Key facts
- Volatility control funds have reached historically high equity allocations, near 98% of their capacity.
- CTAs, a trend-following strategy, also have high equity allocations at the 82nd percentile.
- Estimates peg the assets managed by vol control strategies between $300 billion and $500 billion.
- A typical 10%-vol-target fund with 88% equity allocation could need to sell over $100 billion in equities in a mildly bearish scenario.
- A two-sigma market move could trigger five times as much selling on the downside as buying on the upside for these strategies, according to UBS.
Systematic trading strategies, including volatility control funds and Commodity Trading Advisors (CTAs), have accumulated significant equity exposure, raising concerns about amplified market selloffs. These strategies typically increase their stock holdings during calm markets and reduce them when volatility rises.
As the S&P 500 has rallied approximately 12% this year, driven by spending on AI infrastructure, market volatility has decreased. This has compelled these strategies to increase their risk-taking, pushing their equity allocations to historically high levels. Deutsche Bank data indicates that volatility control funds' equity allocations are at the 98th percentile, meaning they have been higher only about 2% of the time since 2010. Similarly, CTAs' equity exposure is at the 82nd percentile.
This high positioning limits the capacity for these strategies to add further to their equity holdings, potentially drying up a source of buying support. More critically, it leaves them vulnerable to market shocks. Stefano Pascale, head of US equity derivatives research at Barclays, noted that even a mild rise in volatility could force a significant unwind of positions, potentially exacerbating market turbulence.
Estimates suggest that volatility control funds manage between $300 billion and $500 billion in assets. While this amount is relatively small compared to the overall market capitalization of the S&P 500, analysts believe their selling can disproportionately amplify volatility due to a reflexivity effect, potentially influencing other market participants. Nathan Shetty, chief investment officer at SEI, which runs a global managed volatility fund, described this as a signal in itself that could lead other managers to adjust their positions.
Using a typical 10%-vol-target fund as an example, Pascale illustrated the asymmetric risk: a further drop in volatility could necessitate an additional $25 billion in buying to reach a 99% equity allocation. Conversely, in a mildly bearish scenario, the allocation could fall below 40%, requiring the sale of more than $100 billion in equities.
Analysts at Barclays highlighted that with US midterm elections approaching, the precarious positioning of these systematic strategies is an increasingly relevant risk. A UBS estimate from late August suggests that a rare two-sigma market move could trigger five times as much selling on the downside as buying on the upside for these strategies.