Mo­men­tum surfers re­vive painful mem­o­ries

Crit­ics see un­nerv­ing like­ness be­tween hedg­ing strat­egy and 1987-style port­fo­lio in­sur­ance

Financial Times Middle East - - Markets & Investing - ROBIN WIG­GLESWORTH

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’

Maria R Ba­s­tone/AFP/Getty

‘Dy­namic hedg­ing’: on Black Mon­day re­lent­less sell­ing of in­dex fu­tures and op­tions wors­ened the stock mar­ket crash

Newspapers in English

Newspapers from Saudi Arabia

© PressReader. All rights reserved.