Over the years, and across countless articles, I’ve described the extent to which all market participants, carbon-based and otherwise, employ the same basic calculus at a conceptual level.
Our process generally permits more leverage into positive momentum and dictates reducing exposure when the “instability” part of the all-too-familiar “stability breeds instability” dynamic comes calling.
In a classic note from March of 2020, Nomura’s Charlie McElligott wrote that, “Even traders who view themselves as ‘fundamental’ or discretionary are in the same boat as momentum players [as] we all operate under frameworks which allow for greater leverage deployment into trending markets, and conversely, dictate de-grossings into VaR-events.”
Suffice to say the pandemic macro environment further blurred the line between, on one hand, mechanical trend-following and momentum-chasing and, on the other, fundamental, discretionary investing. BofA’s derivatives strategy team underscored the point in their outlook piece for 2024.
“Forecasting the economy and markets has proven particularly difficult in the now three years since COVID,” the bank said, noting that although macro prediction was next to impossible, CTAs were able to do well over long stretches thanks to price momentum. Not surprisingly given that conjuncture, the correlation between discretionary macro strategies and CTAs rose steadily from 2020 through Q3 of 2023.
That’s probably a reflection of the discretionary crowd “having to chase trades that are performing and in which they may not have been fundamentally positioned for,” BofA remarked.
Is that bad? Maybe. As with most things in life, it depends on your definition of “bad.”
BofA, stating the obvious, said it could be exaggerating price swings in either direction. “It could also be making reversals more painful as now a larger amount of assets exit the same trade at the same time,” the bank wrote.
The light blue bars in the figure above show estimated CTA AUM (around $350 billion, but more like $1 trillion with leverage). The dark blue line is effectively fragility.
Recall that 2023 saw two of the larger CTA drawdowns in recent memory, the first in March, around the regional banking crisis, and the second in November, when a sharp decline in bond yields triggered an across-the-board buy-to-cover in the same legacy STIR and bond shorts which were responsible for the lion’s share of CTA performance going back to late 2021.
So, what’s the takeaway? Well, how much time ya got?, as the saying goes. In the interest of brevity, I’ll quote BofA again. “The risk of being whipsawed by momentum reversals is rising,” the bank’s derivatives team said. “Everyone’s a closet CTA.”
