Heisenberg Report

How Much Did CTAs And Risk Parity Sell During The Friday-Monday Bloodbath?

Right, so last night we brought you the following chart which seems to suggest that at least according to the SG CTA Index, CTAs just had one of their worst 5-day runs in history:

Notably, that was through Wednesday – i.e. not including Thursday’s action. “With pain like this, one would hope a significant deleveraging may have already occurred,” Bloomberg’s Ye Xie wrote of the wipeout.

There are lingering questions (and really, these questions have been hanging over quants since at least August 24, 2015, when everything went to hell in a handbasket amid jitters about the fallout from China’s devaluation of the yuan two weeks prior), about the impact of CTAs, vol. targeting strats, risk parity and [fill in the blank with any strategy Marko Kolanovic has mentioned in the past two years].

 

The worry is that they will mechanically deleverage depending on the severity and scope of a given adverse market event and the impact of that selling pressure is the subject of vociferous debate.

One question following last week’s turmoil and the even more dramatic moves this week, is whether systematic selling played a role and, more to the point, if it has a role to play going forward in the event volatility remains elevated. It seems virtually indisputable that exposure was running high going into February.  “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,” Goldman wrote earlier this week, before adding that “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.”

Now obviously none of this is “new” per se, and clearly you can’t just lump all of these together as people are prone to do (risk parity, for instance, won’t de-risk as quickly as the others), but as Goldman goes on to write, it is entirely possible that should realized vol. reset higher over the next couple of weeks and if bonds continue to sell off with equities, deleveraging from those funds could continue.

And you know, I never hear any great arguments as to why that assessment is wrong. All I ever hear are arguments as to why the selling won’t be large enough to exacerbate an already bad situation. But that seems to a certain extent disingenuous. Kind of like saying “well sure, I’m not helping the murder rate if I shoot my neighbor the next time his dog pisses on my side of the imaginary line that divides our yards, but my one murder isn’t going to have a material impact on the statistics at the national level.”

Additionally, it kind of seems to gloss over the danger inherent in indiscriminate resets. I mean these are model-driven strats, so the de-risking is by definition mechanical. If it’s mechanical then no one is thinking about it. That’s another one of those criticisms that I’ve never heard adequately addressed.

In any event, BofAML has their story and they’re apparently sticking to it. According to the bank’s models, the bond selloff that was exacerbated by the AHE beat last Friday (recall that that’s what really tipped the first domino as it seemed to “validate” the inflation narrative) reduced diversification (i.e. flipped the stock-bond return correlation positive as equities ceased to interpret rising yields as a barometer of the robustness of a recovery and instead began to interpret rate rise as a problem for the Fed) leading “unlevered risk parity volatility to rise and therefore triggering a deleveraging in order to maintain volatility targets.” The bank continues: “At the same time, stop losses were triggered for equity positions in our CTA model.” Here are the charts:

Ok, so how big of a deal is this and is it accurate in terms of whether that deleveraging was real or merely theoretical based on BofAML’s assumptions about response time? Also, how large was this in the grand scheme of things? Well, here’s the bank’s answer:

Risk parity and CTAs unwound or are in the process of selling $200bn equities. While our model implements position changes in response to a given day’s moves on the close the same day, in reality, both risk parity and CTA strategies operate over varying horizons. But we expect actual rules-based risk parity and CTA strategies to implement significant allocation changes within a few days of when our model’s positioning shifts. If we assumed $200bn in rules-based risk parity strategies and $250bn in model-driven CTAs, then our models estimated $140bn of global equity unwinds as a result of Friday’s moves and another $60bn as a result of Monday’s moves (Chart 15). For perspective, over the same two days global equity index futures volumes across the largest markets was approximately $1.6 trillion. So if we were to assume the entirety of equity unwinds were completed, then it would equate to approximately 12% of the volume over the last two days. We expect that if risk parity and CTAs are still unwinding equities in the coming days, then it will be against a continued rise in volumes due to higher volatility.

Ok, so there are all manner of caveats that go along with that analysis and there are a number of projections that accompany it in terms of what BofAML figured might happen next. And because the excerpts above are from a note dated Tuesday, one certainly imagines the bank’s derivatives team is furiously working to update all of this after the manic action that’s unfolded since then.

But that’s not the point. The point is that what you read above is a best guess estimate of the impact of risk parity and CTAs during the Friday-Monday mayhem. Again, assuming those numbers are some semblance of accurate and assuming the unwind was actually implemented, it would have amounted to roughly 12% of two-day volume.

You can draw your own conclusions there, but what you should also do is consider that everything said above was set against a backdrop of some $33 billion in outflows from global equity funds from investors who aren’t the strats mentioned above.

So I guess at the end of the day, this is always an exercise in finger pointing but what it comes down to is that some folks and some machines were selling by God, and trying to sort out who was taking their cues from “who” is an exercise in trying to disentangle a reflexive dynamic or, in other words, an exercise in futility.

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