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Welcome to flow world

Aneet Chachra
— 1 minute read

Many of the uncertainties of 2020 are resolved for now. The US 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 channelled into equities and other risky assets.

Aneet Chachra

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.

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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 incentivise 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 favourable 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.

Aneet Chachra, portfolio manager at Janus Henderson Investors

 

Welcome to flow world
Aneet Chachra
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