Momentum surfers revive painful memories
Critics see unnerving likeness between hedging strategy and 1987-style portfolio insurance
On Wall Street, bad ideas rarely die. They often simply go into hibernation until they are resurrected in a different form. A case in point is portfolio insurance — a leading contributor to the 1987 “Black Monday” crash — which some say is making a return.
Institutional investors are allocating billions of dollars to “risk mitigation” or “crisis risk offset” programmes, which are designed to act as a counterweight when markets are in turmoil. They mostly comprise long-maturity government bonds and trend-following hedge funds, which tend to do well when equities plummet.
The trend-following hedge funds in question are commodity trading advisers, sometimes called managed futures funds.CT As are computer-driven vehicles that take advantage of markets’ tendency to momentum. Assets that have gone up tend to go up further, and assets that are falling tend to continue to slide.
But some analysts and fund managers worry that, if taken to extremes, allocations to CTA hedge funds could play the same role as portfolio insurance did 30 years ago, when it was blamed for aggravating what remains the worst US stock market collapse.
“There’s a big portfolio insurance industry that no one is talking about,” says Robert Hillman, head of Neuron Advisors, a London-based quantitative asset manager. “CTAs are dangerously close to portfolio insurance .”
CTAs often automatically bet against a falling market, shorting it to profit from further falls. They did extremely well in 2008 and at the start of 2016, when markets were in a tailspin over China’s slowdown. Although they lost their footing when markets rebounded last year, their reputation as crisis was intact.
Trend followers were the only hedge fund group that recorded healthy inflows in 2016, with total assets growing to a record $287bn by the end of the year, according to Hedge Fund Research.
CTA managers say inflows were driven primarily by pension funds and other institutional investors looking for insurance against any shocks, after being burntin 2008.
With US stocks trading near record highs, the rise in allocation to trend followers is all the more significant.
The Pension Consulting Alliance, a US consultancy that is a proselytiser for some CTA funds, has coined the term “crisis risk offset”. So far, it has convinced about half a dozen of its 35 US pension fund clients to carve out money for a CRO programme.
Neil Rue, PCA managing director, says investors suffered two severe bear markets in the noughties and “have grown weary of these gyrations ”.
The biggest US pension fund to have adopted the CRO approach recommended by the PCA is the $196.4bn California State Teachers’ Retirement System, which last year allocated $16bn to “risk mitigation strategies”.
But the rise in insurance programmes that use trend-following funds is causing disquiet, including inside the CTA industry.
David Harding, head of Winton Capital, warned in an investor letter late last year that using simplistic trend-following strategies was akin to portfolio insurance. “When an institution allocates to a momentum strategy in the hope of cushioning itself from stock market downdraughts, it is really commissioning someone to sell stocks on its behalf into a falling market,” he wrote. This was “no different to the failed portfolio insurance strategy that was implicated in the 1987 crash ”.
Mr Harding declined to comment beyond the letter.
The similarities between the strategies are evident. Portfolio insurance was invented by Hayne Leland, John O’Brien and Mark Rubinstein in the 1970s, and became wildly popular in the 1980s as a way to protect against corrections. Insured funds would automatically sell index futures when markets fell, capping their downside in return for a modest premium. Its proponents called it “dynamic hedging”.
But the technique became too popular. On Black Monday it proved a diabolical machine, with many funds relentlessly selling index futures and options and worsening the crash the practice was supposed to protect against.
When the closing bell rang on the New York Stock Exchange, the S&P 500 was down more than 20 per cent, the worst one-day drop in US history.
“The problem with portfolio insurance was that it was programmatic, and caused a feedback loop,” says Richard Bookstaber, a former risk officer at Moore Capital and Morgan Stanley who advises the University of California’s investment office.
Inside the CTA industry, the disquiet is mainly directed at a new breed of cheap,simple—somesayfacile—trendfollowing exchange traded funds and bespoke bank products.
Even if cheaper momentum strategies do not cause broader havoc, many CTAs say their simplicity ignores the fact that complex financial markets are constantly evolving.
“Investors increasingly look at fees, but you get what you pay for,” says
Anthony Todd, chief executive of Aspect Capital, a UK trend-following hedge fund. “We’ve seen a rush into static trend followers, and that’s a risky proposition.”
The PCA appears unconcerned. Mr Rue argues that established participants dislike simple types of trend-following because these are not only cheap but make it harder for them to make money from momentum.
Such approaches are “rules-based and relatively low-cost, and costs can make a huge difference”, he says. “We’re not trying to generate alpha through the trend-following component.” Nor does he worry that the trend-following component of CRO portfolios will create a feedback loop when markets are turbulent, as portfolio insurance did.
Trend-followers, Mr Rue says, surf the momentum in the largest and most liquid markets, and the industry is far too small to have a significant impact.
At the moment that is probably true, given that the CTA industry is worth less than $300bn — which equity futures churnoverinaday.
But with leverage the heft of CTAs is increased, and the size of the new breed of simple momentum vehicles is unknown. Critics say that with the popularityof crisis insurance mounting, it is a phenomenon that bears watching.
“The activity is gussied up under a fancy but incomprehensible title like alternative beta, crisis risk offset or tail risk protection,” Mr Harding wrote in his letter. “If the odd institution wishes to protect itself in this way there is no contradiction, but if they all do, the risk of destabilising short-term market behaviour will once again be high .”
‘You get what you pay for . . . The rush into static trend followers is a risky proposition’
‘Dynamic hedging’: on Black Monday relentless selling of index futures and options worsened the stock market crash