By Saqib Iqbal Ahmed
NEW YORK, Oct 1 (Reuters) - The recent stock market rally has left some systematic trading strategies so heavily exposed to equities that even a modest market pullback could force them to dump billions of dollars of shares, amplifying any potential selloff.
Volatility control funds – systematic investment strategies that typically buy equities when markets are calm and sell when they grow turbulent – bought up stocks as the S&P 500 rose 12% for the year.
As stocks have rallied on
robust earnings performance, propelled by spending to build out AI infrastructure, volatility has petered out, meaning these strategies needed to ramp up risk-taking.
The buying has continued in recent weeks, pushing these strategies' equity allocations to the 98th percentile — meaning they've been higher only about 2% of the time since 2010, according to Deutsche Bank data.
Not only do these strategies now have limited capacity to add further to their equity holdings — drying up a reliable source of buying support for the market — but they are also increasingly vulnerable to any market shock.
"Volatility control exposure is historically stretched," said Stefano Pascale, head of US equity derivatives research at Barclays.
"In particular, even a mild rise in volatility would theoretically cause a significant exposure unwind, which could potentially further exacerbate volatility in the market," Pascale said.
That could exacerbate any selloff and illustrates the fragility of markets right now. The narrowly-led, tech-driven rally has left investors crowded into the same stocks, so a small shock could snowball.
With 1-month and 3-month S&P 500 realized volatility — how much stocks are actually swinging — hitting multi-month lows earlier this month, it would not take much to jolt market gyrations higher from these depressed levels, analysts said.
"Further volatility compression would support incremental re-levering, while a volatility spike could trigger sharper de-leveraging," JPMorgan global equity derivatives strategists said in a note on Monday.
ASYMMETRIC RISK
Vol control strategies are run by a variety of firms, including insurance and annuity issuers as well as asset managers. Since these funds generally don't publicly disclose exact strategy-level AUM, there's no single authoritative figure, but estimates from various banks peg their assets at $300 billion to $500 billion.
While the potential scale of selling is relatively small compared with the $66 trillion value of the S&P 500 alone, selling by such funds often tends to exacerbate volatility well beyond what their size would suggest, analysts said.
"Their first-order effect is rather limited ... the tail won't wag the dog," said Nathan Shetty, chief investment officer at SEI, a financial technology and investment management firm. SEI runs the Global Managed Volatility Fund, which aims to reduce risk by picking steadier stocks, not by cutting equity exposure when volatility rises.
"(But) watching their behavior is and can be a signal in and of itself ... there's a reflexivity to it that could lead to other managers, professional investors and otherwise changing their positions," Shetty said.
Vol control strategies react differently to shifts in volatility, but Pascale uses a typical 10%-vol-target fund to illustrate the reaction function: with an equity allocation currently around 88%, a further drop in volatility that pushed that allocation to 99% could require an additional $25 billion in buying.
Conversely, applying that same reaction-function model to a mildly bearish scenario, the typical fund's equity allocation could fall to below 40% — a shift that would entail selling more than $100 billion in equities.
"That's a lot of asymmetry," Pascale said.
Equity allocations for another volatility-sensitive systematic strategy, Commodity Trading Advisors (CTAs) — trend-following funds that scale exposure up or down based on price momentum and volatility — also sit at a historically high 82nd percentile, according to Deutsche Bank.
Like with vol control funds, these too present limited scope to add equity exposure, having already priced in much of the recent momentum. The potential gains for equities are dwarfed by potential losses should markets falter.
A UBS estimate from late August — the most recent analysis available — suggests a two-sigma move, a rare price swing that happens only about 5% of the time, could trigger five times as much selling on the downside as buying on the upside.
With US midterm elections in five weeks, the precarious positioning in these systematic strategies is a risk "that appears increasingly relevant," Barclays analysts said in a note.
(Reporting by Saqib Iqbal Ahmed; editing by Megan Davies and Nick Zieminski)
