Ok, so we’re going to eschew our penchant for over-the-top cynicism and biting market commentary in favor of treading very lightly here, because we’d rather not do too much to piss off our quant followers.
This is a particularly touchy subject under normal circumstances and this week is not a week that falls in the “normal circumstances” category, which means this debate is even more contentious than it usually is.
As regular readers are aware, there are effectively two stages to what we’ve variously characterized as the market “doom loop“, which is a kind of nightmare scenario where once the first domino is tipped, there’s no turning back.
Up until Monday, the feedback loop between VIX ETPs and the underlying (i.e. the whole “tail wagging the dog” dynamic) was written off by most pundits as something of an urban legend, but what happened earlier this week proved otherwise. The rebalance risk (i.e. inverse and levered VIX ETPs panic-buying VIX futs into a vol. spike and exacerbating the situation to the detriment of markets) came calling in the form of a 23-standard deviation flow that resulted in the largest VIX spike in history and ultimately deep-sixed XIV.
Long story short, the first part of the doom loop was indeed triggered. It wasn’t an urban legend. The monsters under the bed were real.
The second part of the doom loop involves a sustained vol. spike and any accompanying market mayhem resulting in the forced deleveraging for systematic/programmatic strats. This isn’t something we dreamed up. It has been discussed exhaustively by the likes of Marko Kolanovic at JPM, Rocky Fishman at Goldman (formerly at Deutsche), BofAML’s derivatives team, and on and on. Here’s what Fishman said this week:
We think the bullish equity positioning has in part been supported by systematic investors, such as CTAs, vol target and risk parity funds, that have been attracted to equities by their low volatility trend, especially in recent months. As trend followers, CTAs (c.US$350 bn, Source: BarclayHedge) would in simple terms buy assets with positive momentum – and the recent negative short-term trend reversal in equities triggers selling. As Exhibit 16 shows, the net dollar CFTC long positioning in the S&P 500 has been correlated with the CTA beta to the S&P 500.
Risk parity and vol target funds, which have combined AuM close to US$1 tn, have also likely increased their exposure to equities due to their low volatility – they use both realised and implied measures of volatility (and often also correlation). Based on a simple risk parity and vol target strategy, they are currently running very high equity allocations (Exhibit 17). Risk parity funds usually focus on longer-term measures (6m realised) while vol target strategies often use a shorter window, which suggests they are more likely to de-risk as a result of shorter periods of high volatility. Depending on where realised volatility settles in the coming weeks, selling from those funds might continue. For risk parity and procyclical multi-asset funds, the combined equity/bond sell-off can further increase pressure to reduce risk.
For those interested in the journalistic take on this, Bloomberg’s Dani Burger is the go-to and you can read her latest here.
Ok, so getting back to what we said here at the outset, we don’t want to extrapolate too much about the potential for a systematic unwind to exacerbate what is quickly becoming a pretty acute situation across markets, but it is certainly worth noting that at least according to the SG CTA Index, CTAs just had one of their worst 5-day runs in history:
This was pointed out earlier by BBG’s Ye Xie and then again later this evening by Axel Merk. “With pain like this, one would hope a significant deleveraging may have already occurred,” Xie wrote.
As the above-mentioned Dani Burger puts it, CTAs are “the market’s boogeymen,” so this is something that will likely be scrutinized heavily in light of recent events.
We’ll reserve judgement in the interest of not getting (at least) two frustrated e-mails.