Human Traders Are Trouncing The Machines

The contemporary low volatility trading environment has been kind to actively managed equity funds - particularly if they piled into large-cap momentum stocks like Facebook and Amazon, which have been responsible for the bulk of this year’s rally.

But while active managers have enjoyed three quarters of strong returns, quant funds – purportedly the future of asset management, according to many an “expert” on Wall Street – are falling further and further behind. As Bloomberg reports, during the first nine months of 2017, the average equity fund was up 9.7 percent while quant funds rose only 0.6 percent, according to data from Hedge Fund Research.

The striking reversal has validated the views of the handful of quant-fund skeptics on Wall Street, many of whom were previously branded as “luddites” for questioning the inherent superiority of algorithm-driven investment strategies. Quant funds, as we are learning, don’t function well in a low volatility environment because there are fewer opportunities to exploit small disparities in price.

The environment that lifts stock pickers - steady markets that enable their long-term trades - is not so friendly to quants. They do best in periods of volatility and dispersion, when their algorithms can find small price disparities to exploit. But the U.S. stock market has been unusually tranquil since last year’s presidential race. At an average level of 11.6 since Election Day, the CBOE Volatility Index has hovered about 40 percent below its lifetime average.

“To a certain extent they are lowly correlated," Tim Ng, chief investment officer of Clearbrook Global Advisors, said of the two strategies. “The factors that drive positive returns in each are different, so what helps one doesn’t necessarily help another.” His firm invests in hedge funds.

Despite their recent underperformance, quant funds have continued to receive the bulk of hedge fund inflows. Last year, total hedge fund assets AUM dropped for the first time in years as investors pulled money from actively managed funds and reallocated to both passive and quantitative strategies.

Still, both quant funds and traditional discretionary managers have on average continued to underperform the S&P 500.

Equity funds betting on technology have posted some of the biggest gains in the first three quarters. Light Street Capital Management’s Halogen fund, which focuses on technology, media and telecommunications stocks, soared 44 percent, said a person familiar with the matter. The flagship fund at Philippe Laffont’s tech-focused Coatue Management jumped almost 24 percent, according to an investor letter seen by Bloomberg News.

Computer-driven funds struggled to keep pace in the period. BlueTrend, the main fund at Leda Braga’s Systematica Investments, dropped almost 7 percent, another person said. The Diversified fund at $6.6 billion Aspect Capital fell 4.7 percent, according to an investor letter seen by Bloomberg News. Winton Group’s Futures fund is about flat on the year, according to a person with knowledge of the returns.

While the hedge fund industry’s overall performance is improving, it still lags behind the S&P 500 Index, which was up 14.2 percent with reinvested dividends this year through September. Funds across all strategies on average returned 4.3 percent on an asset-weighted basis in the period, compared with 0.7 percent in the first nine months of last year, according to Hedge Fund Research.

As we noted above, funds focusing on tech stocks have posted some of this year"s biggest gains:

Equity funds betting on technology have posted some of the biggest gains in the first three quarters. Light Street Capital Management’s Halogen fund, which focuses on technology, media and telecommunications stocks, soared 44 percent, said a person familiar with the matter. The flagship fund at Philippe Laffont’s tech-focused Coatue Management jumped almost 24 percent, according to an investor letter seen by Bloomberg News.

And to be sure, not all quant funds have had a bad year. Bloomberg managed to find one that’s up 53%.

Not all quants have had a bad year. The QIM Tactical Aggressive Fund gained 53 percent in the first nine months, according to a letter seen by Bloomberg. Nor have all traditional stock pickers done well. Crispin Odey, who is known for his bearish bets, saw his European equity fund sink 14 percent this year through Sept. 15 in its U.S. dollar share class.

* * *

After Eagle’s View Asset Management, a $500 million fund-of-funds that invests with 30 managers, half of them quants, recorded its worst monthly performance ever in June, the fund’s manager Neal Berger penned a letter to clients explaining why quant strategies have broken down over the past year.

It comes down to two factors, he said:

1.Increased competition: more investors are using algorithms to fight over the same inefficiencies in the market.

“Now every bank has a factor model,” said Benjamin Dunn, president of the portfolio consulting practice at Alpha Theory LLC, which works with managers overseeing about $200 billion.

“You’ve had a democratization of a lot of data and analytics that were once the domain of very systematic quant investors. Everything is getting arbitraged away.”

2. Low volatility: quantitative funds are most successful in an environment where there is large disagreements in the market over the prices of assets. Today there is little disagreement, and the best way to earn outsized returns is placed highly leveraged bets that the market will remain calm. That"s working for some investors, but is far too risky for others.

In fact, the persistently low level of volatility has brought out an increasing number of hedge funds strategies oriented toward regularly selling volatility. Although we believe that this is "picking up nickels in front of a bulldozer", shockingly, these Funds have been some of the best performing strategies over the past years.

Although our guess is as good as anyone"s, we believe the shockingly low levels of volatility has to do with an increase in computer driven, quantitative trading coupled with banks selling options to offer "yield enhancement" structured products to investors who are starving for this yield.

This feedback loop, the increase in assets run by hedge funds, and, the rise of quants, has created unusual patterns, dislocations, and low levels of volatility.

While those simply following the broader market indices wouldn"t realize anything is amiss, it is our belief that these factors have created a challenging mix for trading oriented strategies. It won"t last forever, but, it could last longer than we can.

Additionally, he explains, systematic strategies require an endless supply of victims to thrive, and the growth of quant and passive funds has caused dumb money to behave unpredictably or disappear altogether.

With all the geniuses in quant, high-powered computers, and enormous data, where are the "suckers" who are providing the juice for all of these absolute return quantitative strategies?

Simply put, the "edge providers" have moved aggressively into passive index funds and broader market ETFs.

As such, we have a condition amongst the traditional quantitative strategies whereby we have robots trading against robots. Without a steady source of "edge providers", these "edge demanders" are just trading money back and forth with each other.

We believe increased quantitative trading coupled with passive indexation by retail, and, low levels of realized and implied volatility may be creating a feedback loop that has caused unusual price movements in a variety of securities that have challenged trading oriented strategies.

Of course, all of this could change shortly as market strategists like Bank of America’s Michael Hartnett warn that a sharp selloff could be in store for the fourth quarter. Investors have upped their bullish bets through S&P 500 calls, buying more S&P 500 delta over the past two weeks than at any point since 2007.

In summarizing the contemporary market, Hartnett explains that the "best reason to be bearish in Q4 is there is no reason to be bearish.”

Complacent active managers ought to keep this in mind.

The Last Time The Market Did This Was After Kennedy's Assassination

Via LPLResearch.com,

There have only been eight moves of at least 1% for the S&P 500 Index so far this year - the least since 13 in 1995. The all-time record was an incredible three in 1963.

What about a big move? The last time the S&P 500 moved at least 4% was nearly six years ago.

In fact, the S&P 500 had four consecutive days with 4% (or greater) changes in August 2011. Other than 2008 and the crash of ’87, that is the only other time since the Great Depression to see four consecutive 4% changes.

That isn’t anything like today’s action...

As the chart below shows, so far in 2017, big moves have been nonexistent; and even 1% changes have been rare.

Per Ryan Detrick, Senior Market Strategist,

“If you had forecast that the 11 months after the 2016 U.S. presidential election would be one of the least volatile periods ever, you would be in the minority.

Then again, the last time we saw a streak of calm like this was the year after John F. Kennedy was assassinated in November 1963.

Once again proving that the market rarely does what the masses expect and usually surprises us.”

And as LPL Research additionally notes, as equity markets continue to move higher, and as a result, several long streaks are taking place. Per Ryan Detrick, Senior Market Strategist,

“This is the Frank ‘The Tank’ market, as multiple streaks have taken place recently that are in the history books, with some being the most impressive ever.”

Here are some of the notable recent streaks:

• Yesterday ended a streak of 17 consecutive closes for the S&P 500 Index within 0.5% of its previous closing price – the longest streak of small daily changes since 1969.


• The S&P 500 Index has closed higher 8 days in a row for the first time since 2013 and has closed at all-time highs 6 days in a row for the first time since June 1997.


• The S&P 500 has been up 8 consecutive quarters for the fifth time ever.


• The Russell 2000 Index recently closed at a new all-time high eight days in a row.


• The Euro STOXX 600 recently closed higher nine days in a row—the longest streak in more than two years.


• The CBOE Volatility Index (VIX) yesterday closed at 9.19, its lowest close in history. It also closed beneath 10 for 7 consecutive days for the second time ever. Last, it averaged only 10.94 in the third quarter which is its lowest quarterly average ever.


• The Russell Microcap Index recently closed at a new all-time high 12 out of 14 days.


• The S&P 500 has closed higher a record 11 consecutive months on a total return basis (i.e., including dividends). Since 1950*, that has only happened two other times, with both instances taking place during the bull market of the 1950s. Be aware though, neither of those made it to 12 months.

Now That’s a Win Streak

Frank “The Tank’s” run through the quad and into the gymnasium eventually ended - and these long market streaks will eventually end as well. It is important to remember that daily streaks of new highs can’t go on forever, and that increases in volatility aren’t necessarily something to be overly concerned about; pullbacks are a regular part of investing.

In fact, the latter stages of the economic cycle have historically seen relatively more volatility, and we expect it to pick up in the fourth quarter and as we head into 2018.

VIX Set For Lowest Annual Average Ever, But...

While intra-month the CBOE Volatility Index reached its highest since November, before plunging back to earth into the end of the month, VIX is still on track to post its lowest annual average on record.

Bloomberg notes that in the past decade, VIX gains in August were followed by September declines in all but one instance.

While VIX has collapsed so far this year, it may not last.

Though VIX ended up paring its August gain to 3.2% - a gauge tracking longer-term wagers posted its biggest increase since January 2016.

In fact, after last month’s 11 percent gain, the CBOE S&P 500 3-Month Volatility Index has reached its highest level relative to the VIX since Aug 2012"s European credit crisis.

The September Federal Reserve gathering and debt-ceiling discussions are among events that could lead to increased market volatility at a time when the S&P 500 Index trades near a record high.

Retail Investors Are Piling Into "The Most Dangerous Trade In The World"

It shouldn"t be too surprising that the XIV exchange-traded note - which is designed to deliver the inverse performance of the well-known CBOE Volatility Index (or the VIX) on a daily basis - is attracting fresh attention after surging as much as 87 percent this year.

But, as CNBC notes, some caution that investing in the exchange-traded product now could be deeply risky.

This could be "the most dangerous trade in the world," according to macro strategist Boris Schlossberg of BK Asset Management.

"It"s already had a massive runup because we"ve had very low volatility," but at this point, "it"s very likely that volatility is going to increase," Schlossberg said Thursday on CNBC"s "Trading Nation."

The rise in this product hasn"t escaped traders" attention. In terms of the dollar value of shares traded, the short-VIX-futures XIV has actually surpassed the long-VIX-futures VXX.

"We think it"s especially interesting that there is now more XIV trading than VXX, perhaps pointing to the growing interest in shorting volatility among retail [investors] and others who are not specialists in volatility trading," Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors, wrote in a Wednesday note to clients.

As for Schlossberg, his warning about the product is based on his view that volatility is set to rise from its current, ultralow levels.

"It"s simply a dangerous trade from a macro point of view," he said Thursday. "As central banks begin to increase rates, we"re going to see more volatility, and this [product] is going to show some very negative days."

In fact, "negative" may be putting it mildly. On a day when the VIX and the VIX futures double in value (perhaps due to bad news out of Freedonia), the VXX could easily double as well, while the XIV could perform the inverse move.

"One big thing that we"ve been highlighting is that this product can actually go to zero," Chintawongvanich said Thursday on "Trading Nation."

"Right now the VIX is around 12 -- just think of a scenario that takes the VIX from 12 to 20-plus in a single day. It"s not impossible. In that case the XIV could easily go to zero," which is something "many investors in this product may not be aware of."

Those who buy the XIV with money they cannot afford to lose, then, could be putting their portfolio in great danger indeed.

And while shares outstanding in the "bearish" VXX has exploded (as shares outstanding in "bullish" XIV), adjusted for the endless decay in price, the trend is clear - forget hedging, forget fear, sell VIX!!

What could possibly go wrong?

US Volatility Spikes To 21-Month Highs (Relative To Europe)

Today"s sudden "Minsky Moment" in markets has pushed US equity risk perceptions to their highest relative to Europe since August 2015, back to old "norms".

As Bloomberg notes, U.S. politics are taking center stage as risks recede in Europe following the French presidential election. With Donald Trump facing the deepest crisis of his presidency, the CBOE Volatility Index surged on Wednesday, while Europe’s VStoxx Index rose less than 5 percent.

Volatility expectations for the S&P 500 Index are near their highest since August 2015 relative to the Euro Stoxx 50 Index.

And it is starting at the short-end of the VIX curve (i.e. this is systemic and not an event-timing risk issue).

And has pushed Equity risk back to its old pre-Trump "norms" against bond risk...