While human portfolio managers fret over economic uncertainty and the health of the US banking system, some algorithmically driven hedge funds have been buying stocks at one of the fastest rates in a decade, according to bank trading desks.
Quant funds have been piling into US stock markets in response to falling volatility, helping to prop up the market as active managers sit on the sidelines.
“Systematic reallocation has really been the [main] source of demand outside of corporate buybacks” this year, said Charlie McElligott, an equity derivatives strategist at Nomura.
Quant, or systematic, funds use algorithms to automatically detect trends and ride momentum across different markets.
A recent research note from Bank of America summed up the views of many investors by declaring the “bulls are becoming an endangered species”. But the trend among quant funds helps to explain why the US stock market has proven surprisingly resilient this year despite the widespread pessimism, with the S&P 500 gaining 8 per cent year to date.
“These funds move fast and unemotionally,” said McElligott. “They’re not parsing through earnings or taking a view on the stickiness of inflation . . . this is about price trends and momentum.”
There are several types of systematic strategies, including “volatility control” funds, commodity trading adviser funds, and “risk parity” funds. Their approaches vary, but all three rely on realised and expected market volatility as critical drivers of where they allocate assets.
Nomura estimates that vol control funds alone have added about $72bn in US stocks in the past three months. That was a greater flow than in 80 per cent of three-month periods over the past decade. Separate analysis by Deutsche Bank showed overall equities positioning across systematic funds is at its highest level since December 2021.
In contrast, stock market exposure among active managers is close to a one-year low, according to Deutsche.
Wild swings in markets throughout 2022 encouraged systematic funds to reduce their exposure or even bet on further declines, exacerbating the downturn. The S&P fell 19 per cent last year. However, volatility has fallen dramatically since the fourth quarter as fears about US interest rate rises and the health of the global economy have eased.
The Vix index, which reflects expected stock market swings over the next month, has closed below its long-term average 57 times so far this year, compared with just 23 times in the whole of 2022. In April, Cboe’s backwards-looking index of realised volatility hit its lowest level since November 2021, and even after a recent pick-up it remains less than half last year’s average.
Those falls automatically prompt many quant funds to ramp up their stock investments, according to McElligott.
“Discretionary investors have basically refused to engage with this rally so far,” said Parag Thatte, a strategist at Deutsche. He said investors briefly began increasing their allocation to US stocks after a strong start to the year in January, but have been put off again since the collapse of Silicon Valley Bank in March triggered broader worries about the US banking sector.
Low exposure to stocks has contributed to poor performance among many investors. Two-thirds of actively managed mutual funds failed to beat their benchmark in the first quarter as portfolio managers were caught off guard by the rally, according to Bank of America.
Still, while flows from quant funds have helped to prop up stock indices, they have not been enough to offset losses elsewhere in many hedge funds’ portfolios. CTAs were hit badly by sharp moves in Treasury markets, and a Société Générale index tracking the largest funds has fallen 4 per cent so far this year.
Quant funds are relatively small compared to the overall market. CTAs had total assets under management of about $365bn at the end of 2022, according to BarclayHedge, less than 10 per cent of the $4.8tn hedge fund industry.
However, because multiple funds tend to follow trends in tandem, their flows can affect the broader market, particularly when other investors are avoiding making any bets.
“We do see their trading has a big impact on equities,” said Thatte. “They don’t tend to lead the market . . . [but] they tend to amplify moves that are already happening.”
He added, however, that with quants now approaching normal levels of equity allocation, their impact may soften going forward.
“If discretionary investors continue to be underweight and not raise their own exposure, there’s a limit to how much systematics can do on their own.”