Human decisions to sell stocks may have been behind the August rout for equity markets after all, with hedge fund and mutual fund managers selling in response to turbulence and fears for the Chinese economy.
The conclusion, based on work by strategists at JPMorgan, is a riposte to those who have attempted to blame esoteric trading strategies such as “risk parity” for the size and speed of the summer correction.
“Discretionary managers were likely the ones responsible for the recent equity market sell-off,” said Nikolaos Panigirtzoglou, global asset allocation strategist for the bank, in a note to clients.
Macro hedge funds and balanced mutual funds, both of which can invest in a variety of asset classes, took abrupt steps to reduce the risk of stock market losses during the month. The aggregate equity beta of portfolios, a measure of the relationship between equity index movements and those for individual investment funds, declined sharply in August.
The bank also found betas for so-called long-short hedge funds, stock market specialists, declined sharply in August as managers reacted to volatility by paring bets. JPMorgan’s work is based on a regression analysis of index movements, such as the HFRX, a hedge fund benchmark, as a proxy for fund holdings.
The beta for risk parity funds, by comparison, declined only a small amount. Such funds have attracted attention owing to their attempts to blend a combination of stocks, bonds and commodities, with selective use of leverage to produce returns similar to traditional investment products, while taking less risk.
Leon Cooperman, the founder of Omega Advisors, last week blamed “systemic/technical investors” for the August sell-off that handed losses to his hedge fund, along with many peers. The veteran investor pointed to influential risk parity strategies pioneered by hedge funds such as Bridgewater, as well as so-called CTAs, funds specialising in trading derivatives based on computer models.
However, leverage used by risk parity funds tends to be concentrated in bonds, as prices for the securities have historically been less volatile than those for stocks. Performance for such funds has been poor this year, but there was no pronounced rise in bond volatility or the correlation between stocks and bonds in August.
JPMorgan also found that CTA strategies posted a small gain in the third week of August, when the sell-off occurred. Such performance suggests they were positioned ahead of the decline, so trades were unlikely to amplify market moves.
Equity betas for balanced mutual funds are close to historical lows, but those for hedge funds still have room to fall further, Mr Panigirtzoglou said. Equity volatility also remains elevated, with the Vix, a widely watched measure of volatility, remaining at levels last seen in 2011, a year when fears for the eurozone predominated and most hedge funds lost money for their clients.
The report contrasts with another recently published by a different part of JP Morgan, the bank’s quantitative strategy team. The earlier work, which suggested risk parity and CTA managers exacerbated the August sell off, has been much discussed by investors and traders.
Beyond apportioning blame for the August moves, there is also the question of whether the correction reflects a broader reassessment of the outlook for the economic cycle and stock prices.
“Cyclical risk became market risk in August,” said Andrew Lapthorne, strategist for Société Générale. He said that attention was now focused on the extent to which any turn in the economic cycle starts to affect the availability of credit for businesses.
For instance Glencore, the commodity trader, on Monday announced a $2.5bn equity raise as it attempts to repair damage to its balance sheet inflicted by the collapse for commodity prices.
“There are a lot of economic challenges ahead,” Mr Lapthorne said.