You know the name. He’s Gandalf. Nostra’quant’mus. JPMerlin.
If you frequent these pages, you’re well acquainted with Marko. He’s JPMorgan’s quant wiz and his star has risen over the past several years along with the market’s interest in the systematic strats he covers.
More specifically, Kolanovic likes to shed light on the shadowy corners of the market inhabited by programatic “devils” like CTAs (the “trend followers”), risk parity (who is having a tough go of it as stock-bond return correlations become less negative), and vol targeting strats.
The argument is that these systematic strategies have a tendency to exacerbate large drawdowns. Those interested can read Kolanovic’s latest in full here, but do note this excerpt:
Given that the average volatility of individual stocks and sectors has been remarkably stable (at ~20%, and 13% respectively), an increase of correlations would drive market volatility higher. Correlations will increase from these levels, which will likely push short term S&P 500 realized volatility up to ~4% higher (i.e. from 6% to 10%, assuming single stock volatility stays constant at ~20% and correlations increase from ~15% to 35%).
This type of volatility increase would cause a meaningful de-leveraging of strategies such as volatility targeting and risk parity. For instance one could see ~$40-50bn equity outflows from volatility targeting strategies, ~$20-30bn from risk parity strategies, and additional outflows from other strategies on account of increased level of market risk. While this on its own may not cause the market correction, it represents a significant risk that is building up.
Ok. So essentially, the worry is that recent one-way market action has left the strats mentioned above all-in. And in the event something goes wrong, their deleveraging will make the pain all that much worse for the broad market.
Well on the eve of the Fed, Goldman is out with an exhaustive look across markets and here’s what the bank has to say about all of the above…
Low volatility and trending markets tend to attract systematic investors, whose size and impact has increased in recent years. CTAs (Commodity Trading Advisors) are trend-followers or momentum investors that mostly use futures – if the market shows a clear uptrend there is a strong chance that CTAs are long the market. The beta of two main indices tracking macro HFs and CTAs. to the S&P 500 has soared in recent months and is close to its highest levels since the 90s (Exhibit 16).
Another group of investors that are attracted by low volatility are risk parity funds (and possibly investors with volatility targets). They allocate to assets targeting risk levels, i.e., they invest based on the volatility. With the recent declines in equity volatility, also relative to more sticky rates volatility, risk parity funds have likely increased their equity exposure, too. Exhibit 17 shows what the relative equity allocation of a simple risk parity portfolio of S&P 500 and US 10-year bonds would be (using 3-month realised volatility to scale weights). In the event of a reversal of the trend, these systematic investors are likely to reduce equity exposure quickly, which could exacerbate an equity drawdown and result in a faster and larger volatility spike. ‘Vol of vol’ risk is higher, also owing to changes in regulation and market microstructure, which have reduced liquidity across assets.
In other words: Marko was right.