with the beauty of wrapping it all in an ETF wrapper. So that investors don't have to do it themselves. I mean they're welcome to do it themselves and a large number of investors do that. But it's still a minority. For the most majority of investors, it's a packet solution, which is where funds are, and they can put in a ticket and get this risk profile in one click of a button.

Stewart Webster   00:07:25

Absolutely. And I'm sure the industry is blowing up, the ETF industry. And when I say blowing up positively, it's increasing rapidly versus mutual funds. Historically, mutual funds were to go to for retirement clients or individuals who are retiring. And the reason why ETFs are more liquid in nature and then they have lower expense ratios, right? So -- but I guess if we can talk a little bit about the risk that you see as an ETF manager. One of the risks I have learned about is the tracking risk, right, where, let's say, you have a fixed income, you're tracking a fixed income index and let's say, it's an aggregate fixed income index with thousands of companies, you can't track every single one, right? You can't take that full replication approach because it's so expensive. So I guess you would take like a sampling approach or some type of optimization approach. But I guess how do you eliminate tracking risk on your side?

Karan Sood   00:08:14

Right. Yes. So we -- I'll talk about what specifically we do, which is kind of unique, perhaps even talk in general to that risk. So in general, to that risk, there are pockets of the market where that risk is maybe more magnified. But I would say like ETFs have been around for a few decades now, passive investing, if you may, has been around enough that there's such a high level of expertise in this space now that tracking at a risk is something that you don't necessarily have to take unless you're being rewarded for taking that kind of risk, right? So if you're -- as a manufacturer of products, our intent is to deliver to our investors investments with low tracking error, there's no excuse. It's feasible today to deliver investment with very low tracking error to negligible tracking error. But the beauty of our products is that we use derivatives and derivatives are contracts. So there is generally a counter party to the derivative. So if you're using listed options as an example, the counterpart of the listed options is the option clearing Corporation, a systematically financially important institutions in the U.S. ecosystem. that has guaranteed the return that's embedded in the derivatives. So it's -- there's a contractual guarantee that if you're buying, as an example, a derivative or an option on S&P 500 Index, the counter party is going to deliver us the returns of S&P 500 Index. That's a really neat way to build an investment where there's no tracking error because it's like the counter party is contractually obliged to deliver you the returns of the S&P 500.

Stewart Webster   00:10:03

And the derivatives that you're mentioning, they're more standardized contracts, right, options. Do you guys get into any of the over-the-counter type contracts that would increase counterparty risk that you have to assess?

Karan Sood   00:10:14

Yes. So I would answer it in 2 parts. So first, there is a very high -- very robust infrastructure in place for listed -- standardized listed options. But the same infrastructure that exists for standardized listed options also exists for a unique kind of an option called the flex option. So all the benefits of being on an exchange, multiple counter parties, multiple liquidity providers competing to give you nationwide best bid offer, but the exchanges allow you to customize certain elements of the option contract. So these flex options, many people have heard of them. They've existed since 1993, but it's only recently since we sort of -- we, along with other firms, have like led the charge in building these kind of investments that these flex options have become extremely liquid, extremely robust. And we, in our firm, capitalize on those. So it gives you the best of both worlds. You get customization, which generally is feasible through OTC derivatives, but also you get the standardized liquidity infrastructure that's available through exchange trading. Now having said that, we've been doing this for more than a decade now, and the industry has sort of followed in our footsteps and there have been flux around in this category. As you talked about, ETFs are blowing up in a positive manner. This space is also blowing up in a very positive manner. And today, the space has evolved to take this liquidity infrastructure that has become very robust and replicate it, starting to replicate it over-the-counter derivatives. So you can have multiple counterparties competing at the same time, even though they're over-the-counter and you're doing it on a party-by-counterparty basis. There's a robust fund infrastructure to collateral manage. So to the extent there is a counterparty risk, it's being collateralized on a daily basis with liquid collateral like treasuries. And so that mitigates the chance of a credit concern that you might have with more uncollateralized or unsecured obligations, which is not the case up here. So I would say there's always a hazard in like if you try to tell what's going to come in the future. But I would hazard a claim that we will see a lot more ETFs and all kinds of funds that are built on this new layer of OTC derivatives.

Stewart Webster   00:12:46

That's fascinating. And one of the things I wanted to ask you about -- so we talked about this already. One of the benefits of ETFs is the liquidity aspect, right? You can sell at any time during market hours versus a mutual fund, you have to wait to the end of the close essentially. But now I'm starting to see alternative investments, private credit perhaps being placed in ETF. So you're taking an illiquid investment strategy and putting it into a liquid vehicle, right? So how does that affect the liquidity of ETFs when you start introducing these illiquid assets?

Karan Sood   00:13:18

Yes. I mean I can't speak very specifically to those products because our company does not manufacture those products. But I would say, as a manufacturer, as a designer of products, there is a standard that's established by regulation, right? Like there's the Invest Company Act of 1940. There is the ETF rule. And then there is an expectation that's set by the customer, right? So we take it all for granted that ETFs are liquid. But that assumption sits on an infrastructure of authorized participants. There's a whole ecosystem market structure around ETFs that needs to function for this to be viable. And so if you are coming up, which we do sometimes, coming up with investments where the underlying securities that are held by the ETF have potentially a different liquidity profile. How do you match the liquidity profile of a daily liquid ETF -- and there are different ways to do that. I think I could enumerate and we could be sitting here for hours if we wanted to go through all of them. But one example is you can source contractual liquidity from the marketplace for some of these underlying investments, right? So you can say, hey, I get into a contract with a liquidity provider who has expertise in managing the risk of these kinds of investments and up to a size, I can get contractual liquidity that fulfills the liquidity that you're trying to map on to with the fund. And if you can do that in a robust manner, you can do that with a large number of counterparties, then you can live up to the high governance standards set by the law. You can live up to the expectations for the clients. I think that's how we would choose to do it. That's how we've done it. And it can be sometimes a bit of a slippery slope where you feel the pressure too highly from the customer wanting certain kind of access -- and perhaps in their hunger for that kind of access, they're probably turning a blind eye to potential risk that could be playing downstream down the line. And it's -- we take pride in managing those risks. And if we anticipate that the customer really wants a liquid risk profile, if we cannot fulfill that demand from another vehicle, then we'll make sure we put all this infrastructure in place for the ETFs.

Stewart Webster   00:15:43

Sure. And you mentioned your customers a couple of times. Who are your customers? Are they the retail investors who are retiring? Or are they institutions like endowment funds, pension funds or perhaps a hybrid of both?

Karan Sood   00:15:54

So like one sort of framing of the market as a whole is like you have self-directed investors on one side who are like really managing their money by themselves, large voice on the Internet. And then you have institutional investors who also manage -- professionally manage money themselves. They have the resources to do that. But then you have this really large segment in the middle, which is sort of called mass affluent or wealth management, where generally the wealth of families and individuals is being managed by intermediary, like a financial adviser. This is the space we focus on. So we believe there is a level -- even though we try to simplify the product, there is a level of complexity, perceived complexity in our products. There is a level of education you should have to use them responsibly, and that's best tackled by a professional. And so we work with financial professionals. We educate them how to use our investments. And to manage the wealth of a wide diversity of investors, investors who are young, investors who are older, investors who have different risk profile, regardless of their age, our investments, not exclusively, of course, there are other very compelling investments from other asset managers. fit into this portfolio approach that the financial professionals take. They make room for these kind of investments because they have certain utility in their clients' portfolio, along with other investments.

Stewart Webster   00:17:22

Sure, absolutely. And you live in or work in the space where many investors who are not professional finance investors, they really don't know that you guys exist. And what I mean by that is if you have someone who's retired and they purchase a bunch of ETFs, they know their financial adviser, the person who sold the ETF and decided that they should put their money in that ETF, but they don't realize that there's someone who actually engineered the exchange traded fund and is involved in the portfolio construction. So you guys are kind of like saving the day behind the scenes, if you will. I did want to get your take on where we currently are in the market, right? This is interesting times because the larger indexes, S&P 500, the NASDAQ, they're at all-time highs right now. But then I do see crude oil prices increasing dramatically. The long end of the yield curve is increasing as well. So I am seeing some risk being priced in the market on the fixed income side and commodity side. But then on the equity side, we're just making all-time highs every day. And I guess that could be because of CapEx spend. But I guess, do you think we're in the area of exuberance? And when do you think we will start to pull back, if you will?

Karan Sood   00:18:32

Yes. I think like maybe sometimes it's good to answer these kind of questions by taking like 10 paces back and look at it from a high level. And I think embedded in your question is this very sound assumption that like contrarian thinking is generally rewarded by the markets and like overcrowded trades are punitively punished by the market. And so what is it today that investors are overcrowded in? And the irony is that I think the overcrowding is happening on risk management. So if you go to ask like most people, hey, what's your best tool for managing risk? I would think like 9 out of 10 investors. And I'm not trying to qualify like there's a knowledge arbitrage up here. I would say this is probably true for even financial professionals who will say, diversification. It's a really good tool. It's a blunt tool. Everybody seems to be using it. And I think that's a dangerous thing. It is a sound concept, like I could evoke my late grandma and she would say, don't put all your eggs in the same basket. It makes total sense. I could evoke the great Harry Markowitz and he would spell out the modern portfolio security, which basically says, hey, don't put all your eggs in the same basket. But I think it's not the free lunch that everybody is making it out to be. I almost I use this phrase to describe what's happening in the market today, and I call it the diversification delusion that you're sort of thinking your risk management is your pie chart. Like I've got a little bit in equities, I've got a little bit in bonds, I've got a little bit in private equity, and you feel like you have this one blanket of protection if things were to go haywire. But I don't think that one blanket is an armor. Well, firstly, because if you look at like you pointed out on the equity side, we're highly concentrated in most broad equity exposures in U.S. equities. very high concentration in U.S. equity. So when you look at U.S. equity benchmarks, again, S&P 500, 10 companies. We take such high level of comfort with that number, 500, S&P 500, a lot of companies feels nice and cozy like I'm diversified. But 2% of the company, the top 10 stocks are making up 40% of the performance, right? So highly concentrated. And then I would say that's the sort of tactical concern with regard to diversification, like everybody thinks on the surface, things are diversified, but under structurally, they're very concentrated. But also, there's like -- I think to some extent, there's a structural case against diversification, which is there are all these threads that connect asset classes, which are perceived to be noncorrelated. -- like sentiment is one of them. Valuation is some kind of multiple on earnings. So your earnings could be highly diversified. But if you look at valuations today, they're so high because of that multiple. And the multiple is sentiment driven. It could be the same sentiment that's driving prices higher in oil in gold that might be driving prices high in equities. And so when the sentiment change, all these perceived non-correlated asset classes could go down together, right? There's leverage. Leverage is a common aspect around these, like so if you take this dilution to another level and you say, "Oh, this is like I'm so diversified. I have like low risk. Let's leverage this. And then when this turns, you're going to delever from all these asset classes together, so they will get correlated. There's common risks like interest rates. Interest rates are like gravity. -- like when interest rates go up, you talked about the yield curve going up. it's going to pull all asset classes, prices down, right? So again, everything is correlated. So you look back at data, thanks to the data available to us through S&P Global, you can like look at the data analysis and you come with a single correlation number. It's like, wow, this is low correlation. But what you don't realize is that correlation number is not static. It's going to go really high when you need it most to be low, right? So we saw Nifty 50 in the 1970s, right? 50 names, everybody thought there were the darlings of the time and like probably 2 names left out of those 50. We saw in the dot-com bubble, right, like really strong interest seems almost similar to what we are feeling right now around how Internet was going to change the world, and it did, right? But when it did not for a while, everything became corated. -- everything went down together. So when you need this diversification, it portrays you. And I think this is the risk. This is where everybody is diluting themselves into this comforting position that we are safe because we are diversified because you look at that pie chart. But there are all these connections in that pie chart that you're not looking at.

Stewart Webster   00:24:00

Yes, I completely agree with your sentiment because, let's say, as an investor, I can be in U.S. large-cap equities, U.S. small-cap equities, I can be in fixed income, global fixed income or domestic fixed income as well. And I can say on paper, I'm diversified, I am, right? But I'm not diversified in terms of the risk factors, right? There's inflation risk factors. There's interest rate risk factors that I mentioned. And let's say, the bond portion of my portfolio, that bond allocation can -- one of the risk factors that affects it is inflation, but then also on the equity side as well, right? So I need to eliminate the inflation risk factor to diversify effectively, right? You have to diversify the risk factors, not necessarily diversify the allocations.

Karan Sood   00:24:43

Yes. So yes, one approach is to diversify the risk factors. And I think it's a sound, well-motivated approach. But just like diversification, which is sound conceptually, but once you get into the details, it all rests on some mathematical assumptions like correlation being static, right? Like the moment you say the correlation is not static, you've got to model correlation. But then if you make it random, then you actually see it's very -- it's not as resilient. And so my worry is that even factor-based approach, you're just replacing it with from one lesion to another. I mean, I see the sound aspect of it, and I certainly think it's a better approach than to just look at asset classes and assume they're not correlated.

Stewart Webster   00:25:35

Absolutely.

Karan Sood   00:25:37

I'm going to hazard another claim, which is there is another way to do it. And the analogy I draw is how do -- how we manage risk in our own lives, right? Like so if you're going to drive to work every day, you're not going to diversify your risk of driving by taking different routes every day or you're not going to drive different vehicles every day. You're not going to say, I'm going to take the bus today, I'm going to take the train today, I'm diversified, right? Like what you do is you say, I'm going to buy myself some insurance. And you say, if I was to go get into an unfortunate accident, the loss that I would incur to my health, to my vehicle, to my property would be covered by somebody else who I'm prepared to pay a premium to to make up. That risk is risk mitigation, but it's more active risk transfer as opposed to this more diversification approach. And if you think about what's the insurance of capital markets, what is something that says if this happens, then I will get compensated for every dollar, it's worse than this event. That's an option. That's a derivative, right? So you're basically saying, if the S&P 500 drops more than a certain strike level, for every dollar it's below that strike level, this option contract, like an insurance contract is going to pay me. And so if you can build investments through derivatives, where you're actively transferring the risk that you don't want and paying for it also with some of the upside opportunity that you think you're ready to give up, you can build something that's not dependent on backward-looking assumptions. It doesn't depend on correlation. It doesn't depend even though better than your analysis of risk factors, which could be fallable, is almost like a contractual level of guarantee that you're not going to feel that risk.

Stewart Webster   00:27:44

Absolutely. That's a great point you made. And I guess as my last question, what risk do you think investors are underestimating the most when we look at the next market cycle?

Karan Sood   00:27:53

Yes. I would say it's the correlation risk. It's the diversification. I think the risk is this comfort feeling that we are diversified. And like it's eerily similar to the credit cycle in 2008, eerily similar to the cycle in the dot-com of 1999, where for every phenomena, there's a very good explanation like it is justified for us to be concentrated because look at it, it's the Internet. It's going to change our lives or look at it, we are putting together credit from different neighborhoods of mortgage loans. And so they're non-correlated. But that wasn't true because tail risk, we assume is linear, but it doesn't -- tail risk compounds. It's multiplicative. When there's a default in one neighborhood, it has a contagion effect to the other neighborhood because one person's income is another person's livelihood. One person's income is another person -- one person's expenditure is another person's income. And so this just we are connected in so many ways, the asset classes are connected in so many ways that it's hard to appreciate how this is an illusion. -- diversification can become an illusion. And I think there is tactical, topical measures that are just off the charts right now in terms of how concentrated we are in terms of the risks.

Stewart Webster   00:29:44

Thank you, Karan. It's nice to meet you, and thank you for joining Master of Risk today.

Karan Sood   00:29:48

Likewise, thank you.