Quant Funds Are Searching For Alpha In Dangerously Illiquid 'Exotic' Assets

Given the (until very recently) persistent upward trajectory of benchmark market returns since the financial crisis, many traders have become numb to the risks stemming from an over-reliance on leverage. This concept is even more applicable to illiquid, exotic markets like, say, betting on European power spreads, a strategy that last month forced one uber-wealthy Norwegian power trader into bankruptcy and nearly brought down the Nasdaq Nordic commodities exchange, because, as the trader, who was once the largest taxpayer in Norway, learned the hard way, when buyers are scarce, a chasm can open up between bids and asks, causing prices to plunge whenever a trader is forced into a firesale, leading to staggering losses. 

Now, with US stocks poised to catch down to the ROW following months of decoupling as the bout of market turbulence that started earlier this month stretches into its second week, Bloomberg has brought us a story about the growing popularity of a "niche" investing strategy being embraced by CTAs and other quant funds. The strategy hopes to generate "uncorrelated returns" (particularly useful when stocks enter correction territory) and some extra alpha by investing in the aforementioned power markets, Turkish scrap steel, obscure chemical products, or eggs in China.

Ctas

These funds have septupled in size over the past five years, climbing from $1 billion to $7 billion in total AUM among CTAs alone. However, as speculative flows into these tiny markets intensify, it could create problems for investors hoping to recover their money in a selloff.

With at least $7 billion invested across at least eight such funds, up from one fund and $1 billion five years ago, these alternative CTAs remain very much a niche strategy. But trend-following funds have been blamed in the past for amplifying selloffs in some of the most liquid assets, because they tend to rely on similar models. As more money is targeting much smaller markets, even some managers warn of risks if funds pile into the same trade or unforeseen events cause a selloff.

"These assets are less arbitrated and subject to wider moves," said Philippe Ferreira, a Paris-based senior cross-asset strategist at Lyxor Asset Management, which invests in hedge funds.

Still, with equities already so richly priced, the lure of uncorrelated returns has proven too strong to resist.

Investors have flocked to exotic trend followers because they promise diversification and a way to shield portfolios from broad market shocks. Electricity markets in Northern Europe, for instance, may be relatively more dependent on rainfall in Norway than on global market trends. Prices of purified terephthalic acid, a chemical used to make polyester, depend on sales of yoga pants or plastic bottles.

Outside of CTAs, funds targeting alternative assets have multiplied over the past few years as capital has poured in...

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Since last year, five new funds have joined the fray from money managers such as Aspect Capital and GAM Holding AG. One reason is that traditional trend-following funds struggled this year as volatility returned and some investors shifted to cheaper smart beta funds.


After attracting net inflows of about $51 billion in three years through 2017, investors pulled about $14 billion this year, according to Eurekahedge. The strategy suffered its worst loss in years in February when a particularly popular trade -- a bet that volatility would remain low -- imploded in sudden market selloff. They are suffering another tough month in October, with the SG Trend Index, which tracks returns for 10 such funds, down 5.4 percent through Oct. 18.

...And they recently received the blessing of pension funds.

Their alternative siblings, by contrast, have mostly made money this year, attracting investors. The latest stamp of approval came from the pension funds for New York City’s police and fire departments, which in August allocated a combined $134 million to London-based Florin Court Capital that runs one of these money pools.

Cambridge Associates, a consultant which guides some of the world’s largest pensions and endowments on where to invest, approved alternative market fund Gresham Quant ACAR earlier this year, according to people with knowledge of the matter. CERN Pension Fund, which invests for employees of the European nuclear physics research organization, allocated $10 million to the AHL Evolution last year even as it cut exposure to hedge funds, according to its annual report.

But the increasing popularity of these strategies can amplify risks as an influx of trend followers more easily distorts prices, increasingly the likelihood of a devastating crash.

Critics fear that their popularity could become their biggest enemy as more money chases higher returns in relatively small markets. Often, firms will use over-the-counter contracts to place their bets because there’s no exchange where futures on these assets are traded. That means fewer buyers when markets go south, and it means fewer data points for the computer models to build on.

Fund mangers acknowledge that crowded trades in alternative markets could pose a risk, but they argue the strategy will always be a niche, the icing on the cake for sophisticated investors who understand the illiquidity risk. They also say that such funds will be capped because there’s a limit to how much money each can put to work in their exotic markets.

"Growth of such strategies should be naturally limited by the liquidity and tradability of the underlying alternative markets and the first mover is likely to take all," said Nicolas Roth, head of alternative assets at Geneva-based investment firm Reyl & Cie.

Though others argue that, since speculators are more likely to interact with actual producers who need these assets for different purposes, like providing power to swaths of northern Europe, it could be easier for both sides of the trade to declare a "win", since the buyer can have a material need that would be impossible to fulfill else where.

But regardless, if the selloff in US stocks continues, expect more investors to look elsewhere for opportunities to continue earning that alpha as volatility returns to traditional markets.