A battle royale of Wall Street quants has erupted.
In one corner, we have JPMorgan’s chief quant, Marko Kolanovic who moments ago said that the selling pressure from systematic, vol-targeting strategies such as risk-parity, CTAs, and trend following is mostly over and that the “current setup favors buying the dip.“
In the other corner, Barclays’s quant Manesh Deshpande completely disagrees with Kolanovic, and overnight wrote that while “some signs of capitulation are emerging” he thinks that “more selling is yet to come.“
A lot more.
Deshpande, like so many others in recent days, writes that Thursday’s sell-off was similar to the Feb 2018 liquidation, in that there was indiscriminate selling across equities and the ratio of put to call volume increased significantly.
However, unlike Kolanovic who is confident that the selling has now been mostly exhausted as we discussed earlier, Desphande warns that there are no signs of ETF selling which accompanies sell-offs.
In fact, over the past few days ETF flows have not turned negative yet and in fact have been mildly positive ($0.59 and $0.34 billion for the 10th October and 11th October, respectively). Thus this class of investors has not capitulated yet, according to the Barclays quant. Looking at history as a guide, ETF outflows between Feb 1st and Feb 9th earlier this year was ~$35Bn or 1.7% of AUM. Given the higher AUM currently, ETF investors are likely to sell ~$40Bn over the next few days.
It’s not just ETFs. Compared to the sell-off during February 18, 2018 which was driven by the VIX complex, the current sell-off options complex has been relatively orderly. In particular the SPX Skew as shown below has not steepened significantly despite the sharpness of the sell-off.
Meanwhile, Desphande notes that the market activity in SPX Put/Call option volume ratio has spiked “and is showing some signs of capitulation among investors as they scramble to buy protection.”
So in light of the recent surge in the VIX, which as Goldman calculated overnight was the 25th largest one day spike…
… the spike in equity volatility is likely to drive further systematic selling from Volatility Control Funds according to Barclays. How much?
To answer that question, Deshpande first estimates that the AUM in the Volatility control/Targeting strategies is ~$355Bn.These funds decrease their overall leverage to maintain fixed portfolio volatility (the higher the VIX, the more the selling), creating a positive feedback loop:
Since the forecasted volatility increases during market declines, these funds sell risky assets that would exacerbate the selloff. The precise details of how portfolio volatility is forecast are likely to vary across funds but we use the S&P Daily Risk Control 10% index (ticker: SPXT10UT) as a benchmark strategy. This index rebalances between S&P exposure and cash to maintain a 10% volatility target.
Next, the Barc quant calculates allocation trigger points, and writes that until the past week the allocation according to the benchmark strategy was 100% to equities. However, with the sell-off, the allocation has been reduced to ~65%.
Putting it all together, Barclays reaches a conclusion that is diametrically opposite that of Kolanovic, i.e., “we expect further systematic selling to the tune of ~$130Bn from these funds to reduce allocation to equities over the next couple of days.“
Putting this number in the context of the February 2018 VIXtermination crash, back the systematic volatility control funds sold over $150Bn exacerbating the volatility and lead to a second leg lower. So between the $80BN or so already sold, and the $130BN still left to sell, by the time the systematic selling is over, the aggregate vol-targeting deleveraging (selling) will be substantially higher than what was experienced in February when the S&P tumbled as much as 10%.
So in this Wall Street battle royal of quants, who will be victorious: JPMorgan’s cheerful Kolanovic or Barclays’ gloomy Deshpande? Considering that the Dow opened 400 points higher and shortly after noon turned negative, if this selling accelerates, especially into the critical last hour of trading, it may well be a technical knock out.
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