Hedge funds struggle as stocks keep behaving like bonds
Market-watchers fret that equities and fixed income are becoming more closely linked
Shalin Madan is nervous. After his investment firm Bodhi Tree Asset Management had a tough October, he pored over the market runes. What he saw scared him enough to switch off his automated trading models.
Fort Lauderdale-based Bodhi is a small quantitative firm with just $12m under management that invests in exchange traded funds according to the signals its computer models spit out. Its bearish bets on the global economy were hit hard as markets picked up last month, pushing the fund’s returns into negative territory for the year.
What is worrying Mr Madan is that swaths of the stock market have become more sensitive to movements in bonds, as income-starved investors have been forced to scour equities in the hope of finding companies that throw off reliable streams of cash.
Traditionally, utilities and real estate trusts have been the most sensitive to rising bond yields; because of their steady dividends they are often known as “bond proxies”. But much broader chunks of the stock market becoming de facto fixed-income substitutes has sucked in too much money, according to Mr Madan.
“Bond risk is more like equity risk, and equity risk is more like bond risk,” he said. “As a result, almost every investment factor is becoming bond-linked.”
So far, there are few signs of this autumn’s sell-off in bonds hurting the stock market, aside from the traditional bond proxies. But Marko Kolanovic, head of quantitative strategy at JPMorgan, says there is still “extreme crowding” in the more defensive, bond-like parts of the stock market, as well as in stocks enjoying positive momentum. He said this was evidence of the “prevalence of groupthink . . . across investment strategies”.
The current environment looks “fragile”, agrees Roberto Croce, a portfolio manager at Mellon, highlighting the recent turbulence in fixed income. The rolling 90-day volatility of the US Treasury market — a key indicator for what is arguably the bedrock of the global financial system — has climbed sharply from an all-time low in 2018 to a four-year high last week.
“It’s impossible to know the catalyst, and this market is good at shrugging off bad news. [But] bond market volatility is a good sign of the fragility,” Mr Croce said. “We've seen steadily rising bond volatility this autumn, and that will eventually have an impact on asset prices.”
Something similar happened in early 2018, and then again last autumn, when rising Treasury yields eventually caused stock markets to buckle, in what was dubbed “Red October” by traders. That led to a spate of forced selling by quant funds that respond to swings in volatility, which in turn inflicted losses on many hedge funds, forcing them to ratchet back their positions. By December, markets were sliding.
Market-watchers at Morgan Stanley are also looking on anxiously. Michael Wilson, head of US equity strategy, feels investors should not necessarily interpret the recent rally in asset prices as “a definitively bullish signal on future growth, given how much of it has been due to excess liquidity provisions” from major central banks around the world.
But there are reasons to be optimistic that the recent rise in government bond yields will not lead to a repeat of “Red October”. Despite concerns about crowding, JPMorgan’s Mr Kolanovic estimates that Treasury yields can rise by another one-and-a-half percentage points before they become a potential problem. Aside from the so-called bond proxies, which tend to drop as bond yields rise, such a move higher is actually likely to be positive for the stock market, he argues.
Moreover, equity hedge funds have a neutral exposure to the stock market at the moment, according to JPMorgan, indicating that they are unlikely to be forced to deleverage if markets turn south again.
The monetary policy backdrop is also very different today. At this stage in 2018, the US Federal Reserve was shrinking its balance sheet and preparing its fourth rate increase of the year, while the European Central Bank was ending its own bond-buying programme, lifting the 10-year Treasury yield to a seven-year high above 3.2 per cent in early October. Now it is back below 2 per cent, as both central banks ease policy.
However, Mr Madan is unconvinced. He argues that there is less slack built into market valuations to allow bond yields to rise much further without causing carnage. He reckons a sustained move above 2 per cent in the 10-year Treasury yield might be enough to cause the stock rally to unravel.
Therefore, instead of letting Bodhi Tree’s models trade on autopilot in this more uncertain environment, he has now put a bet on bond-linked stocks getting clobbered. “It could be like a meteor hitting the dinosaurs,” he said.