(Bloomberg) -- A small band of humans is taking up arms against the rise of the machines.
Fund managers who ride big sell-offs in stocks are relishing fresh Wall Street warnings that robots and the like are leaving the bull market more vulnerable to explosions in volatility and crashes in liquidity.
They’re ready to pounce when the herd -- from quants to passive money -- is forced to unwind in a downturn just as the relative firepower of fundamental managers to buy the dip gets depleted.
All told, today’s equity rally is storing up all the ingredients for a flash crash, according to Dominick Paoloni in Denver. The founder of IPS Strategic Capital started a fund three years ago to hedge price swings triggered by robotic programs going haywire -- and sees the current market calm prone to disruption.
“Algorithmic trading strategies and other quantitative traders have caused exacerbated moves on both the up and downside in equity markets,” he said. “As AUM continues to flow out of actively-managed equity funds there are less participants available to bring markets back to equilibrium.”
Computers are a favorite scapegoat when risk assets are falling and volatility edges higher. But the paranoia makes sense in these rising markets given last year’s sudden maelstrom and the ensuing melt-up.
JPMorgan Chase & Co. estimates that U.S. equity liquidity in December was one-third of previous sell-offs this cycle. The bank blames in large part the shift away from human to electronic market makers.
Over in London, Richard “Jerry” Haworth also argues algorithmic traders are a destabilizing force. His 36 South Capital Advisors LLP offers protection against tail risks through long-dated out-of-the-money options on multiple asset classes.
“There’s an illusion of liquidity because the algos are active,” Haworth said in an interview in his Mayfair office. “But if they switch their machines off because they’re uncertain about some information that has come to light, that’s a lot less liquidity.”
Liquid Dreams
The scale of this shift in market structure was underscored in JPMorgan research that concluded index and exchange-traded funds, quants and options-related strategies dominate all but 10 percent of U.S. stock trading. The amount invested in large-cap equity funds tracking indexes recently eclipsed cash in actively run funds of the same type.
Put another way, there’s a vanishing cohort of human-powered funds with the conviction to snap up single-stock names in a falling market. They would act as a brake on losses.
Paoloni’s Absolute Return Strategy fund primarily trades equity-index options and VIX contracts. It’s had some of its best days when the S&P 500 plummeted by more than 4 percent in a single session. The $64 million fund is getting more inquiries of late from financial advisers wary of another 2009-style crash.
The potential of a one-day decline of more than 5 percent has increased in recent years, according to the investor.
Defenders of funds programmed to sell or buy on volatility triggers point out they are reducing spreads and day-to-day price swings in part thanks to their growing arsenal of assets. But the risk is that when volatility reawakens, they’ll exit the market on a dime and expose its fragility, says Paoloni.
“The illusion of a lot of liquidity dampens volatility,” Haworth said. “When that illusion is broken, volatility will be a lot higher than it otherwise would have been.”
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