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.

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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.

How Passive Investing Distorts Earnings Season

In a spirited defense of today"s inefficient market, one which is allegedly unimpaired by the relentless metastasis of passive investing, Bloomberg wrote an article using Macro Risk Advisors data, in which it said that "for all the handwringing about how the growth of passive investing strategies is distorting the stock market" it concluded that "there’s virtually no market impact from it. Correlations remain at all-time lows and the amount of shares that are passively managed isn’t affecting single-stock."

Conventional wisdom has held that as passive investment strategies accumulate larger piles of assets under management -- the 14 percent represents an all-time high -- it would lead to lockstep moves in stocks, making life harder for traders seeking informational edges by offering fewer opportunities to capitalize on insights into earnings and other signals. Instead, the MRA data show, that any reaction in the market has been muted -- if there’s even been one at all.

Bloomberg was referring to these three familiar charts, showing the acute fund flow from passive to active strategies in recent years.

Unfortunately for defenders of the ETF boom, Bloomberg"s assessment is also wrong, because in a separate analysis released concurrently by Bank of America, Savita Subramanian reached just the opposite coinclusion.

BofA looked at the response of stocks which missed EPS estimates, and found two dramatically different outcomes for stocks with high vs low passive ownership. This is how she describes her findings:

Not only can crowding by active managers suggest risk to stocks, but high-passive ownership can matter, particularly during earnings season. Over the past seven quarters (including the 2Q earnings season so far), stocks with high passive ownership that missed on EPS and sales have underperformed those with low passive ownership by 1.5ppt on average during the following day, and the spread has widened significantly during recent quarters. This increased performance spread may be attributable, in part, to lower "true float" in these stocks, which appears to have driven increased volatility.

The increasingly disproportionate adverse reaction of high passive ownership stocks is shown in the chart below: it is most evident in Q2 2017 earnings.

The recent trend of stocks to have a materially more pronounced negative response to earnings misses has been discussed previously, however until now there was no quantifiable explanation.

BofA"s take, which can easily be tested for validation purposes, presents various arbitrage opportunities chief among which is creating a basket of high passive ownership stocks, and betting on sharp declines either through single-name short positions or puts while avoiding low passive ownership names, with expectations of this skewed return profile. One potential hurdle is that this earnings season - which is as of now 66% complete - companies that miss have been relatively few, although if this pattern persists, it should provide significant alpha opportunities during the Q3 earnings season, when the overall quality of earnings is expected to decline substantially as the base effect of last year worst quarter will be in the rearview mirror, while the much anticipated surge in energy earnings will have trouble materializing if oil fails to trade solidly in the mid-$50 range, not to mention the risk of either inflation finally creeping higher or the Fed following through with its balance sheet unwind promise.

The Tech-Wreck - A Shot Across The Bow For "Passive Indexers"

Authored by Lance Roberts via RealInvestmentAdvice.com,

I wanted to pick up on a discussion I started in this past weekend’s missive, with respect to both Friday’s rout in technology stocks as well as Monday’s rather nasty open. While the issue seemed to be a simple short-term rotation in the markets from large capitalization Technology and Discretionary stocks into the lagging small and mid-capitalization stocks, the sharpness of the “Tech Break” on Friday revealed an issue worth re-addressing. To wit:

“Both Discretionary and Technology plunged on Friday as a headline from Goldman Sachs questioning ‘tech valuations’ sent algo’s running wild. The plunge was extremely sharp but fortunately regained composure and shares rebounded. A ‘flash crash.’

One day, we will not be so lucky. But the point I want to highlight here is this is an example of the ‘price vacuum’ that can occur when computers lose control. I can not stress this enough.

This is THE REASON why the next major crash will be worse than the last.”

I am not alone in this reasoning. Just recently John Dizard wrote for the Financial Times:

“The most serious risks arising from ETFs are the macro consequences of too much capital being committed in too few places at the same time. The vehicles for over-concentration change over time, such as the ‘Nifty Fifty’ stocks back in 1973, Mexican and Argentine bonds a few years after that, internet shares in 1999, and commercial property every other decade, but the outcome is the same. Investors’ cash goes to money heaven, and there is a pro-cyclical decline in productive investment.

Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing. Since US growth stocks such as Avon, the cosmetics company, Polaroid, the photography group, and IBM, the computer company, outperformed the market, growth-orientated portfolio managers raised more money in the early 1970s, which then led to more cash going to buy the same stocks.”

Andrew Lapthorne from Societe Generale also weighed in:

“The sell-offs themselves are not particularly unusual, but the uniformity of the prices moves all on the same day indicates a market driven by price chasing momentum, with investors heading for the door all at the same time.

Indeed, those S&P 500 stocks which sold-off on Friday were almost all from the strongest performing decile over the previous 12 months (the r-squared on the S&P 500 line in the chart below is 85%). Within Nasdaq, the relationship is even stronger at 95%.

Such a uniform sell-off strikes us as systematic, especially as the relationship weakens once you look at the broader and less liquid Nasdaq composite. For price chasing investors, Friday’s plunge serves as a warning; when it’s time to head for the door, you better move fast.”

These points are absolutely correct, and as I addressed in the Passive Indexing Trap:

“At some point, that reversion process will take hold. It is then investor ‘psychology’ will collide with ‘margin debt’ and ETF liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the ‘herding’ into ETF’s begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause catastrophic spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments. Don’t believe me? It happened in 2008 as the ‘Lehman Moment’ left investors helpless watching the crash.”

“Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious and without remorse.

Currently, with complacency and optimism near record levels, no one sees a severe market retracement as a possibility. But maybe that should be warning enough.”

Warning Shot

As was seen on Friday, and again on Monday, the consequence of a “rush for the exits” can leave investors a bit flat-footed in the process. However, don’t mistake the importance of that statement.

One of the biggest problems facing investors is ultimately when “something goes wrong.” When this happens, the initial response is paralysis, followed by a bit of panic, before ultimately falling prey to the host of emotional mistakes that repeatedly plague investors time and again. 

This time is likely to be no different.

Currently, I do not believe that we have begun the next major corrective cycle. In fact, the current rout has all the earmarks of another “buy the dip” move to feed the ongoing bullish mantra.

While there is certainly damage being wrought in the Technology and Discretionary sectors, the rotation to Financials, Energy, Small and Mid-Capitalization areas are offsetting the correctionary process. As shown below, the markets remain confined to the bullish trend currently while the overbought condition is being reduced.

However, this should be a clear “warning shot” to investors who have piled into ETF’s in the hopes indexing will offset the penalties of not paying attention to the risk they have taken on. 

“While passive indexing works while all prices are rising, the reverse is also true.”

Importantly, it is only near peaks in extended bull markets that logic is dismissed for the seemingly easiest trend to make money. Today is no different as the chart below shows the odds are stacked against substantial market gains from current levels.

As my partner, Michael Lebowitz, noted in a recent posting:

“Nobody is going to ring a bell at the top of a market, but there are plenty of warped investment strategies and narratives from history that serve the same purpose - remember Internet companies with no earnings and sub-prime CDOs to name two.”

Once prices fall enough the previously “passive indexer” becomes an “active panic seller.” With the flood of money into “passive index” and “yield funds,” the tables are once again set for a dramatic and damaging ending.

In the near term, over the next several months or even a year, markets could very likely continue their bullish trend as long as nothing upsets the balance of investor confidence and market liquidity. However, of that, there is no guarantee.

As Ben Graham stated back in 1959:

“‘The more it changes, the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, ‘the more it changes.’

The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound,  then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.

In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one.”

He is right, of course, things are little different now than they were then.

What is important to remember is that for every “bull market” there MUST be a “bear market.” While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline. 

Oh…so you say you’re going to “sell” those “passive ETF’s” before that happens?

Ahh! Well, you are not so “passive” after all.