Welcome to Flow World
Large-scale trading activity periodically creates short-term dislocations. Portfolio Manager Aneet Chachra considers the investment opportunity around these flow-driven price moves.
3 minute read
- There has been strong growth in price-insensitive strategies with fixed trading rules, including passive funds.
- Inflexible strategies that must trade typically induce a price response to incentivize buyers/sellers.
- This is a favorable backdrop for alternative strategies designed to benefit from higher volatility and greater flow effects.
“Notice that the stiffest tree is most easily cracked, while the bamboo or willow survives by bending with the wind.” – Bruce Lee
Many of the uncertainties of 2020 are resolved for now. The U.S. election is decided, the stimulus bill has passed, the Federal Reserve is holding rates near zero, and vaccinations have started. Most investors need to save money for retirement. But with inflation-adjusted bond yields negative around the world, savings are being disproportionately channeled into equities and other risky assets.
Stocks are historically expensive based on most valuation measures, but attractive relative to current interest rates. However, they are also much more volatile than cash or high-quality bonds. Equities provide immediate liquidity at uncertain prices.
Meanwhile, there is strong growth in price-insensitive strategies with fixed trading rules. Passive funds are the obvious example: hold minimal cash, buy after receiving contributions, sell after redemptions, and add/delete per schedule. But many other styles are similarly constrained. For example, volatility-targeting strategies must sell when volatility is rising and buy when volatility is falling. Target-date, 60/40, risk parity, trend following, factor funds, etc. likewise follow set instructions after changes in price, volatility and correlation.
The post-COVID surge in option trading is an accelerant. Most retail investors do not hedge their option positions, but market makers do. Option market growth increases hedging flows in the underlying assets. The inherent leverage of options, margin trading and retail interest in speculative stocks escalates price moves in both directions.
In this environment, flows often matter more than fundamentals. Inflexible strategies that must trade typically induce a price response to incentivize flexible buyers/sellers. These flow-driven price moves also increase volatility unrelated to any actual change in the asset.
This “Flow World” dynamic creates opportunities for alternative strategies that are designed to capture dislocations. For example, large corporate stock or bond sales require discretionary capital to deploy cash and risk-taking capacity. Governments and central banks transact enormous quantities of sovereign debt over a short window. Flows periodically cause equity share class anomalies while bank structured product issuance and hedging distort referenced markets. Passive funds, factor rotation and option activity similarly lead to short-term buying/selling pressures.
These examples all involve directly or indirectly intermediating flows from participants who are raising/investing money, or constrained due to mandate or strategy. Such inflexible flows are generally growing in size due to larger issuance, increased passive share and higher option volumes. This shift is happening while flexible, multi-day discretionary participants like active managers and bank trading desks are broadly shrinking.
Investors face difficult choices to balance portfolio return and volatility. In this low-conviction Flow World market environment, large buys/sells can result in disproportionate price impact relative to other assets.
Conversely, this backdrop is favorable for alternative market-neutral strategies designed to benefit from higher volatility and greater flow effects. These are skill-based approaches that build upon experience, access and infrastructure to target attractive and differentiated returns.
Finally, this flow-driven market regime could suddenly change, and new uncertainties can and will emerge. It is important to also allocate to strategies that seek positive returns during periods of sustained market stress and large underlying moves. Pairing short-term with longer horizon strategies can help investors capture current market opportunities while being prepared for the unexpected.
End of page
Please read the following important information regarding funds related to this article.
- Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall. High yielding (non-investment grade) bonds are more speculative and more sensitive to adverse changes in market conditions.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund involves a high level of buying and selling activity and as such will incur a higher level of transaction costs than a fund that trades less frequently. These transaction costs are in addition to the Fund's Ongoing Charges.
- The Fund may invest in contingent convertible bonds (CoCos), which can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- SPACs are shell companies set up to acquire businesses. They are complex and often lack the transparency of established companies, and therefore present greater risks to investors.