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.

New Warning Signs Emerge For Subprime Auto Securitizations

Last month, we pointed that one of wall street"s largest underwriters of auto debt was suddenly slashing their own holdings of auto loans while simultaneously ramping up the issuance of auto securitization facilities thereby pawning off the risk to "suckers" who have no idea they"re jumping in front of yet another financial freight train (see "Deja Vu: JPM Slashes Auto Loans For Their Own Book; Ramps Up ABS Issuance For The Suckers").

Now, according to Bloomberg and Wells Fargo, new signs are emerging which suggest that auto ABS facilities, like their RMBS cousins of last decade, aren"t quite as bullet proof as the "suckers" thought they were.  While a subtle degradation, Wells Fargo points out that fewer auto borrowers are suddenly paying off their loan balances early.  And while that may not sound as dire as say a default, it suggests that auto borrowers may be finding it more difficult to find new financing when they go to trade in their 3-year old clunker for that brand new BMW.

Fewer subprime borrowers are paying off their auto loans early, a possible sign that consumers with weaker credit scores are struggling more, according to a report by Wells Fargo & Co. researchers.

Borrowers are making fewer extra payments on loans that were bundled into bonds in 2015 and 2016, compared with loans in 2013 and 2014 bonds, according to Wells Fargo analysts led by John McElravey. The data on prepayments may offer another sign that subprime consumers are having more trouble paying their bills, the analysts wrote in a note dated Tuesday. Borrowers are already defaulting on a growing amount of auto debt.

Last decade, slower monthly payment rates on credit cards were an early sign of the consumer credit cycle changing for the worse, the analysts wrote. For auto loans, slower prepayment may be more of a coincident indicator than a leading one, they wrote.

Of course, just like 2007, the largest seller of auto ABS, Wells Fargo (just as Bear Stearns did in 2007), is telling investors that they have nothing to worry about...unless you think slower paydowns and a massive declines in used car prices are a problem...

The researchers at Wells Fargo, the number one seller of bonds backed by subprime auto loans, have said that the bonds pose few risks to bondholders, even though they recommend investors cut their risk exposure because of valuations.

Slowing prepayments can hurt investors in bonds backed by car loans, said Peter Kaplan, a senior portfolio manager at Merganser Capital Management. They can result in a deal’s bonds getting paid down more slowly, which can hurt the riskiest securities in a transaction.

“I think downgrades are completely possible,” with a remote possibility that the riskiest securities will take losses, he said.

Lenders and big bond graders, such as S&P Global Ratings, have pointed to the debts’ fast amortization and possible upgrades as reasons for investors to have faith in the securities.

Of course, this is just the latest sign of trouble in auto ABS...below are recent developments in delinquency and default trends courtesy of Morgan Stanley.

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If you"re among the growing minority of investors still under the impression that  "everything if awesome" in the auto industry simply because new car sales volumes continue to hover around all time highs, while turning a blind eye to soaring incentive spending and that pesky little debt bubble, then we may need your help with how we should be interpreting the following subprime auto loan delinquency stats from Morgan Stanley. 

In a recent report, Jeen Ng of Morgan Stanley took a look at 266 subprime auto ABS deals to assess the underlying "health" of the auto loan market and this is a recap of what he found.

First, despite low unemployment, high consumer confidence and debt-to-income ratios at 30-year lows, 60+ day delinquencies and default rates are soaring back to "great recession" levels for prime and subprime auto securitizations.

Meanwhile, loss severities are also starting to rise... 

....just as used car prices come under pressure...

...which likely has something to do with the flood of lease returns that are about to hit the market...

Of course, it can"t be that these deteriorating credit metrics are the result of 21 consecutive quarters of loosening lending standards from 2Q 2011 through 2Q 2016, right?

Lending Standards Have Eased...: While overall household debt remains below pre-crisis peaks, auto debt has ballooned to all-time highs. While this debt grew, the median FICO score of borrowers receiving auto loans fell roughly 30 points from peak to trough. According to the Senior Loan Officer Opinion Survey (SLOOS), auto lenders eased lending standards for 21 consecutive quarters from 2Q 2011 through 2Q 2016.

...but Lenders Now Appear to Be Reversing Course and Tightening Standards: While FICO scores did drop precipitously, they have recovered in recent months, and the SLOOS reports 3 quarters of tightening standards after the 21 of easing. A look at the weighted average FICO scores of loans going into subprime ABS deals reveals similar trends, with a number of lenders reporting increases in these scores over recent years. However, the overall trend has moved lower since 2013.

Meanwhile, just like in the past housing crash, the mix of "deep subprime" collateral being pawned off on the ABS market is soaring...because who else would buy it?

Shift in Deal Mix the Real Culprit: The main driver of this dynamic appears to be that, while individual lenders are increasing their weighted average FICO scores, the securitization market has become more heavily weighted towards issuers that we would consider deep subprime - those with a weighted average FICO score below 550. In fact, since 2010, the share of Subprime Auto ABS origination that has come from these deep subprime deals has increased from 5.1% to 32.5%.

Deep Subprime Driving Delinquencies: Since 2012, 60+ delinquencies of non-deep subprime deals picked up from 3.03% to 3.92%. While that 89bps increase certainly demonstrates deterioration, it pales in comparison to the over 300bps increase coming from these deep subprime deals.

But sure, 18mm new cars per year is probably a "normalized" level of demand for the U.S. market...just like 1.3mm in new home sales was "normal" in 2005.

The Other Shoe Drops: Prime Auto Loans Losses Surge As Recoveries Tumble

When we looked at subprime auto delinquencies most recently, we found some troubling trends: first, in February, we showed that 61+ day delinquencies in General Motors" subprime securitization book would support a rather bleak thesis for future auto sales, and specifically the demand side of the equation, with January 2017 delinquency rates soaring to the highest levels since late 2009/early 2010. 

Ironically, this hasn"t stopped lenders from providing financing, and according to Morgan Stanley since 2010, the share of Subprime Auto ABS origination that has come from deep subprime deals has increased from 5.1% to 32.5%, suggesting that yield-starved buyside will put "other people"s money" into anything as long as it provides a slightly higher yield.

Meanwhile, the subprime shock has already impacted the broader market, observed with the latest monthly auto sales data which declined four month in a row heading into May. An even bleaker picture of the subprime market emerged a month later when looking at the latest securitization analysis from Morgan Stanley which revealed that 60+ day delinquencies at 266 subprime auto ABS deals were surging - despite low unemployment, high consumer confidence and debt-to-income ratios at 30-year lows - back to "great recession" levels. Meanwhile, loss severities were also shooting higher just as used car prices were sliding.

 

In part, this tied in with the overnight look at the "flood of off-lease vehicles", according to which by the end of 2019, an estimated 12 million low-mileage vehicles are coming off leases inked during a 2014-2016 spurt in new auto sales, which is set to put even more pressure on used (and new) car prices for the foreseeable future.

As Reuters noted, a computer search for available used vehicles within 150 miles of Reel revealed an eye-popping figure: 668 Escapes. That"s enough to put more than 40 percent of the inhabitants of this small northeastern Ohio town, population 1,600, into the popular crossover. A search for the Chevrolet Equinox, a comparable crossover, showed 461 available.

"The automakers have flooded the market," said Reel, owner of Reel’s Auto in Orwell, Ohio, about 40 miles east of Cleveland.

The above trends validate a recent bearish Morgan Stanley analysis, which forecast that the plunge in used car prices is just getting started, and in a bear case, the bank sees used car prices dropping by up to 50% over the next 5 years.

 

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However, in an even more troubling development for US consumers, it now appears that the other shoe for the US auto market has finally also dropped, and according to analyses by both Morgan Stanley and S&P, losses on prime auto loans are also surging.

In the latest note by Morgan Stanley"s Jeen Ng, the analyst reports that "fundamental performance deterioration has not been confined to Subprime. Both 60+ day delinquencies and default rates in Prime ABS pools have nearly doubled from their post-crisis lows."

A slightly better picture - at least according to MS data - emerges in terms of loss severities. Still, while subprime losses are far worse, the deterioration among prime loans is unmistakable: compared to peak levels, 60+ day delinquencies in Prime auto loan pools are roughly 65% of the way back, whereas Subprime pools are close to 95% of their peak levels. On the default rate side, the deterioration is somewhat more subdued, with Subprime over 80% of the way back to prior peaks while Prime has yet to reach the 45% mark.

One troubling observation, as confirmed in the recent Fed Senior Loan Officers Survey is that credit standards have continued to ease: as in Subprime, some of the ongoing Prime deterioration can be attributed to a relaxing of credit standards.

Aggregate credit scores have decreased by about 5 points, which while easier is not even half as much as the 10+ point deterioration in Subprime. The same is true for longer origination terms. Most Prime issuers have extended loan terms by 3-4 months over the past 5 years. In Subprime, extension in most cases has been longer than 10 months. These easier standards can help explain both why delinquencies and defaults are higher, according to Ng. Also, keep in mind, there is a limit as to how far Prime issuers can expand their credit box in the form of lower credit scores before the deals become Subprime.

Some more observations from Morgan Stanley, which finds a particular deterioration in recent loan issuance at Huyndai and Mercedes:

As auto lenders expand their credit box to weaker credit borrowers, we should expect to see poorer credit performance among more recent deals relative to the more seasoned ones.

Across the OEM originators above, we see a very consistent shift in lending standards over time - marginally longer loan terms, higher credit scores and lower used car composition. Overall, the longer loan terms and higher credit scores have offsetting effects on fundamental performance. If we look at the 60+ delinquencies and 3-month CDR curves by vintage, we don"t necessarily observe performance  deterioration over time, and for some issuers we even see relative outperformance among recent deals. However, we do see higher severities among recent vintages, which we can at least partly attribute to the decline in used car values.

HART (Hyundai) and MBART (Mercedes Benz) serve as exceptions to the above, with a higher % of used vehicles and FICO migration of less than +10 points over the last 7 years. They are also the two shelves which show the most pronounced performance shift. TAOT (Toyota) also extended their credit score by less than 10 points, but their change in origination loan terms has been minimal and they have a lower  composition of used vehicles over time.

Additionally, in terms of loss severities, the bank finds that all originator types appear to be trending higher in similar fashion, with non-bank originators printing the lowest recovery values. OEM originators overtook bank originators to see the highest recovery values last year.

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In a separate, and even more downbeat report, S&P Global Ratings analyst Ann Matin noted that losses in bonds tied to "prime auto loans have surged surged in recent months from a year ago, hurt by falling recoveries" and notes that prime net losses rose to 0.73% in February from 0.57% in same month last year. According to S&P, bonds from some issuers that have become a larger share of the index, including Mechanics Bank’s California Republic and TCF Financial Corp., and both are contributing to those higher losses.  Additionally, the rating agency referred to the abovementioned loan losses at Huyndai, stating that “we’ve increased our expected cumulative net loss levels for certain issuers, including Hyundai’s most recent transaction, HART 2017-A."

Margin also wrote that prime asset-backed deals issued in 2015 seem to be performing worse, comparatively, than those sold between 2010 and 2014, and the deterioration in loans made to strong credit borrowers has forced S&P to revise its net loss expectations for various bonds.

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To summarize: subprime loan losses have been surging alongside loss severities (with the buyside happy to soak up any and all issuance, regardless of underlying fundamentals), as recoveries slide, and in recent months this deterioration has finally shifted over to prime loans. Meanwhile, used car prices are tumbling, while new car sales have declined for 4 consecutive months as auto loan demand among tapped out consumers has tumbled. Meanwhile, millions of used cars are about to hit the market as they come off lease, which in turn will further pressure used car prices and new car sales.

So what happens next?  Here, we"ll repeat what we concluded last night:

Unstable used car prices will almost certainly reduce OEM reliance on leases as the implied 3-year depreciation (or residual values, if you prefer) will make them all but completely uneconomical: remember, Americans only care about that monthly payment.  Meanwhile, the relative value between used and new cars will tilt heavily in favor of the used market.  Thankfully Americans will still be able to buy that Mercedes they require to get back and forth from their minimum wage jobs, while maintaining a monthly payment of $500 or less, but it will just have to have 30,000 miles on it.

Of course, the OEMs of the world won"t admit that their game is over until it"s way too late.  So, they"ll keep right on producing new cars to cover a 17-18mm SAAR environment up until the point they face an outright revolt from their dealer networks.  At that point, however, dealer inventories will be so high that Detroit will be forced to shutdown for months on end while new car prices are slashed to reduce the massive inventory glut.  Tanking new car prices will put even more pressure on used car prices which will mark the beginning of the death spiral that will result in a new round of inevitable auto bankruptcies, catalyzing the next economic contraction... assuming one hadn"t started already.