Quant funds support market rally by ramping up bets on US stocks
Quant funds are increasing their bets on US stocks, helping fuel a sharp rally that has added $7tn in value to markets since June even as economic data point to a slowdown in the world’s largest economy.
In many cases, the funds — which look for trends in the market and then attempt to ride the momentum — have quickly unwound positions taken in late 2021 and earlier this year that were structured to benefit from falling stock markets.
As they have closed out those bearish bets, they have helped push stock prices higher — and then followed the new trend by making fresh wagers that benefit from the rally.
Charlie McElligott, a strategist at Nomura, said quant funds “moved fast and unemotionally” to shift their stance, catching “a very bearish market . . . very flat-footed”.
These funds have spent tens of billions of dollars on futures, helping push the benchmark S&P 500 and tech-heavy Nasdaq Composite up double-digits from recent lows, according to traders and analysts.
Nomura estimates that trend-following hedge funds and volatility-control funds have purchased $107bn of global stock futures since markets hit a low in late June, with a large portion of that used to close short positions.
“With positioning basically at the low there was a lot of cash on the sidelines and so as the market stabilised and started to rally, more and more of this flow has come back into the market,” said Glenn Koh, the head of equities trading at Bank of America.
The role of the computer-driven funds helps to partly explain the head-scratching advance in the $47tn US stock market.
Whether the “risk-on” shift can last depends in part on whether the Federal Reserve can raise rates to damp economic activity and stamp out inflation without pushing the world’s largest economy into recession.
Investors moved to the sidelines en masse as stocks slid earlier this year, and many trend-following hedge funds placed short bets on the market as they predicted further declines.
Markets were pummelled by Russia’s full-scale invasion of Ukraine in February, surging commodity prices and the threat of economic slowdowns in China, the US and western Europe just as central banks raised interest rates to snuff out inflation.
But after the S&P 500 fell into a bear market in June, the market snapped back, recouping more than half its losses this year.
Investors have pointed to other factors propelling the recovery in addition to the short-squeeze pushing some funds back into the market. Some managers are betting inflation could peak, while others argue a spurt of weak economic data might stop the Fed from lifting interest rates as aggressively as some policymakers believe it must.
Alongside the rally, the dramatic price swings that had characterised the sell-off earlier in the year have eased. Gauges of volatility have fallen, with the Cboe’s Vix volatility index closing this month below its long-term average of 20 for the first time since April.
Daily swings in the S&P 500 and in many of the stocks that comprise the index have become smaller than they were between January and June. If that trend continues, the door will be open for a large pool of funds that shift positions based on volatility to increase their wagers on equities.
JPMorgan Chase analysts said the buying may continue. It told its hedge fund clients last week that volatility-targeting and risk-parity funds were buying roughly $2bn to $4bn worth of equities a day. The bank estimated those purchases “can last perhaps another 100 days if volatility stays low”.
Marko Kolanovic, a JPMorgan strategist, said the rally had reached most corners of the market. About 88 per cent of S&P 500 stocks are trading above their average over the past 50 days, up from just 2 per cent in mid-June.
“Strong participation is an indication that this rally is durable, and another expression the market’s tail risks have receded,” Kolanovic said. “Volatility targeters can be expected to add exposure overall, and especially to equities.”
Fund managers have grown more optimistic. After polling portfolio managers this month, Michael Hartnett, strategist at Bank of America, said they were “no longer apocalyptically bearish”.
Big caveats remain. Fed policymakers have warned they could raise rates higher and keep them there for longer than traders currently predict. And an inflation or growth shock could yet rattle markets.
That explains why the rally so far has been led by systematic funds rather than traditional money managers and long-short equity hedge funds.
“You see some people taking shorts off,” said Mike Lewis, the head of US cash equity trading at Barclays. “But you haven’t really seen people taking money and putting it back to work.”