VIX index move was historic - The impact will be a negative feedback loop leading to equity selling from volatility rebalancing

The size of the move in the VIX index was large. The market is at the highest VIX level in years. We have to go back to 2015 to see this level. On a percentage basis, the change in the VIX was the single greatest increase over the last eleven years we looked at for comparison. It was a 77% increase from the previous day and more than 50% higher than the next greatest one-day increase.  Sorting the percentage changes gives another look at magnitude of the change. This was a historic day for volatility.

The market should be concerned about this move because so much money is now associated with volatility targeting and short volatility strategies. Take the simple case of volatility targeting. The increase in volatility will have to be offset with position selling to get portfolio volatility back to target levels. This will create a negative feedback loop. The selling will lead to more volatility and further selling. This should concern any investor. The effort of trying to employ better risk management will create more risk.

Hedge fund performance strong in January, especially for CTAs and global macro

Hedge fund performance, as measured by the HFR indices, showed strong performance in January especially for global macro and systematic CTAs. Systematic CTAs also generated returns that were in the top three categories for the last twelve months. 

The reason for these performance gains is not complex. The wide diversity across asset classes allows these strategies to find opportunities beyond equity beta and alpha situations. For the case of January, there have been strong down price trends across the global bond markets. These funds are able to take advantage of these bond moves while the constrained duration relative value equity funds usually stay out of the bond sector.  Given the dynamic bond beta bets, managed futures and global macro can profit from asset class dislocations.

January sector performance strong for style, sector, and sovereign ETFs and poor for bond ETFs

Equities started the year with strong performance across style, sector, and country groupings; however, there were some exceptions to these gains and also some signs of potential for performance declines. Bond ETF returns were all negative except for international bonds which gained from the dollar decline. These returns are consistent the fundamental story of strong growth and expected higher inflation. There will be peak and valley in return even with the clear story, but the general direction is still risk-on for equities and avoidance of duration for bonds.

Within our style grouping, there was a fall-off in price relative to the short-term moving average in mid-cap, small caps, and value markets based on declines near the end of the month. Global equities, especially emerging markets, were still the style winner for January. 

Performance within sectors was more disperse with strong gains in health, technology, finance, and consumer discretionary sectors. The interest rate sensitive sectors, utilities and real estate, declined similar to bond returns. Trends still suggest utilities and real estate should be avoided.

Good gains in Italy, Spain, Brazil and Mexico are consistent with the increases in global growth in emerging markets as well as the eurozone. There should be some concern with future returns in Japan and Canada based on short-term moving averages.

Bond sectors were negative across the board with the only exception being international bonds. The strong global bond performance and the limited losses in emerging markets were associated with the dollar decline. These international bond sectors are often currency return surrogates.

The end of the week saw a sharp sell-off in equities based on the further increase in bond yields. This is a concern especially given the high valuation for many market styles and sectors. Volatility has seen a further spike which suggests there is a growing degree of market uncertainty; however, we are cautious about rebalancing positions on the second day of the month.

Strong managed futures returns from multiple asset classes - Consistent with fundamentals

Managed futures showed strong performance in January from a variety of asset classes. Many managers were able to continue to take advantage of the trend in US equities, albeit with a giveback of some profits at the end of the month. Global bonds generated gains from short positions as a significant sell-off accelerated through the month. The dollar decline made trading currencies also profitable. The trend in oil and refined products also continued although a surprise inventory increase at the end of month added volatility. Selective trading in precious and base metals also added to performance. There were also commodity opportunities from newly formed trends.

This was the best month for the SocGen CTA index in the last year and a half. For the CTA mutual fund index, this was the best month since the index began in 2014. The average manager beat all asset classes except for beta plays in equities. These high returns from trends were consistent with the current fundamental themes of high growth and higher expected inflation for 2018.