By Saqib Iqbal Ahmed
NEW YORK (Reuters) – Volatility-related investment strategies are joining the emerging sell-off in U.S. stocks and could help accelerate declines if market swings continue to widen.
Volatility control funds — systematic investment strategies that typically buy stocks when markets are calm and sell when they turn turbulent — have pumped up stocks as the S&P 500 marched to record highs this year.
Now that the S&P 500 has moved more than 4% off these levels and the Cboe Volatility Index is near its highest point since October, some of these funds are becoming sellers again.
While the S&P 500 is still up about 5% this year, further swings could lead to more selling of the funds: Analysts at Nomura estimate the strategies could dump about $45 billion worth of stocks if the S&P 500 would experience an average daily price movement of 1%. during the next two weeks.
“Their positioning is clearly above average,” said Parag Thatte, a strategist at Deutsche Bank. “There’s room for them to retreat in terms of exposure.”
Nomura’s Charlie McElligott estimates that volatility control funds have already started selling off, losing about $16.2 billion in equity exposure in the past week.
While that’s small compared to the S&P 500’s $42 trillion market cap, the funds’ tendency to follow market momentum can sometimes exaggerate price movements, market participants said. Other, slower-moving strategies could also join in as volatility increases.
The recent market gyrations were preceded by a long period of calm during which investors poured into stocks, driven by signs of strong but stable economic growth and expectations that the Fed would make several interest rate cuts this year. The VIX has not risen above 20 for 120 sessions – a level associated with healthy demand for portfolio hedging – the longest streak since 2018.
Stock swings have increased in recent weeks as hopes for rate cuts fade due to stronger-than-expected inflation. These concerns have been exacerbated as a spreading conflict in the Middle East pushes up oil prices, threatening to increase inflation.
Volatility has also increased in other asset classes. The MOVE index, which measures the expected volatility of U.S. Treasury bonds, is at a three-month high after a steady rise in Treasury yields. The Deutsche Bank FX Volatility Index, a measure of swings in the currency market, rose to its highest in almost 10 weeks despite a rally in the US dollar.
“The increase in volatility we are seeing applies across asset classes,” said Mandy Xu, head of derivatives market intelligence at Cboe Global Markets. “I think it’s the market waking up to the potential downside risk.”
One reason selling from volatility control funds hasn’t kicked into high gear so far is that declines in the S&P 500 have been relatively muted, Barclays strategists wrote.
“However, the funds are quite sensitive to a massive pullback from the current high level of equity allocation, especially if volatility rises as inflation continues to surprise on the upside, limiting the Fed’s ability to cut rates,” Barclays said .
Volatility control funds have a relatively short fuse compared to other computerized strategies, making them among the first to respond when the market landscape changes.
A more pronounced jump in volatility could also trigger slower-reacting funds that use volatility as a trading signal, including commodity trading advisors and risk parity funds, increasing pressure on the market as they ramp up selling.
Nomura’s McElligott said CTAs could sell off about $31 billion worth of shares if the S&P 500 falls another 2% to around the 4,914 level in the coming weeks.
A catalyst for such moves could be the corporate earnings season, which kicked off last week. Investors will brace for gains next week from a slew of tech and growth heavyweights, including Tesla, Meta Platforms, Microsoft and Google parent Alphabet. The US will also look at another inflation measure on April 26 when the personal consumption expenditure index is released.
“Volatility control has been the biggest force so far in terms of systematic deleveraging… during this choppy downturn,” McElligott said. “CTAs will join the party in the coming weeks if weakness persists.”
(Reporting by Saqib Iqbal Ahmed in New York; Editing by Ira Iosebashvili and Matthew Lewis)
