As long as the algorithms are all trading in a positive direction, there is little to worry about. But the risk happens when something breaks.
“Mike ‘Wags’ Wagner: ‘You studied the Flash Crash of 2010 and you know that Quant is another word for wild f***ing guess with math.’
Taylor Mason: ‘Quant is another word for systemized ordered thinking represented in an algorithmic approach to trading.’
My friend Doug Kass made a great point on Wednesday this week:
“General trading activity is now dominated by passive strategies (ETFs) and quant strategies and products (risk parity, volatility trending, etc.).
Active managers (especially of a hedge fund kind) are going the way of dodo birds – they are an endangered species. Failing hedge funds like Bill Ackman’s Pershing Square is becoming more the rule than the exception – and in a lower return market backdrop (accompanied by lower interest rates), the trend from active to passive managers will likely continue and may even accelerate this year.”
He’s right, and there is a huge risk to individual investors embedded in that statement. As JPMorgan noted previously:
“Quantitative investing based on computer formulas and trading by machines directly are leaving the traditional stock picker in the dust and now dominating the equity markets.
While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals. Fundamental discretionary traders’ account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago.”
As long as the algorithms are all trading in a positive direction, there is little to worry about. But the risk happens when something breaks. With derivatives, quantitative fund flows, central bank policy and political developments all contributing to low market volatility, the reversal of any of those dynamics will be problematic.
There are two other problems currently being dismissed to support the “bullish bias.”
The first, is that while investors have been chasing returns in the “can’t lose” market, they have also been piling on leverage in order to increase their return. Negative free cash balances are now at their highest levels in market history.
Yes, margin debt does increase as asset prices rise. However, just as the “leverage” provides the liquidity to push asset prices higher, the reverse is also true.
The second problem, which will be greatly impacted by the leverage issue, is liquidity of ETF’s themselves. As I noted previously:
“The head of the BOE Mark Carney himself has warned about the risk of ‘disorderly unwinding of portfolios’ due to the lack of market liquidity.
‘Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.’”
When the “robot trading algorithms” begin to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures as the exit will become very narrow.
Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause large spreads between the current bid and ask pricing for ETF’s. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.
Algo’s were not a predominant part of the market prior to 2008 and, so far, they have behaved themselves by continually “buying the dips.” That support has kept investors complacent and has built the inherent belief “this time is different.”
But therein lies the “risk of the robots.”
What happens when these algo’s reverse course and begin to “sell the rallies” in unison?
I don’t want to be around to find out.