Despite Wall Street’s worst fears, momentum-chasing quants probably aren’t behind this selloff. In fact, they were ready for it.
Often considered the bogeymen of Wall Street because of their potential to create volatility, commodity trend advisers typically take positions across asset classes that pay off if things continue to go the way they have been. It’s a strategy that flourished in January as virtually every asset exhibited strong momentum by climbing higher day after day. That concerned casual observers who feared the quants’ ever-growing exposure to markets meant that if the trend reversed and CTAs pulled out suddenly, havoc would break loose.
The trend is being tested (the S&P 500 took its biggest dive in two years last week), and CTA positioning has shown itself to be a bit more nuanced amid the selloff. Markets didn’t crack up enough for the quants to rush the exit en masse, and CTAs had already began to quietly reduce U.S. equities holdings a few days before.
The average fund is actually set up to sustain this type of price action, according to Mark Connors, the head of risk advisory at Credit Suisse Group AG. CTAs reduced equity exposure from a three-year peak on Jan. 24 to be in line with the one-year average and boosted their commodity footprint to a six-year high, according to data from the Swiss bank.
“CTAs were selling equities ahead of this and stayed long commodities because the reflation trade has stayed intact,” Connors said from New York. “Going forward, the pressure is already out of the system. Shorts aren’t being covered and quants aren’t deleveraging.”
There’s also evidence that last week’s pain reduced the likelihood that CTAs will flood the market with selling anytime soon. Some funds bet on mean reversion strategies, which tend to encourage selling when things look overheated and staying the course amid sudden drops, according to Nikolaos Panigirtzoglou, a global market strategist at JPMorgan Chase & Co.
Equity price momentum has also stayed intact, allowing trend-chasers to carry on buying the most popular shares. A Bloomberg long-short pure U.S. momentum index ended the week barely changed, down less than 0.1 percent.
“Consistent with our previous research, we think that the move was not large enough to trigger broad deleveraging,” Marko Kolanovic, JPMorgan’s global head of quant and derivative strategy, wrote in a note dated Feb. 1. “Equity price momentum is positive and trend followers are not likely to reduce equity exposure.”
CTAs enjoyed the fruits of last month’s Treasury selloff, with momentum strategies enjoying record trends in the rates market, according to Bank of America Corp. research.
Though things are stable in trend-following land, some strategists are still concerned. The fact that CTAs have retained their long-stocks and short-bonds positions and loaded up on commodities means that any selling may just have been delayed. In this view, the threat has actually grown amid their recent success. Folks in this camp argue that sudden inflationary spikes may trigger an increase in volatility and thus, an unwinding of CTA positions.