Computer-driven investment strategies that automatically sell when market turbulence erupts have exacerbated this week’s swings, offloading up to tens of billions of dollars’ worth of US shares, according to analysts.
So-called "volatility-targeting" funds that manage about $400 billion (€356bn) in assets have bought up stocks this year as markets have calmed since the dramatic end to 2018. But the renewed turmoil means they were pegged to sell $50billion by the end of Wednesday, according to Wells Fargo estimates.
“When volatility jumps, systematic funds rebalance portfolios away from risky assets like equities,” said Pravit Chintawongvanich, an equity derivatives strategist for Wells Fargo.
Automated, volatility-sensitive trading strategies have become a popular bogeyman in recent years, with many analysts and fund managers blaming them for exacerbating market swings.
The renewed spurt of automated selling comes during a crucial period for the US stock market as it responds to slowing growth, fresh tariffs on Chinese goods and a tepid market response to last week’s Federal Reserve interest rate cuts.
There are several different types of funds and trading strategies that target a certain level of volatility, and therefore ratchet their equity exposure up and down according to the strength of market fluctuations. They mostly use liquid financial products such as futures and exchange traded funds.
Volatility funds
Volatility targeting funds, or managed volatility funds, are primarily managed by insurance companies as part of their variable annuity products. They are often grouped alongside other systematic, volatility-sensitive investment strategies such as trend-following hedge funds and so-called “risk parity” funds, although these tend to move more slowly.
Together, they represent about $1 trillion in assets that can have a big impact on market booms and busts, according to some analysts. Monday’s 3 per cent drop for the S&P 500– the worst day this year for the share market – was exacerbated by a group of these funds responding to the sell-off last week, traders and analysts said.
"Systematic flows were a large proportion of the market activity on Monday," said Michael Lewis, head of US equity cash trading for Barclays. "When you see the stock market grind lower, that indicates systematic, quantitative selling, which is likely what we saw on Monday."
Mr Lewis pointed to the heightened trading volume in ETFs, which are popular investment vehicles for systematic funds to gain exposure to the US stock market. ETFs accounted for about 37 per cent of trading volume for the stock market on Monday, up from about 28 per cent for a typical trading day, according to Barclays data.
Volatility-targeting strategies have loaded up on US stocks as volatility has edged lower this year. The CBOE Vix index, known as Wall Street's "fear gauge" dropped from 23 points at the start of the year to 12 by mid-July. The recent bout of selling pushed the index back up to 23 by Wednesday evening, a level that would trigger sustained selling by the volatility targeting funds, said Parag Thatte, a strategist at Deutsche Bank.
“What we’re seeing over the last two or three weeks is a disconnection between systematic funds that increased their exposure to stocks and discretionary funds that have cut back,” said Mr Thatte. – Copyright The Financial Times Limited 2019
