Volatility-control funds, which typically increase equity exposure when markets are calm and cut it as volatility rises, have accumulated stocks as the S&P 500 has climbed about 12% this year. The rally has been supported by strong corporate earnings and heavy investment in artificial intelligence infrastructure, according to a reprot by Reuters.
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As market volatility has declined, these strategies have been required to take on more risk. Their equity allocations have now reached the 98th percentile, meaning they have been higher only about 2% of the time since 2010, according to Deutsche Bank data cited by Reuters.
That leaves limited room for these funds to increase equity exposure further, potentially removing an important source of additional buying support. At the same time, their elevated positioning leaves them vulnerable to a rise in volatility that could force them to reduce holdings.
The report stated that Barclays' US equity derivatives research shows volatility-control exposure is historically stretched; even a modest increase in volatility could trigger a significant reduction in equity exposure and adding to market turbulence.
The risk is particularly notable because the recent stock rally has been narrowly concentrated in technology and other AI-related shares. Heavy positioning in a limited group of stocks could make markets more vulnerable to a shock, with selling potentially feeding on itself.
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One-month and three-month realized volatility for the S&P 500 reached multi-month lows earlier this month. Analysts told Reuters that relatively little may be needed to push volatility higher from such depressed levels.
JPMorgan strategists said further compression in volatility could encourage systematic funds to increase leverage, while a volatility spike could lead to a sharper reduction in exposure, the report stated.
Asymmetric risk
Volatility-control strategies are operated by a range of firms, including insurance and annuity providers and asset managers. Because these firms generally do not disclose strategy-level assets under management, there is no definitive estimate of their size. Estimates from various banks put their combined assets at between $300 billion and $500 billion, according to Reuters.That amount is relatively small compared with the roughly $66 trillion value of the S&P 500, but analysts told Reuters that trading by these strategies can have an outsized impact on market volatility.
SEI Chief Investment Officer Nathan Shetty said the direct market impact of such funds is limited, but their trading patterns can serve as a signal for other investors. A sharp reduction in systematic exposure could prompt discretionary managers and other market participants to adjust their own positions, potentially creating a feedback loop, the report stated.
Barclays analyst Stefano Pascale used a typical 10% volatility-target strategy to illustrate the potential impact. With equity exposure currently around 88%, another decline in volatility that pushed the allocation toward 99% could result in roughly $25 billion of additional equity purchases, according to the analysis cited by Reuters.
However, a relatively mild deterioration in market conditions could have a much larger effect in the opposite direction. Under the same reaction-function model, equity exposure could fall below 40%, implying more than $100 billion of potential equity selling, Reuters reported.
That creates a significant imbalance between the potential buying capacity remaining in the strategies and the amount of selling they could unleash if volatility rises.
Other systematic strategies are also heavily positioned. Equity exposure among Commodity Trading Advisors, or CTAs, which use price trends and volatility to adjust positions, stands at the 82nd percentile historically, according to Deutsche Bank data cited by Reuters.
Like volatility-control funds, CTAs have limited room to increase equity exposure after the recent gains and momentum in stocks. Their positioning therefore creates considerably greater downside risk if market trends reverse.
A UBS estimate from late August indicated that a two-standard-deviation market move could generate roughly five times as much selling on the downside as buying on the upside, according to Reuters.
With the US midterm elections approaching in five weeks, Barclays analysts said the stretched positioning of systematic strategies is becoming an increasingly important risk for investors.
The combination of elevated equity exposure, low volatility and a concentrated technology-led rally means systematic funds could provide less support if stocks continue rising while becoming a potentially significant source of selling if market conditions deteriorate.
(Disclaimer: This article is based on inputs from agencies. These do not represent the views of The Economic Times)
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