As human portfolio managers worry about economic uncertainty and the health of the U.S. banking system, some algorithm-driven hedge funds have bought stocks at one of the fastest rates in a decade, according to the banks’ trading desks.
Quantum funds have piled up US stock markets in response to declining volatility, helping to support the market while active managers remain on the sidelines.
“The systematic reallocation has really been there [main] source of demand outside of corporate buybacks” this year, said Charlie McElligott, an equity derivatives strategist at Nomura.
Quantum, or systematic, funds use algorithms to automatically detect trends and ride momentum across different markets.
A recent Bank of America research note summed up the views of many investors by declaring that “bulls are becoming an endangered species.” But the trend among quantum funds helps explain why the US stock market has proved surprisingly resilient this year despite widespread pessimism, with the S&P 500 gaining 8% year-to-date.
“These funds move fast and without emotion,” said McElligott. “They’re not analyzing earnings or assessing the stickiness of inflation. . . it’s all about price trends and momentum.
There are several types of systematic strategies, including “volatility control” funds, commodity trading advisory funds, and “risk parity” funds. Their approaches vary, but all three rely on realized and forecasted market volatility as the critical drivers of where they allocate assets.
Nomura estimates that volume control funds alone have added about $72 billion in U.S. stocks in the past three months. That was more than 80% of the quarters over the last decade. A separate analysis by Deutsche Bank showed that stocks’ overall ranking among systematic funds is at its highest level since December 2021.
Conversely, equity market exposure among active managers is close to a one-year low, according to Deutsche.
The sharp swings in the markets throughout 2022 encouraged systematic funds to reduce their exposure or even bet on further declines, exacerbating the recession. The S&P fell 19% last year. However, volatility has declined sharply since the fourth quarter as fears about rising interest rates in the US and the health of the global economy have eased.
The Vix index, which reflects expected stock market swings over the next month, closed below its long-term average 57 times this year, compared to just 23 times for the whole of 2022. In April, the index realized volatility has reached its lowest level since November 2021 and, even after a recent recovery, remains less than half of last year’s average.
These falls automatically prompt many quantum funds to increase their equity investments, according to McElligott.
“So far, discretionary investors have essentially refused to participate in this rally,” said Parag Thatte, a Deutsche strategist. He said investors briefly began to increase their allocation to US equities after a strong start to the year in January but were put off again by the Silicon Valley Bank collapse in March that triggered broader worries about the banking sector. American.
Low exposure to equities contributed to the poor performance of many investors. According to Bank of America, two-thirds of actively managed mutual funds failed to outperform their benchmark in the first quarter as portfolio managers were caught off guard by the rally.
However, while flows from quantum funds have helped support stock indexes, they have not been enough to offset losses elsewhere in many hedge fund portfolios. The calls to action were hit badly by strong moves in Treasury markets, and a Société Générale index tracking the largest funds is down 4% so far this year.
Quantum funds are relatively small compared to the overall market. CTAs had total assets under management of approximately $365 billion at the end of 2022, according to BarclayHedge, less than 10% of the $4.8 trillion speculative fund industry.
However, since multiple funds tend to follow trends in tandem, their flows can affect the broader market, particularly when other investors shy away from placing bets.
“We see their trading having a big impact on the stock,” Thatte said. “They don’t tend to lead the market. . .[but]they tend to amplify moves that are already happening.
He added, however, that with the quantities now approaching normal equity allocation levels, their impact could subside going forward.
“If discretionary investors continue to be underweight and don’t increase their exposure, there’s a limit to how much systematics can do on its own.”
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