Cross-Asset Quants Are Facing Their Worst Losses in a DecadeBy
CTA funds plunge 5.1 percent for worst period since 2007
Selloff in stocks, bonds worry critics of systematic funds
Hawkish signals from central bankers have punished stocks and bonds alike in the past week.
Also punished: investors who make a living operating in several asset classes at once. They’ve been stung by the concerted selloff that lifted 10-year Treasury yields by 25 basis points and sent tech stocks to the biggest losses in 16 months. Among the hardest-hit were systematic funds who -- either to diversify or maximize gains -- dip their toes in a hodgepodge of different markets all at the same time.
Losses stand out in two of the best-known quant strategies, trend-following traders known as commodity trading advisers, and risk parity funds. CTAs dropped 5.1 percent over the past two weeks, their worst stretch since 2007, according to a Societe General SA database of the 20 largest managers. The Salient Risk Parity Index dropped 1.8 percent, the most in four months.
To a category of critics, it’s an environment where the potential for snowballing losses becomes greater, as the overseers of such funds take steps to reduce risk. So many face losses at once, the theory goes, that a chain reaction of selling ensues with the potential to whack markets further.
So far, there’s no clear indication that’s happening. Selling in U.S. equities has been confined mostly to tech shares, with financial stocks rising toward 10-year highs. Bonds yields have spiked, but remain below levels seen in May.
Any systematic selling was probably drowned out by discretionary managers, according to Roberto Croce, director of quantitative research at Salient Partners LP.
“I don’t think we can say that the moves in the market are due to them,” Croce said. “Some portion of the investing base freaks out and runs for the hills, but these types of portfolios tend to snap back quickly if you don’t take any risk off. It’s much more likely to be discretionary investors that are fleeing whatever they’re holding without a plan.”
It’s far from clear risk-parity and CTA funds react to the same set of inputs. While both invest in multiple asset classes and employ leverage, risk parity tends to be a slower and more passive strategy, aiming to engineer a smoother ride by giving smaller weightings to higher-volatility assets. CTAs, a type of managed futures strategy, follows short-term trends and tends to be more volatile and less correlated to the market.
Risk parity would only unload positions quickly if managers kicked in some type of stop loss, which only a few do, according to Croce.
That may be true for the biggest players, but doesn’t account for the actions of a less illustrious category of risk parity funds, many of which have started to unwind, according Brean Capital LLC’s Peter Tchir.
“I don’t think this move has caused much of an unwind from true risk parity funds, but much more from the homebrew or risk parity lite crowd -- making the real fun just beginning,” Tchir wrote in a note Thursday. “Risk parity selling should kick in when expected volatility of the strategy exceeds target volatility of the strategy.”
As employed like Bridgewater Associates LP’s All Weather Fund, risk parity holds consistent levels of exposures. When it rebalances, the fund buys assets that have fallen and sells ones which have gained -- hardly a recipe for disaster. AQR Capital Management LLC does use a risk management strategy to gradually reduce exposure when returns are very poor, but that hasn’t kicked in all year, according John Huss, a portfolio manager on the risk parity team.
“We’re not trying to chase one day or one week moves,” Huss said. “When there are larger shifts in exposure, like the way we were positioned in 2008 versus 2012 with really noticeable changes in size, they tend to happen more slowly over time.”
CTAs may be a bigger threat. They’re large -- Barclays PLC estimates them to be about 7 percent of hedge fund industry assets -- and react quickly. Take $1.4 billion Quest Partners LLC, which runs mostly managed futures funds. Before last week the firm was mostly long Treasuries, and has already flipped to a short position, according to Nigol Koulajian, co-founder and chief investment officer.
Last week’s pain wasn’t as clear cut as a selloff in fixed income for some trend-followers. The managed futures fund at Salient, for example, suffered from a short position in agricultural commodities after wheat futures rallied to four-year highs.
“Momentum trading can create systemic risks. CTAs are a good example, they’ll ride the trend up and ride the trend down,” said Maneesh Shanbhag, who co-founded $500 million Greenline Partners LLC after five years at Bridgewater. “Connecting that to risk parity, the more basic idea will not cause instability in markets. But a levered risk parity strategy is at risk of all asset classes falling.”
On the surface, it’s strange that both strategies suffered over the past week since they’re supposed to behave differently. A classic risk parity strategy is always long fixed income, equities and inflation risk assets. But as momentum threw its weight behind stocks and bonds, many CTAs took a similar long position.
It gets worse zeroing in on CTAs: about half of the assets are controlled by 10 managers, who are about 98 percent correlated, meaning same-way bets will indeed affect the market, according to Quest’s Koulajian.
“CTAs who have adapted to this market environment are trading more and more long-term, and their position sizing has grown,” Koulajian said. “Many people are using exactly the same strategy, and as there’s a reversal in trends, they’re impacting the market significantly.”