Don't Kid Yourselves. Robot Sellers Haven't Vanished From Stocks

  • Automated funds gaining influence on S&P 500 as calm remains
  • Risk-parity funds have added to equity holdings since March

While holding fewer bullets than in August, a gun is still pointing at the head of U.S. investors in the form of automated funds that sell when turbulence increases.

So writes UBS Securities LLC’s Rebecca Cheong, who says the relative calm in stocks since February has spurred managers of strategies such as risk parity quietly to reload. Their involvement in stocks -- or, phrased another way, their ability to amplify selloffs should markets start to crack -- is about 18 percentage points below its level nine months ago, but it hasn’t gone away, according to Cheong.

Interactions between price-insensitive quantitative funds and the U.S. equity market became an obsession on Wall Street last year after research from JPMorgan Chase & Co. suggested automated traders exacerbated the selloff that upended stocks in August. While the strategies come in wrappers such as risk-parity and volatility-targeting, the common theme is buying and selling boatloads of shares as market turbulence ebbs or flows.

In general, quieter markets prompt so-called risk-controlled funds to buy -- meaning that as calm grows among U.S. investors, the potential for computerized sellers to wreak havoc grows with it. That’s what’s going on now, Cheong says. Throughout the rebound that began in mid-February and even during periods such as last week, when stocks fell but didn’t fall violently, quant funds added to positions.

“Despite market weakness, recent low realized vol has enabled risk-controlled funds to add more equity risks, which make downside-upside risks even more asymmetric,” the head equity derivatives strategist wrote in a note to clients Wednesday. “We remain cautious of the sustainability of the current low realized vol environment and the market implication when vol starts to rise.”

The S&P 500’s two-month historic volatility, a measure of actual price swings, currently sits at the lowest level since right before the August correction, Bloomberg data show. Risk-parity funds have upped their S&P 500 holdings by 25 percentage points over the past two months, increasing the potential for trouble should things go south, according to Cheong.

Since the start of March, there have only been six days where the benchmark has moved more than 1 percent. That’s the longest comparable stretch of peace since May 2015. If muted price movements prevail through May, risk parity funds will have the same potential sway on the S&P 500 as they did before the August crash, Cheong wrote.

Among some industries in the S&P 500, realized volatility isn’t so muted. For example, the SPDR Energy Select Sector ETF has a two-month historical volatility that’s twice that of the SPDR S&P 500 ETF. Differing sector volatility cancels itself out, creating a relatively calm-looking benchmark, said Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors. Stocks moving up or down due to earnings-related news also offset, he said.

“People might be scaling more into equities, but it would only be true if they’re just buying S&P index futures directly,” Chintawongvanich said. “Some might do it by sectors and not the index as a whole. If you’re looking at specific sectors, you’re not going to see as low a realized volatility.”

While the S&P 500 as a whole has had minimal turbulence, traders in the options market are snapping up protection against increases in near-term volatility. On Wednesday, the spread between realized and implied one-month volatility grew to the highest in nine months, data from Bloomberg show.

For traders who find such data traumatizing, there are reasons for comfort. Should volatility pick up before month-end, the impact of volatility-fund selling would be less extreme than last summer, according to Cheong. If price swings began to mirror the action in August, where there were five days of movement greater than 2 percent, risk parity strategies would ditch one-third of their S&P 500 holdings. That compares with a 60 percent divestiture nine months ago.

The difference this time around is a function of math. The calmness of the bull market heading into 2015 had lured funds into buying the S&P 500 index until it made up more than 90 percent of their holdings by mid-August, data from UBS show. Currently, exposure sits around 76 percent. Because they hold fewer stocks, they have fewer to sell.

“You need continuous and really low realized volatility for risk parity funds to stay in the S&P 500,” said Cheong by phone. “But the risk is that you only need a few days of a market correction for them to start selling on top of it.”