Volatility-Targeting Funds Leverage Up at Fastest Since ‘18 Rout

(Bloomberg) -- A breed of systematic trader acutely sensitive to volatility is charging into U.S. stocks at the kind of pace last seen before “volmageddon” rocked Wall Street almost two years ago.

Volatility-targeting funds are doubling down on equities after geopolitical turmoil that threatened to derail the bull market in the end barely slowed it down. These players buy and sell based on price swings, and their leverage -- a measure of exposure to stocks -- now sits at its 81st percentile since 2011, according to Morgan Stanley.

Volatility-Targeting Funds Leverage Up at Fastest Since ‘18 Rout

That might be a cause for hand-wringing in some quarters of the market, as it echoes the run-up to February 2018, before a swift de-risking by systematic players is thought to have intensified a market plunge. Algorithmic traders are often seen as weak hands because many strategies are at the mercy of signals that can flip on a dime.

“Considering that systematic strategies are very levered, traditional investors’ gross and net exposures are very high, and retail traders are also more levered-up -- that leaves us susceptible to a real draw-down,” said Alberto Tocchio, chief investment officer at Colombo Wealth SA, a Swiss wealth manager that oversees 2.5 billion Swiss francs ($2.6 billion).

Fortunately, conditions look very different from 2018, Nomura’s Masanari Takada wrote in a note today. Pointing to a lack of fear in the VIX options market, the quant strategist says any short-term dips would likely be treated by investors as buying opportunities.

Meanwhile, the trigger fingers of vol-targeting funds, which by one estimate hold around $400 billion, may be firmer than thought after an extended stretch of tranquility, according to Deutsche Bank AG strategists led by Binky Chadha. These strategies typically load up on stocks when markets are calm and sell when volatility hits.

“They would need to see a large and sustained spike in vol for their selling thresholds to be hit,” the team wrote.

Animal Spirits

Still, there’s little doubt that equity positioning by systematic strategies is stretched. The leverage of short-term trend-followers known as CTAs is at the 78th percentile since 2011, according to Morgan Stanley.

And animal spirits are in the air, with Bank of America Corp. strategists led by Michael Hartnett writing this week they’re staying “irrationally bullish until peak positioning and peak liquidity incite a spike in bond yields and a 4-8% equity correction.”

The possibility that CTAs sell en masse on a change in market dynamics “cannot be ignored,” Nomura’s Takada wrote in an email.

“If any unpredictable but tiny shock causes a correction in the upward momentum of a U.S. stock price index like the S&P 500, systematic trend-followers are likely to rush into exiting from their current bullish trades simultaneously,” he said.

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