With “active”, carbon-based traders slowly becoming extinct (alongside the entire hedge fund industry courtesy of central banks who have banned all market corrections and the need for “hedging”) and are gradually replaced by cheaper robotic, algorithmic, programmatic and other passive equivalents, the market has become progressively more boring, with equity vol collapsing, as most strategies are largely alligned – after all they mostly respond to the same set of signals. However, that is only half the story: while the vol has indeed collapsed, in the process the shift to passive strategies may have planted the seeds of the market’s own destruction as JPM warned over the weekend when Nikolaos Panagirtzoglou said that “The shift towards passive funds has the potential to concentrate investments to a few large products. This concentration potentially increases systemic risk.“
An example of just this “war of the robot (traders)”, is that as Credit Suisse observes, a “quant war” is quietly taking place, and as Bloomberg eloquently adds, “computer is fighting computer in a hedge fund tilt that could get messy regardless of the winner.”
The underlying war involves Commodity Trading Advisors, or CTA funds on one hand, who have turned bearish in recent months, and have pushed short sales against U.S. equities to a level that exceeds any time during the bull market other than August 2015.
On the other hand, we have long-short equity funds, which try to minimize the impact of market moves or add leverage by pairing trades. According to an analysis by Credit Suisse Group, their stock bets are bullish, and last week stood at the highest in nine months.
As the chart below shows, the spread between the implied market bias of these two sets of automated stock pickers is the widest it has been since last summer’s market crash.
It’s the polarization that bothers analysts, who say this kind of positioning has set the table for marketwide volatility in the past and is worrisome when an event like Tuesday’s vote looms, Bloomberg notes. While neither group has built up its holdings with politics strictly in mind, either could be triggered should markets swing as Election Day nears.
What’s worse, the study author observes that “someone is wrong”, and that the return to normalcy for one of these two trades will result in a major surge in market vol.
“No matter what happens, there’s going to be volatility, because someone is wrong,” said Mark Connors, Credit Suisse’s global head of risk advisory in New York. “Even though we won’t have rate resolution, we will have the look of Congress and there will be some position changes given the positioning is very disparate — very long and very short. That’s unstable.”
The problem facing the quant world is learning how to respond to the same signal imputs. For the most part, the responses have not led to a wide divergence, however something appears to have changed this time around: “as the quant population exploded, analysts have spent more time trying to pin down how they will react to volatility and other inputs. And with good reason, as long-short funds are sitting on $215 billion in assets, while CTAs oversee some $330 billion, according to BarclayHedge, a database that tracks hedge fund performance.”
The major divergence observed above is troubling to Connors, because it is reminiscent of the periods before the two most recent corrections, when funds took similar opposing bets. Trend-following commodity trading advisers and equity long/short funds are currently 47 percentage points apart in their U.S. equity exposure, the largest spread since just after the S&P 500 Index bottomed in February. Before that, the last time the spread grew to more than 40 percentage points was in August and September of 2015, the worst two-month stretch for the S&P 500 since 2011.
The causes for the variance in quant sentiment have been isolated: CTAs bearishness is being spurred by an event occurring after the election: the Federal Reserve’s December meeting, when rates may rise, Connors said. On the other side, equity long-short managers have been buying neglected companies like banks in anticipation of higher rates, he said due to relative valuation mispricing.
But even before the December rate hike, there is even more political risk in the form of Tuesday’s election: as Bloomberg points out, while traders are pricing in a 78% chance of a rate hike in December, the election threatens to act as a catalyst before the Fed meeting arrives. While the market has been pricing in a Hillary Clinton victory, if Donald Trump wins or the Democrats sweep Congress, the result may be selling, according to Citigroup Inc.’s Tobias Levkovich. “The markets aren’t not happy with either a sweep, with Democrats it’s a worry about taxes and stuff like that, or if Trump wins because of the uncertainty factor,” Levkovich said on a Wednesday interview on Bloomberg TV.
While either CTAs or long-shorts are poised for a major loss, by virtue of their relative positioning, it has already been a tough year for for managers in both groups, which may leave them impatient if markets turn. According to BarclayHedge, equity long-short managers returned 0.6% YTD while the SG CTA Index fell 2.1% over the same period, while the S&P 500 gained 4 percent.
Because they fell behind the benchmark, equity long-short funds have been forced to buy more stocks as U.S. earnings surpass analyst estimates, said James Abate, chief investment officer at Centre Funds in New York. Meanwhile, increased correlations between asset classes have also driven CTAs to ditch stocks, he said.
“The problem with macro-CTAs is they tend not to be anticipatory of anything, they tend to be trend followers,” Abate said “People are going to react to the election, not position themselves prior to the election.”
While it is unclear if the market rises or falls over the next few months, one thing that appears certain is a surge in volatility. Options traders have already begun gearing up for volatility. A spread tracking demand for protective hedges — implied versus realized volatility on the S&P 500 — just reached the widest since right before the British vote to leave the European Union, data from Bloomberg show.
“Faced with a binary event like the elections, investors simply cannot go into it unhedged, especially with the memory of Brexit still fresh,” wrote Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors in New York, in a note to clients Wednesday. “The bid to near-term volatility is being driven by hedging ahead of the elections, especially as the polls tighten.”
As we pointed out earlier, VIX has nearly doubled in the past week, and today closed at the highest level since the Brexit vote. Because in the quant war, the humans’ best option is to play defense.