While human portfolio managers are concerned about economic uncertainty and the health of the U.S. banking system, some algorithm-driven hedge funds have been buying stocks at one of the fastest paces in a decade, according to the bank’s trading desk.
Quant funds have been piling into U.S. stocks in response to falling volatility, helping support the market as active managers stay on the sidelines.
Charlie McElligott, equity derivatives strategist at Nomura, said this year “systematic reallocation has really been the (major) source of demand outside of corporate buybacks.”
Quantitative funds or systematic funds use algorithms to automatically detect trends and trends in different markets.
A recent Bank of America research note summed up the views of many investors, declaring that “bulls are becoming an endangered species.” But trends in quant funds help explain why U.S. stocks have been surprisingly resilient this year, with the S&P 500 up 8% year-to-date despite widespread pessimism.
“These funds acted quickly and calmly,” McElligott said. “They didn’t analyze earnings and they didn’t take into account the stickiness of inflation.” . . It’s about price trends and momentum. “
There are several types of systematic strategies, including “volatility control” funds, commodity trading advisor funds, and “risk parity” funds. Their approaches vary, but all three rely on realized and expected market volatility as a key driver of their asset allocation.
Nomura estimates that volatility-controlled funds alone have added about $72 billion in U.S. stock exposure over the past three months. That’s more traffic than in 80% of the three-month periods over the past decade. A separate analysis by Deutsche Bank showed system funds’ overall equity positioning was at its highest level since December 2021.
By contrast, active managers’ equity market exposure is near one-year lows, according to Deutsche Bank.
Violent market volatility throughout 2022 encouraged systematic funds to reduce exposure and even bet on further declines, exacerbating the downturn. The S&P is down 19% in the last year. However, volatility has fallen sharply since the fourth quarter as concerns over U.S. rate hikes and the health of the global economy have eased.
The Vix index, which reflects expected stock market volatility over the next month, has closed below its long-term average 57 times so far this year, compared with just 23 times in all of 2022. In April, Cboe’s forward-looking index realized volatility hit its lowest level since November 2021, and even after the recent recovery, it was still less than half of last year’s average.
Those declines automatically prompted many quant funds to increase their equity exposure, McElligott said.
“Discretionary investors have largely refused to participate in this rally so far,” said Deutsche Bank strategist Parag Thatte. Investors have held off adding to their holdings since the collapse of Silicon Valley Bank in March sparked broader concerns about the U.S. banking sector.
Low exposure to stocks caused many investors to underperform. According to Bank of America, two-thirds of actively managed mutual funds failed to beat their benchmarks in the first quarter as portfolio managers were caught off guard by the rally.
Still, while quant fund inflows have helped prop up stock indexes, they haven’t been enough to offset losses elsewhere in many hedge funds’ portfolios. CTA has been hit hard by wild swings in the Treasury market, with the Societe Generale index tracking the largest fund down 4% so far this year.
Quantitative funds are relatively small compared to the overall market. According to BarclayHedge, CTAs will have about $365 billion in total assets under management by the end of 2022, less than 10% of the $4.8 trillion hedge fund industry.
However, since multiple funds tend to follow trends at the same time, their flows can affect the broader market, especially when other investors are avoiding bets.
“We did see their trades have a significant impact on the stock,” Thatte said. “They don’t tend to lead the market . . . (but) they tend to amplify moves that have already taken place.”
However, with quants now approaching their normal stock allocation levels, their influence may wane in the future, he added.
“If discretionary investors continue to reduce their holdings and do not increase their own exposure, then there is a limit to what systemic investors can do on their own.”