Algorithms support the market while anxious humans steer clear of uncertainty

While human portfolio managers worry about economic uncertainty and the health of the US banking system, some algorithmic hedge funds have been buying stocks at one of the fastest prices in a decade, according to banks’ trading desks.

Quantitative funds are piling up in US stock markets in response to lower volatility, helping to prop up a market as active managers sit on the sidelines.

“The systemic reallocation has really been [main] “The source of demand is outside corporate buybacks,” said Charlie McClegott, an equity derivatives analyst at Nomura.

Quantitative or methodological 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 quantitative funds helps explain why the US stock market has proven surprisingly resilient this year despite prevailing pessimism, with the S&P 500 up 8 percent year-to-date.

“This money moves quickly and unemotionally,” McElligott said. They don’t do earnings analysis or look at flat inflation. . . This relates to price trends and momentum.”

There are several types of systematic strategies, including “volatility control” funds, commodity trading advisor funds, and “risk par” funds. Their approaches vary, but all three rely on realized and expected market volatility as critical drivers of where they allocate assets.

Nomura estimates that volume control funds alone have added about $72 billion in US equities in the past three months. This was a larger outflow than in 80 percent of the three-month periods over the past decade. A separate analysis by Deutsche Bank showed the overall stock position across regular funds at its highest level since December 2021.

In contrast, stock market exposure among active managers is near a one-year low, according to Deutsche.

The extreme volatility in the markets throughout 2022 encouraged regular funds to reduce their exposure or even bet on further declines, exacerbating the downturn. The Standard & Poor’s Index fell 19 percent last year. However, volatility has eased significantly since the fourth quarter with concerns about rising US interest rates and the declining health of the global economy.

The Vix, which reflects expected volatility in the stock market over the next month, has closed below its long-term average 57 times so far this year, compared to just 23 times in all of 2022. Realized volatility hit its lowest level since November 2021, and even after the recent rebound, it remains less than half of last year’s average.

These declines automatically prompt many quantitative funds to increase their equity investments, according to McClegott.

“Disciplined investors have basically refused to get involved in this rally so far,” said Parag That, a strategist at Deutsche. He said investors briefly began increasing their allocations to US stocks after a strong start to the year in January, but have been put off again since the collapse of the Silicon Valley bank in March sparked broader concerns about the US banking sector.

Low exposure to equities contributed to the underperformance 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.

However, while inflows from quantitative money have helped support stock indices, they have not been enough to offset losses elsewhere in many hedge fund portfolios. Central trade agreements have been hit hard by sharp moves in treasury markets, and the Societe Generale index, which tracks the largest funds, is down 4 percent so far this year.

The amount of funds is relatively small compared to the market as a whole. Total assets under management from the CTA were about $365 billion at the end of 2022, according to BarclayHedge, less than 10 percent of the $4.8 trillion hedge fund industry.

However, because multiple funds tend to follow trends in tandem, their flows can affect the broader market, particularly when other investors avoid making any bets.

“We see their trading as having a significant impact on the stock,” That said. “They tend not to lead the market . . .[but]They tend to exaggerate movements that are actually happening.”

He added, however, that with volumes now approaching normal levels of capital allocation, their impact may ease in the future.

“If discretionary investors continue to underweight and don’t raise their own exposure, there is a limit to how much methodologies can do on their own.”

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