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Quants Warn of ‘Nasty Accidents’

A former hedge fund manager claims that funds in five sectors have become too highly correlated and are at risk of being caught out.

  • By Joe Mcgath

Five categories of global hedge funds have become highly correlated to just four major macro-economic themes, researchers claim.

A quantitative analysis of positions held by risk parity, absolute return, emerging markets, macro CTA and equity long/short funds, conducted by Quant Insight, found four major macro themes playing across all strategies. 

“All sorts of strategies have ended up herding into the same view,” said Mahmood Noorani, founder of Quant Insight. “When global investors all end up the same way around, that is often the recipe for nasty accidents.”

Noorani, himself a former portfolio manager for BlueCrest Capital Management, Citi Capital Advisors, and Millennium Capital Partners, said funds may be vulnerable if investors begin to agree that asset prices are moving without underlying reasons to support the moves.

“When the information set stops explaining the asset price movement, that tells us that actually, sentiment trend followers are now jumping on this bandwagon without supportive moves in the factors.” Noorani said that this “disconnect” was now starting to become apparent.

The trends were identified using combinations of factors that, researchers say, can show the top-down exposure of each fund. A measure of one-year and five-year rate volatility, for example, can help express a view of quantitative easing expectations.

The researchers found that all strategies have bought into the idea of global reflation, with emerging markets funds looking for a more benign U.S. backdrop and absolute return funds eyeing a synchronized, global recovery.

“We are in a reflationary era. Whether it is true reflation, I’m not sure, but it certainly seems logical,” said James Clunie, head of strategy for absolute return at Jupiter Asset Management. “We were in a deflationary era. That seemed to stop in February 2016 when the Chinese government started to intervene to stop the renminbi devaluing.”

The Quant Insight research also found that all strategies analyzed showed positive sensitivity to global sovereign risk, Eurozone peripheral spreads in particular, suggesting that funds were long Italian bonds or were anticipating a stable political landscape in both Italy and Spain.

This supports a December Institutional Investor report, which found fund managers predicting a win for Italy’s populist Five Star Movement in the March election, but believing it would have little impact on markets.

[II Deep Dive: Investor Fears Ease Ahead of Italian Election

“The March Italian election and/or re-emergence of stress between Spain and Catalonia present a clear risk, pretty universally,” said Huw Roberts, a macro specialist at Quant Insight.

Other widely held views included expectations for a weaker US dollar and higher energy prices, according to the research.

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