It was just over two months ago - well before VIX hit its record stretch of nearly 20 days below 11 - when we first discussed why one of the major threats to the complacent market was the danger of a forced liquidation by trend-following and vol-neutral, CTA, risk-arb and other systematic funds - many of whom have been the fundamental catalyst for the unprecedented VIX compression seen in May - resulting in an explosive unwind of vol positions.
Of course, nobody knew just what catalyst could led to such an outcome, which is perhaps why last night's quasi-black swan sequence of events involving Trump, which has prompted at least some analysts to suggest could end in impeachment, has had such a dramatic impact on stocks. It is also why vol kept grind lower and lower, as the mechanics of vol-supression in the fund level, as observed most recently in the Catalyst fund collapse, created a feedback loop whereby lower vol led to even more vol selling, and so on, until eventually VIX dropped to an all time low below 9 just a few days ago.
Now, it may be payback time.
First, here's what we know.
According to Bank of America, a combination of upward trending global equity markets with very low volatility have "conspired to push trend following CTA (Commodity Trading Advisor) equity positioning to near record levels. As the chart below show, CTAs have outsized, near-record positions in global equities."
Those curious what assets are currently held by the CTA community, BofA explains that "a significant portion of assets in CTAs appear to be in cross-asset, risk controlled, trend following strategies. More specifically, we find that CTA allocations across multiple asset classes are primarily a function of two factors: (1) the asset’s current price trend and (2) the asset’s prevailing volatility. This understanding forms an intuition for why CTAs’ current global equity positioning is so stretched."
While the above is not news, what is more notable, especially during selloffs like today, is that as a result of current extreme positioning, "the beta of CTA strategies to global equities is also at extreme levels and specifically during equity market sell-offs."
Tying back to our warning from March, BofA then writes that "for CTAs who are risk controlled, which we think most are, in the current environment it could take a relatively smaller equity market decline to trigger rules-based selling pressure. However, as different CTAs have varying sets of rules and risk control mechanisms, the selling pressure may not necessarily occur simultaneously or even within the same day."
While bulls would be delighted if CTA liquidation is asynchronous, BofA's Benjamin Bowler writes that on average it would seem that CTAs do react relatively quickly and in sync to sharp price reversals as the realized volatility of a CTA benchmark (the SG CTA Index which is priced daily) has remained historically stable despite wide-ranging volatility for the cross-asset universe in which they allocate.
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Next, we take a look at what we don't know, which in this case is far more important: how big a vol move would be needed to catalyze a forced CTA liquidation, and what market impact could it have?
For the answer, we again turned to BofA which writes that if the combination of higher stocks on ultra-low vol is indeed putting CTAs’ equity positions at elevated risks of sudden deleveraging, then it is important to estimate the contribution of potential selling pressure versus liquidity of the markets in which they trade, particularly in a risk-off event. However, estimating CTA equity selling pressure is relatively more difficult than rationalizing their outsized positioning as, for example, key questions surround (1) what percentage of total CTA assets are in explicit rules-based, trend following strategies and importantly (2) how diverse the models are for rules-based, trend following CTAs.
According to BarclayHedge, AUM within the CTA industry through the end of 2016 stood at approximately $250bn. In our recent QIS Panorama we showed that the performance of the Altegris 40 Index (an asset-weighted benchmark CTA index priced monthly) could be well-explained by cross-asset, risk controlled trend following strategies. This benchmark currently accounts for $106bn in assets (~40% of the total CTA AUM) and therefore we conservatively estimate the potential range of assets in rules-based trend following strategies as between ~$100bn and ~$250bn.
The current allocation to global equities from our bottom-up CTA model is about 70% of total assets. This equates to somewhere between $70bn and $175bn of global equity exposure for trend following CTAs. Global equity allocations in our model are represented by investments in the three most liquid futures contracts in each of the major regions (US: SPX, NDX, RTY; Europe: SX5E, DAX, UKX, & Asia: NKY, HSI, KOSPI).
As noted above, with CTAs’ current global equity positioning historically high, it would take a smaller equity market decline to trigger rules-based selling pressure. BofA's model of global equity allocations and required 1-day market moves to force an entire unwind are shown in Table 1. While some of the 1-day declines seem feasible (e.g. SPX ~1.5%), others appear less attainable (e.g. RTY ~10%). Even though some moves that would drive a large model-driven unwind seem possible, given the extreme lows in equity volatility currently, many are high relative to current volatility (e.g. ~1.5% SPX 1-day decline would be near a 3.6-sigma move currently).
A one day's crash may not be enough however, and "successive shocks likely needed for full equity unwind but liquidity also higher." BofA continues:
Based on history, there is a low probability that markets could move enough in one day to trigger a full unwind of current record CTA equity positions. However, successive ‘high-sigma’ declines in today’s environment could happen with greater likelihood. By successive high-sigma declines, we mean multiple days of down moves that are high relative to prevailing volatility. In Table 2 are three 5-day periods since 2006 in which global equity markets saw successive high-sigma declines that could in the current environment trigger a complete unwind of near record CTA equity positions.
Looking back at history, Bowler observes that should equity markets decline in similar fashion to the one week periods from late Feb- 07, the Aug-11 US credit downgrade, or the Aug-15 sell-off then according to our model CTAs would unwind mostly all of their global equity positions to limit losses.
Which leads to critical question: how much selling pressure could CTAs unleash?
Based on our estimates, that would be between $70bn and $175bn in global equity futures selling pressure which as a percentage of 3-month median daily global equity futures notional volume is between 20% and 55%. This amount of impact in one day may seem large but does not take into account two important factors. First, in stress events similar to Feb-07, Aug-11, or Aug-15 it’s reasonable to expect a substantial increase in equity index futures volume versus prevailing median levels. Second, in order for the entire unwind to happen within one day, we would need (1) global equity markets to see a never-before seen shock in sigma terms and (2) the entirety of CTA assets to be in pure trend following programs with an extremely similar set of rules to limit drawdowns which we do not think is the case.
In other words, CTAs, on their own, are unlikely to catalyze another Black Monday-type event in one day. What about over several days?
It is more reasonable to consider a situation in which CTAs collectively unwind their global equity positions over multiple days of consecutive high-sigma declines. Through each of the stress events in Table 2 we measured the increase in the respective equity future indices’ notional volume through the 5-day decline versus the median 5-day notional volume over the three months prior. On average, most major global equity index futures saw a doubling in prevailing volume in stress events (Chart 7). Therefore, given current 3-month median weekly notional futures volume on the nine global equity indices of about $1.6 trillion, if we see an event large enough to trigger a model driven unwind of CTA equity positions then we estimate global equity index futures volume rising to $3.2 trillion (Chart 8). In this extreme, if the entirety of our highest estimate for CTA’s total equity allocations (~$175bn) is unwound within a week of successive high-sigma equity market declines, then it would equate to only ~6% of the expected volume.
The estimated equity selling flows from CTAs in high-sigma events could have an impact on markets but it is quite difficult to suggest they would be the dominant driver in a severe shock. While not being the primary seller, conceptually CTAs can have the scope to add convexity to a fundamentally-driven sell-off as they could become a nondiscretionary seller in times when the market is already declining. In this case, the potential flows may become more meaningful depending on how uniform CTA models are, how quickly they react to changing price trends, and as well what portion of CTA assets are represented by rules-based trend-following strategies.
The good news: momentum-chasers will unlikely kill the market on their own. What, however could have a greater impact, is the feedback loop of CTA selling coupled with other traders frontrunning such a move, exacerbating the impact, in other words, when fears of CTAs driving the market lower become a self-fulfilling prophecy. BofA explains:
While our expectations of potential CTA equity deleveraging flows may not dominate volumes in isolation, a remaining unknown is the additional selling pressure from investors fearful of these model driven flows. But even if we were to see volumes increase up to 3x daily levels (vs. 1.5x from CTAs alone), the biggest one-day sigma decline since 2000 would imply only a 2% decline in global equities in a single day. For an even broader perspective, since 1928 the largest one-day S&P 500 sigma decline observed was 11x which off today’s MSCI vol levels equates to only a 3.5% down day.
It’s important to also keep in mind that CTAs will only react to downward price action and that they will not instigate it. But if a sell-off comes in response to no immediate or obviously accountable macro catalyst, then some may look to the role of CTAs in trying to explain the market decline. The fear of CTA’s rules-based, nondiscretionary selling flows in stress periods may cause other more fundamental and discretionary managers to also unwind which could then potentially create a negative feedback loop of successive declines in equity markets.
Further, as we’ve noted in the past, equity futures market liquidity is not only measured by total volume but also market depth which in recent risk-off events has declined in times of vol shocks. The greater the selling pressure that is concentrated in a shorter time period against falling market depth (when liquidity is needed most) could also further exacerbate market shocks.
However, the idea that CTAs can cause another ’87-style crash in our opinion is likely too extreme. First, on 19-Oct-87, the S&P 500 declined nearly 21% in one day which given today’s vol levels would be a 56-sigma event and nearly 5x higher any daily sigma event the S&P 500 has seen since 1928. To observe a historically significant one-day decline, volatility would likely need to be much higher. However, if volatility were indeed higher, then equity positioning in CTAs should be lower and therefore also the amounts they can deleverage. Lastly, circuit breakers that halt trading after sufficient declines which were introduced in response to events like 1987 should also help reduce the likelihood of similar shocks occurring again.
To summarize: CTAs controlling their risk could be forced to sell should there be a sudden fall in equities and spike in volatility. Given their higher beta to equities currently, it should take smaller equity market declines for CTAs to start unwinding longs in order to control their volatility. CTAs are estimated to be currently long somewhere between $70bn and $175bn in global equities. Should we see a sequence of ‘high sigma’ shocks over multiple days similar to those observed in Aug-15 or the Aug-11 US credit downgrade, then according to our models, CTAs could unwind mostly all of their equity allocations.
However, due to various size-related limitations, the real risk is fear itself, but low vol limits shock size. As BofA adds, "the largest risk from CTA selling is the flows generated from non-CTA funds fearful that they could cause the next crash. However, understanding CTA mechanics and the limits of their impact can help investors more confidently take advantage of any potential overreaction.
Importantly, even under a doubling of demands on futures liquidity to 3 times a normal day, that’s still within the bounds of recorded volume shocks since 2000. Even then, markets have not exceeded a 7-sigma event which equates to only a 2% worst-case daily decline at today’s low volatility. Selling from other quant funds, including vol controlled risk parity could add to selling pressure in certain instances but if prolonged over a week are not likely to dominate flows."
While some have suggested model-driven indiscriminate selling from CTAs could be the modern version of portfolio insurance often cited as fuelling the 1987 crash, there are some important differences to keep in mind:
1) Equity exposure in CTAs is finite, and once exhausted it will no longer be a threat; at most it would likely last for a few days or up to a week,
2) any slow build-up in volatility or drift lower in equities would cause CTAs to de-risk from their record equity positioning, reducing potential selling pressure,
3) even if CTAs shifted from long to short during falling markets, the high market volatility would limit the size of their short positons, hence limiting their impact, and
4) historically the type of shock required to cause a full de-risking of CTA positions is nearly unprecedented, as most large shocks build over time
This means that while CTAs would be a critical component of any market selloff feedback loop, on their own they would likely not be responsible for a market crash a la 1987 or 2015. That would require the additional selling pressure from other vol-neutral funds such as risk parity, as well as potential marketwide margin calls.
Still, with the risk of such a pernicious feedback loop emerging in the current low-vol environment in which virtually nobody is hedged for a multiple-sigma move lower, this may be an opportune time for one or more central banks to step in and either directly or verbally jawbone the market higher, as the PBOC did yesterday.
Perhaps the biggest question, in retrospect, would be if the Fed, or other central banks, do not do step in as they have on every other similar occasion in the past 8 years.
Would that imply that traders - be they CTAs, risk-parity, or simply carbon-based - are finally on their own?