The Impact of Quant Trading on Potential Market Corrections

As US stock markets came off recent highs, it was noted that other markets were more highly correlated with equities than in the past, making hedging of downside stock market risk more difficult. Investors typically hold a portfolio of bonds and stocks as bond prices tend to rise when equities fall and there is a “flight to quality” as investors seek the relatively safe haven of bonds. However, with interest rates low and the probability of additional rate cuts less likely, bond prices aren’t moving enough to offset the impact of falling equities. 

Whenever the probability of a correction increases, investors worry how quant trading may impact the move. This concern has grown as index investing has become more popular and a small number of tech names make up a significant portion of market-cap-weighted indexes, so many funds have concentrated positions in a smaller number of names. So how will quant trading strategies impact any potential correction ? Quantitative managers manage multiple risks in the portfolio, most notably beta (the exposure to general market moves) but also to specific sectors (e.g. Financials or Utilities) or asset classes (e.g. Equities, Fixed Income and Commodities). An equity quant manager will calculate a fair value for each stock in a universe such as the S&P 500, then traders will sell those that are overpriced and buy those that are cheap, while constantly managing the risks such as beta and sector exposure. Because of the way the portfolio is constructed, quant strategies have inherent exposure to statistical factors, most notably mean reversion and momentum. 

Quant market neutral strategies with mean reversion exposure seek to profit when a stock trades outside of a normal trading range but is expected to return to a relative mean, or average price. These strategies tend to perform well when price movements are caused by temporary stimuli and there are no strong trends. Momentum strategies seek exposure to strongly trending stocks, assuming the trend will continue for a specific holding period, during which the manager will retain the exposure to those stocks in the portfolio before closing out the position. Ideally, a portfolio manager could increase either mean reversion or momentum exposure and decrease the other in response to changing market conditions. In practice this is difficult to achieve in a single strategy so the fund portfolio will use an optimized blend of strategies with biases towards either mean reversion or momentum. 

Quant funds, particularly the larger ones who have a lot of capital to deploy, tend to hold stocks for longer periods, from overnight to several weeks because of scalability constraints. With the strong trends displayed by the FAANG stocks (you could also add Microsoft here), quant hedge funds and index trackers will have added significant exposure to these names. If the trend in tech names reverses and the funds start to under-perform, risk reduction triggers force fund managers to reduce exposure. In a forced liquidation, both momentum and mean reversion factors tend to under-perform as many quant funds hold similar core positions that are being unwound. Because the funds will have both mean reversion and momentum exposure, it’s not possible to accurately predict what impact a liquidation will have on the tech names and the markets in general but, there is a possibly that the moves could be significant so, it’s worth planning for these moves. 

So, what steps should the average investor take to limit downside risk of a correction in the equity markets, particularly in tech names ? You could buy options, as volatility tends to spike if the markets fall but, as investors have become more concerned following the recent tech sector performance and started buying protection, this may be an expensive approach. In the absence of other less correlated asset classes to act as effective hedges, I would suggest rebalancing your portfolio between asset classes and also bring your tech exposure back to targeted levels and reduce your equity exposure overall. That way you can make cash available to buy stocks at lower levels than today, when the predicted correction happens. Also, as we get closer to elections, volatility is likely to increase so it makes sense to have some cash available to take advantage of temporary pricing anomalies.