Why Algo Traders See Looming ‘Chaos’ in the Markets

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Why Algo Traders See Looming ‘Chaos’ in the Markets

As computer-driven algorithmic trading becomes a more major market driver, the recent large move towards a pessimistic view among a portion of these programs has worrying implications. According to Kathryn Kaminski, chief research analyst and co-manager of a managed futures portfolio at AlphaSimplex Group, as described by The Wall Street Journal, “this is basically the chaos bet.”

“Pretty much any way you run the models, you wind up net short a number of asset classes,” Kaminski continued, adding that this is the largest bullish-to-bearish shift among trend-following algorithms since 2007 and 2008. (see below).That was, of course, the period of the subprime mortgage disaster, the financial crisis, and the most recent bear market for the S&P 500 Index (SPX).

Trend-Following Strategies: Where TheyAre Bearish

  • Stocks
  • Bonds
  • Currencies
  • Commodities

Source: The Wall Street Journal

Significance for Investors

Trend-following investing methods use automated trading algorithms to purchase and sell assets based on asset price momentum. The Journal describes trend-following algorithms as “usually attempting to ride markets when they move substantially in one way.” Trading algorithms in general have been accused for boosting market volatility and exacerbating market falls by generating self-perpetuating waves of selling.

According to AlphaSimplex research, trend-following algorithms currently hold short positions in stocks, currencies, and commodities. The financial advising business and commodities pool operator is a pioneer in trend-following software development. While these algorithms continue to have long positions in bonds, AlphaSimplex believes that this is more of a bearish flight to safety than a strong vote of confidence in that asset class.

An example of the growth in trend-following programs is offered by Commodity Trading Advisors (CTAs), who often rely on them. They managed $357.5 billion as of the third quarter of 2018, up by about 36% during the past 10 ten years, per data from BarclayHedge cited by the Journal.

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However, these strategies did not deliver gains in 2018. The Societe Generale SG Trend Index, which tracks the performance of trend-following funds, was up by 1% in December 2018 and down by 8% for the year. “A lot of trend-followers ended the year down because it was tricky to catch many trends,” as Rufus Rankin, director of research and a portfolio manager at mutual funds company Equinox Institutional Asset Management, told the Journal.

Looking Ahead

Given that trend-following algorithms already have staked out short positions in various asset classes, some observers believe that they are unlikely to add significant additional selling pressure going forward. Meanwhile, the failure of these strategies to produce gains in 2018 casts doubt on their effectiveness going forward. “The story has been sold almost like a 2008 protection trade, but it’s not necessarily true that they will offset the next crisis, because we don’t know what that’s going to look like,” as Chris Solarz, managing director at investment advisory firm Cliffwater LLC, told the Journal.

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