Market fragility

We witnessed a very high degree of volatility in markets in 2020. Unfortunately, lasting shifts in market structure mean that when liquidity deteriorates, market crashes could be a more frequent occurrence.

Contributor

Meghan Shue, Head of Investment Strategy for Wilmington Trust Investment Advisors, Inc. View bio

There has almost always been a disconnect between the drivers of short-term market traders and those of long-term fundamental investors. The latter can provide a check on the former over longer timeframes, but changes in market structure over the last decade may be exacerbating the magnitude of these disconnects.

The spring of 2020 unleashed a historic level of volatility, in stocks, bonds, and other asset classes. In fact, the month of March alone included four of the ten most volatile trading days—as defined by daily percentage change—for the S&P 500 in the last 40 years. So-called circuit breakers were triggered to the downside and upside over the course of a few trading sessions.

Volatility is a customary part of investing. But the magnitude of volatility spikes in recent years, as well as the velocity of those spikes—that is, a pattern of going from essentially no volatility to near-record volatility in a matter of a few days—has become more dramatic. Is this type of volatile trading activity normal? Not traditionally, but we believe it will be part of the new normal. We identify three structural changes in the market since the 2008–2009 global financial crisis (GFC) that have contributed to the new volatile world order:

  • Regulation
  • Rise of exchange-traded funds (ETFs)
  • Quantitative trading strategies

To be clear: We do not posit that regulation, the rise of ETFs, and prevalence of quant strategies are catalysts of higher volatility during typical periods of market activity. In fact, many studies suggest they improve market functioning and liquidity during normal market conditions. However, during periods of stress or market shocks these changes to market structure can backfire, resulting in even higher levels of volatility.1

Regulation

Here’s how markets typically operated before the GFC:

Interactive graphic showing how regulation can impact stock market pre-crisis, post-crisis and during shock event

If a seller cannot find a market during times of stress, banks may step in, dipping into their inventories to provide liquidity and help manage volatility

Pre-Crisis
Market volatility:
Normal

Here’s how markets typically operated before the GFC:

Banks match buyers and sellers, with their own inventories of stocks and bonds (used for proprietary trading)

If a seller cannot find a market during times of stress, banks may step in, dipping into their inventories to provide liquidity and help manage volatility

Post-Crisis
Market volatility:
Normal

When a volatility shock occurs, unregulated entities are more likely to “step away” or vanish from their roles as market middlemen; this is particularly true for the markets of less-liquid stocks or lower-rated bonds, sending high volatility even higher

The number of broker-dealers in the market playing the role of market maker has decreased, and corporate bond holdings on dealer balance sheets have collapsed2

Shock Event
Market volatility:
High

When a volatility shock occurs, unregulated entities are more likely to “step away” or vanish from their roles as market middlemen; this is particularly true for the markets of less-liquid stocks or lower-rated bonds, sending high volatility even higher

Rise of ETFs

Market of Stocks
Graphic of dots depicting individual company stocks
  • Stocks are driven by inherent forces that can negatively impact specific securities (idiosyncratic risk) and by macro trends that impact the financial system broadly (systematic risk), so they are less correlated.
  • A sudden drop in one stock is less likely to drag the others along with it.
Market of ETFs
Graphic of arrows filled with dots representing individual stocks packaged together as ETFs.
  • Stocks are packaged together in a low-cost ETF wrapper, sometimes regardless of their fundamentals, and the market becomes driven much less by stock-specific fundamentals and much more by macro factors. J.P. Morgan estimates that only 10% of U.S. equity trading is traditional, fundamental-driven investing.3
  • Dominance of market-cap weighted indices leads to assets increasingly and indiscriminately flooding into the stocks with the greatest market capitalization.
  • Volatility can increase due to the nature of ETF investors (shorter term) as well as the increased correlation of stock prices. When a shock occurs in a particular stock or group of stocks that comprise a big enough share of an ETF, it could result in the entire ETF selling off. Many stocks with their own fundamentals could end up being dragged along for the ride, and this effect is magnified, as ETFs make up a larger share of the overall market.

Quantitative trading strategies

Quantitative, high-frequency, or algorithmic trading strategies follow a predetermined set of trading rules and are executed at incredibly fast speeds, often in large lot sizes, by computers instead of people.

They have been around for quite some time but today make up a larger proportion—over half—of all U.S. equity trading (as a % of market share, according to the Financial Times and TABB Group). Several high-profile investors, as well as U.S. Treasury Secretary Steven Mnuchin, have highlighted risks associated with algorithmic trading.

Many of these strategies use the market behavior itself—technical indicators such as momentum or volatility—as an input of the strategy. For example, technical or momentum-driven quantitative strategies will buy or sell based on technical triggers in the market, sometimes selling more each time the market moves lower through a new trigger and generating a feedback loop, causing the market selloff to worsen. Similarly, so-called risk parity strategies (estimated to be responsible for more than $1 trillion in assets4) use leverage to allocate in a way such that each asset class contributes equally to the portfolio’s risk. But when volatility spikes, these strategies will aggressively reduce leverage, selling into market weakness and compounding the selloff.

The precise amount of market value that has been destroyed from the market due to high-frequency and algorithmic trading is an evolving area of study, requiring significantly more data and research than regulators and academics have produced to date.

Click on the dots below to learn about positive feedback loops created by momentum (or volatility-targeting) strategies.

Interactive graphic showing how the stock market can perform based on different volatility-targeting strategies

When volatility is low, strategies can create liquidity for the market efficiently and at lower transaction costs, often incorporating leverage during periods of market calm.

1

When volatility is low, strategies can create liquidity for the market efficiently and at lower transaction costs, often incorporating leverage during periods of market calm.

2

When volatility increases suddenly or certain technical thresholds are breached . . .

3

. . . the algorithm can trigger rapid trades to sell the security or quickly reduce leverage in the most affected asset classes . . .

4

. . . thereby exacerbating selling pressure and further elevating volatility in the market.

Managing for our new reality

Market structure is consistently evolving and will likely continue to do so under a new presidential administration. The new market structure created by post-GFC regulation and financial innovation is not a catalyst for perpetually higher volatility. Nor does it suggest that the risks of investing will outweigh the potential long-term benefits. But it does have implications for investment strategy:

Know your drawdown risk, or how much your portfolio could potentially drop at any given time between the most recent stock market peak to the most recent stock market trough. This awareness can make clear the need for a well-diversified portfolio and also help underscore the importance of sticking to a long-term plan when volatility shocks occur.

Consider alternative investments, which may make a portfolio more resilient during bouts of public-market volatility given lower correlations and less liquidity.

Give thought to retaining a mix of active and passive investments because, while passive investments offer low-cost, liquid exposure to a portfolio, active management is often better positioned to take advantage of temporary market dislocations.

Review your investment policy statement to monitor your portfolio, as volatility is often only as dangerous as you allow it to be; reviewing your long-term risk and return goals is a critical component of staying on track—and resisting the urge to make portfolio changes—during market swings.

1. SEC Staff Report on Algorithmic Trading in U.S. Capital Markets, August 5, 2020
2. https://www.fsforum.com/types/press/blog/has-the-volcker-rule-affected-market-liquidity-and-does-it-matter/; https://www.financialresearch.gov/working-papers/files/OFRwp-19-02_the-effects-of-the-volcker-rule-on-corporate-bond-trading.pdf; https://www.federalreserve.gov/econresdata/feds/2016/files/2016102pap.pdf
3. https://www.cnbc.com/2017/06/13/death-of-the-human-investor-just-10-percent-of-trading-is-regular-stock-picking-jpmorgan-estimates.html
4. https://www.ft.com/content/fdc1c064-1142-11e9-a581-4ff78404524e

An alternative to volatility and drawdown? Head of Equities, Nontraditional Investments, and Manager Research Matt Glaser reveals where he finds the potential for differentiated, compelling returns.

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