Analysis: Hesitant rally in U.S. stocks could see volatility-control funds turn sellers – Reuters

A trader works on the floor of the New York Stock Exchange (NYSE) in New York, U.S., August 29, 2022. REUTERS/Brendan McDermid

NEW YORK, Sept 2 (Reuters) – Certain volatility-linked investment strategies could accelerate the sale of stocks if the stock market turmoil, which has been fueled by the U.S. Federal Reserve’s hawkish stance on rising interest rates, worsen.

“Volatility control funds,” systematic investment strategies that learn from levels of market volatility, have been regular buyers of stocks since mid-June when U.S. stocks entered a bear market , rebounding 17.4% through Aug. 16.

But the sharp 8% drop in the S&P 500 (.SPX) over the past two weeks, driven by fears that the Fed will continue to raise interest rates in an effort to control inflation, brings these funds closer to the levels of market turbulence to which they begin to destock at an accelerated pace.

This is a concern for investors as there is evidence that volatility control funds can be a strong pro-cyclical force in bear markets, helping to further exacerbate sell-offs. And September has always been the toughest month for the US stock market. Read more

“As volatility has trended lower over the past month to month and a half, these strategies have started to naturally dip their toes back into the market, buying around $3 billion a day in our model,” Max said. Grinacoff, equity derivatives strategist at BNP. Paribas.

“To the extent that realized volatility starts to rise again, this buying could end.”

One-month realized volatility for the S&P 500, a measure of how stocks actually move over the past month, fell to a four-month low of around 16 in mid-August but rebounded to 20 on Thursday.

The exact level of turbulence at which volatility-control funds become significant sellers is difficult to estimate, as it depends on a variety of factors, including the funds’ current exposure to equities and the level of risk targeted by each fund.

But Grinacoff estimates that a rally in the S&P 500’s realized one-month volatility between 35 and 40 could cause those funds to sell about $10 billion in a week.

Barclays estimates that volatility control funds currently have around $200 billion in assets under management (AUM), while Deutsche Bank pegs it at around $250 billion.

While this is modest compared to the roughly $35 trillion worth of the S&P 500 alone, these funds are worth watching. As buyers in rising markets and sellers when stocks fall, they can often accelerate price swings in either direction, analysts said.

“That puts them well above their AUM weight,” said Parag Thatte, strategist at Deutsche Bank.

Some market participants might anticipate that these funds will sell and attempt to sell ahead of them, Stefano Pascale, equity derivatives strategist at Barclays.

“There may be a psychological aspect to this,” Pascale said.

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History suggests, however, that these funds are a more powerful force when markets fall than when stocks rise.

This is because markets tend to become volatile quickly but then take time to subside, meaning that these funds may exert more concentrated selling pressure when reacting to accelerating volatility than the strength of buying they exercise when the markets stabilize.

During the first quarter – the most intense period of selling this year – volatility control funds were losing up to $25 billion a day, according to Pascale. But when the volatility started to subside from mid-June, they had only been adding about $0.5 billion a day, Pascale said.

“We believe that if these funds have some impact, it will likely be more in a scenario where volatility continues to rise,” he said.

Reporting by Saqib Iqbal Ahmed; edited by Michelle Price and Jonathan Oatis

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