Volatility: how ‘algos’ changed the rhythm of the market

Critics say high-frequency trading makes markets too fickle amid rising anxiety over the global economy  writes Robin Wigglesworth in The FT

Philippe Jabre was the quintessential swashbuckling trader, slicing his way through markets first at GLG Partners and then an eponymous hedge fund he founded in 2007 — at the time one of the industry’s biggest-ever launches. But in December he fell on his sword, closing Jabre Capital after racking up huge losses. The fault, he said, was machines. 

“The last few years have become particularly difficult for active managers,” he said in his final letter to clients. “Financial markets have significantly evolved over the past decade, driven by new technologies, and the market itself is becoming more difficult to anticipate as traditional participants are imperceptibly replaced by computerised models.” 

Mr Jabre is not alone. There has been recently a flurry of finger-pointing by humbled one-time masters of the universe, who argue that the swelling influence of computer-powered “quantitative”, or quant, investors and high-frequency traders is wreaking havoc on markets and rendering obsolete old-fashioned analysis and common sense. 

Those concerns were exacerbated by the volatility in financial markets in December, when US equities suffered their biggest monthly decline since the financial crisis, despite little fundamental economic news. And with growing anxiety over the strength of the global economy, tightening monetary policy across the world and an escalating trade war between China and the US, these trades are getting more attention. 

Even hedge fund veterans admit the game has changed. “These ‘algos’ have taken all the rhythm out of the market, and have become extremely confusing to me,” Stanley Druckenmiller, a famed investor and hedge fund manager, recently told an industry TV station. 

It is true that markets are evolving. HFTs dominate the market-making once done by humans in trading pits and the bowels of investment banks. Various quant strategies — ranging from simple ones packaged into passive funds to pricey, complex hedge funds — manage at least $1.5tn, according to Morgan Stanley. JPMorgan estimates that only about 10 per cent of US equity trading is now done by traditional investors. Other markets remain more human, yet are slowly but surely being transformed. 

This has made “the algos” a fashionable bugbear whenever markets tremble like they did in December. Torsten Slok, Deutsche Bank’s chief international economist, put them at the top of his list of the 30 biggest risks for markets, and even Steven Mnuchin, the US Treasury secretary who caused market unease with comments on liquidity late last year, has said the government will study whether the evolving market ecosystem fed the recent turmoil. 

But markets have always been tempestuous, and machines make a convenient, faceless bogeyman for fund managers who stumble. Meanwhile, quants point out that they are still only small players compared with the vastness of global markets. 

“It’s insane,” says Clifford Asness, the founder of AQR Capital Management. “People are missing the forest for the trees. That we trade electronically doesn’t change things, we just deliver the same thing more efficiently . . . It’s just used by pundits and fund managers as an excuse.” 

The recent turmoil has unnerved many investors, but two other debacles stand out as having first crystallised the fear that algorithms are making markets more fickle and fragile. 

At 2:32pm on May 6 2010, US equities suddenly and mysteriously careened lower. In just 36 minutes the S&P 500 crashed more than 8 per cent, before rebounding just as powerfully. Dubbed the “flash crash” it put a spotlight on the rise of small ultra-fast, algorithmic trading firms that have elbowed out investment banks as the integral intermediaries of many markets. 

Michael Lewis, author of Flash Boys, fanned the flames with his book by casting HFTs as mysterious, investor-scalping antagonists “rigging” the stock market. What was once an esoteric, little-appreciated evolution in the market’s plumbing suddenly became the topic of a vitriolic mainstream debate. 

“It was a wake-up call,” says Andrei Kirilenko, former chief economist at the Commodity Futures Trading Commission who wrote the US regulator’s report on the 2010 event and now leads Imperial College London’s Centre for Global Finance and Technology. “The flash crash was the first market crash in the era of automated, algorithmic trading.” 

In August 2015, markets were once again abruptly thrown into a tailspin — and this time volatility-sensitive quantitative strategies were identified as the primary culprits. The spark was rising concern over China’s economic slowdown, but on August 24, the S&P 500 crashed on opening, triggering circuit-breakers — implemented in the wake of the flash crash to pause wild trading — nearly 1,300 times. That rippled through a host of exchange traded funds, worsening the dislocations as they briefly became divorced from the value of their underlying holdings. 

Many investors and analysts blamed algorithmic strategies that automatically adjust their market exposure according to volatility for aggravating the 2015 crash. Targeting a specific level of volatility is common among strategies known as “risk parity” — trend-following hedge funds and “managed volatility” products sold by insurance companies. Estimates vary, but there is probably more than $1tn invested in a variety of such funds.

Risk parity, a strategy first pioneered by Ray Dalio’s Bridgewater Associates in the 1990s, often shoulders much of the opprobrium. The theory is that a broad, diversified portfolio of stocks, bonds and other assets balanced by the mathematical risk — in practice, volatility — of each asset class should over time enjoy better returns than traditional portfolios. Bonds are less volatile than equities, so that often means “leveraging” these investments to bring the risk-adjusted allocation up to that of stocks. As volatility goes up, risk parity funds in theory rein in their exposure. 

However, risk parity funds can vary greatly in the details of their approach, and are generally slower moving than the $300bn trend-following hedge fund industry. These funds surf market momentum up and down, and also use volatility metrics to scale their exposure. When markets are calm they buy, and when turbulence spikes they sell. 

This has been a successful strategy over time. But it leaves the funds vulnerable to abrupt reversals — such as the market tumble last February — and means they can accentuate turbulence by selling when markets are already sliding.

Leon Cooperman, the founder of Omega Advisors, has argued that the US Securities and Exchange Commission should investigate and tame the new “wild, wild west environment in the stock market” caused by these volatility-sensitive strategies. 

“I think your next guest ought to be somebody from the SEC to explain why they have sat back calmly, quietly, without saying anything and allowing these algorithmic, trend-following models to wreak havoc with what has, up to now, been the best capital market in the world,” he told CNBC in December. 

Some quants will grudgingly admit that volatility-targeting is inherently pro-cyclical and can at least in theory exacerbate market movements. But they say critics wildly overestimate just how much money is invested in these strategies, how much they trade, and their impact. 

“Risk parity is basically a passive portfolio with some periodic, counter-cyclical rebalancing. Our volatility targets aren’t perfectly static, but they only change over a 10-year window,” says Bob Prince, co-chief investment officer at Bridgewater. Other risk parity strategies may vary, but overall “it's only ever going to be a drop in the ocean”, he adds. 

Markets had been vulnerable to panicky plunges long before trading algorithms emerged, yet fears over machines seem deeply embedded in our psyche. A 2014 University of Pennsylvania paper found evidence of what it dubbed “algorithm aversion”, showing how human test subjects instinctively trusted human forecasters more than algorithmic ones, even after seeing the algo make fewer and less severe forecasting errors. 

And there are plenty of other potential culprits to blame for exacerbating recent turbulence. Many traditional active funds suffered a battering in 2018. That has led to a rise in investor redemption notices and has forced many to sell securities to meet the end-of-year withdrawals. 

Hedge fund flow data come with a lag, but traditional equity funds saw withdrawals rise to nearly $53bn in the seven days up to December 12, according to data provider EPFR — comfortably the biggest one-week outflow on record. That probably both reflected and exacerbated the slide that left the S&P 500 nursing a 6 per cent loss for 2018. 

At the same time, market liquidity— a broad term denoting how easy it is to trade quickly without causing prices to move around too much — tends to weaken in December, when many fund managers become more defensive ahead of the end of the year. Liquidity can be particularly poor in the last weeks of the year, when bank traders ratchet back how much risk they take on to avoid extra regulatory charges. 

“This makes it more expensive for dealers to perform their essential functions: providing liquidity, absorbing shocks and facilitating the transfer and socialisation of risk,” Joshua Younger, a JPMorgan analyst, wrote in a recent note. “These costs are generally passed on to customers in the form of higher rates on short-term loans, thinner markets and the risk — now realised — of spikes in volatility.” 

That markets are undergoing a dramatic, algorithmic evolution is an inescapable fact. Although some humbled hedge fund managers may unfairly castigate “algos” for their own failings, there are real risks in how some of these different factors can interact at times of market stress. 

HFTs are far more efficient market-makers than human pit traders. Yet the entire sector probably has less capital than just one of the major banks, says Charles Himmelberg, head of global markets research at Goldman Sachs. It means that they tend to adjust their bids aggressively when market mayhem breaks out. 

Under those circumstances, even a modest amount of selling could have an outsized impact. This is an issue both for human traders and quants, but quant strategies are programmed, quick and on autopilot, and if they start pounding an increasingly thin market, it can cause dislocations between buy and sell orders that can produce big gains or falls. 

For example, JPMorgan estimates that the depth of the big and normally liquid S&P 500 futures market — as measured by how many contracts trade close to the current price — deteriorated in 2018, and was exceptionally shallow in the last months of the year. In December it was even worse than the levels seen in the financial crisis. 

“While it is incorrect to say that systematic flows are the sole driver of recent market moves, it would be equally incorrect to say that systematic flows don’t have a meaningful impact,” says Marko Kolanovic, head of quantitative strategy at JPMorgan. 

Poor liquidity and market volatility have always been linked, and it is in practice impossible to dissect and diagnose the myriad triggers and drivers of a sell-off. But modern markets do appear more vulnerable to abrupt dislocations. 

The question is whether anything should, or even could, be done to mitigate the risks. Mr Kirilenko cautions that a mix of better understanding and modest tweaks may be the only conclusion. 

“We just have to accept that financial markets are nearly fully automated,” he says, “and try to make sure that things don’t get so technologically complex and inter-connected that it’s dangerous to the financial system.” 

Anxiety inducing: the triggers for market fears 

Although the recent market slide has reawakened the debate about whether modern machine-driven markets can exacerbate the severity of any volatility, the fundamental drivers of the turbulence are more conventional. As 2018 progressed, investors grew concerned at three factors: signs that the global economy is weakening; the impact of tighter monetary policy in the US and the end of quantitative easing in Europe; and the escalating trade war between the US and China. The global economy started last year on a strong footing, but markets are always focused on inflection points. Since the summer the impact of US tax cuts has appeared to fizzle, European growth has slowed, and China’s decelerating economy has been buffeted by the trade dispute. That has led analysts to trim their estimates for corporate profits in 2019. At the same time, the Federal Reserve raised interest rates four times last year, and has kept shrinking its balance sheet of bonds acquired in the wake of the financial crisis. That has lifted short-term ultra-safe Treasury bill yields to a 10-year high, and undermined the long-term argument that “there is no alternative” which has helped sustain market valuations. As a result, Treasury bills beat the returns of almost every major asset class last year. Goldman Sachs says that over the past century there have only been three other periods when Treasury bills have enjoyed such a broad outperformance: when the US ratcheted up interest rates to 20 per cent in the early 1980s to subdue inflation; during the Great Depression; and at the start of the first world war.

Sledging in cricket - Pump up the volume

It's time to turn the stump mikes all the way up, and leave them that way

Rob Steen

December 4, 2013

	The next time two players discuss the weather in detail, we'd love to hear what they're saying © BCCI  Enlarge

Taking issue with a pair of sage judges of humankind like George Orwell and Mike Brearley might not be the wisest intellectual venture, but into the valley of the ridiculed here I come.

In his 1945 essay "The Sporting Spirit", Orwell decried the competitive arts as "war minus the shooting" (international sport, that is, not sport per se; his incandescent response to a UK football tour by Moscow Dynamo is so habitually misquoted). Given the quotidian deluge of pain inflicted in its name, not to mention the occasional death, "war minus the looting" might be nearer the mark. Or better yet, as the latest renewal of Ashes mania appears bent on reaffirming, "war plus the loathing".

-----Also Read

Doesn't Sledging Hurt Anyone?

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More recently, this very week, Brearley wrote a typically astute article for the Times, lamenting the intolerably abrasive atmosphere of the Brisbane Test, observing that there was "a narrow line" between acceptable and unacceptable behaviour. This struck me as being overly generous.

What distinguishes sport from every other branch of the entertainment industry is its relationship with its audience, enforcing as it does an acute awareness of its constant (and constantly annoying) dancing partner - sportsmanship. Nobody talks about actorship or poetship or dancership; musicianship and authorship relate, respectively, to craft and rights, not conduct. But what do we actually mean by sportsmanship? It certainly tells us something about its complexities that no feminist I know has ever demanded that we refer to sportspersonship, let alone sportswomanship.

It seems reasonable to define this slippery virtue, broadly, as the willingness, even determination, to a) win fairly, honestly and modestly, and b) lose gallantly, graciously and, almost needless to add, unintentionally. Liable as they are to be copied in playgrounds, backyards and parks, any antic that even smacks of cheating or disrespect sets the most erroneous of bad examples, primarily to the impressionable young millions who invest so much of their emotion in, and glean so much of their joy from, the curious world of ballgames.

Sure, the older and wiser we get, the more we understand the unique nature of athletic battle and its impact on even the coolest of tempers. On the other hand, sports watchers of all ages are resolutely intolerant of relatively trifling misdemeanours such as time-wasting, feigned injury or even a withheld handshake. And woe betide those perceived to be cowardly, whether in the form of a tackle shirked, a risk untaken or an opponent tongue-lashed. And rightly so.

That's why, even as we grow ever more inured to violent images, and admiring of murderous on-screen drug lords and mobsters, sledging still disturbs disproportionately - because it tells us the perpetrator has given up trying to prevail through skill. There's banter and there's sledging, of course, and it is to the spite-rich, wit-free latter that one takes exception. To many, the Brisbane Test was sickening, not because of the savagery of the bowling but the vile viciousness of the verbals. One of the odder things about the three-for-the-price-of-one product cricket has become is that the least frantic variety is the likeliest to arouse indefensible behaviour.

Before we get to the remedy, a dose of perspective seems in order. Amid the same Gabba gabfest that saw Messrs Anderson and Clarke reiterate how far cricketers are prepared to go - and always have been - in quest of an edge, the media ridicule meted out to Jonathan Trott was equally if not more offensive. How sobering, moreover, to open a magazine that weekend and snuggle up with cuddly Mike Tyson.

Interviewed, helpfully, by a woman with whom he clearly felt more comfortable not being Mr Macho, here was a champion whose brutality inside and outside the ring is now matched by a self-flagellating honesty that somehow arouses compassion if not pity. Call it a salutary reminder of sport's capacity to simultaneously thrill and disgust. Call it the hidden price of admission. Still, when it comes to ranking the meanest, baddest-assed sportsmen of them all, Iron Mike the Ear-Cruncher was a spayed pussycat next to Ty Cobb.

When Charlie Davis, that endlessly creative Australian statistician, devised a formula to calculate sporting greatness, he focused on one solo endeavour, golf, and four team games - baseball, basketball, cricket and soccer. Using average and standard deviation (σ), the top three emerged as Don Bradman (4.4 σ above the norm); Pelé, whose goals-per-game superiority over other net-bulgers was 3.7 σ; and Cobb, the early 20th century diamond dazzler whose batting average soared 3.6 σ above the baseball mean. But while the Australian and the Brazilian played sport, the American, like Tyson, warred it.

	Denied the release of physical contact, it was inevitable that a cricketer should coin as dastardly a term as "mental disintegration"

"A red-blooded sport for red-blooded men" was how the perpetually snarly Detroit Tiger described his calling. Professional baseball, he insisted, was "something like a war". In acknowledging that the summit of his own profession was "pretty much a war", Alastair Cook at least had the grace to sound a teeny bit bashful.

Cobb was the ultimate ballplayer-warrior: think Steve Waugh, now multiply by a smidge under infinity. Here was a fellow who brazenly and showily sharpened the spikes on his boots, intimidating opponents and making fielders think twice about blocking his ferocious spurts down the baseline. In 1912, he assaulted a one-armed spectator who'd had the temerity to call him a "half-nigger". An enthusiastic racist, he packed a gun wherever he went; he was also reported to have pistol-whipped a man to death. And yes, he was also a mightily accomplished sledger.

The publicity tagline for Ron Shelton's admirably unmanipulative biopic Cobb was perfect: "The Man You Love To Hate". While no cricketer I can think of has ever warranted such a billing, personally speaking, the one who came closest was Matthew Hayden, whose incessant references to his devout Christianity were contradicted so expertly and shamelessly by those crude and cruel on-field tirades.

Sledging is as fertile a field for baseballers as it is for cricketers, because they, too, go about their labours at a leisurely pace; Tom Boswell, the revered Washington Post baseball correspondent, once described his job as "pondering inaction". Sledging seems so unnecessary. After all, another of the many characteristics the two games share is the extent to which they stack the odds. At any given moment, either nine or 11 men are ganging up on one, the avowed aim to negate, nullify and, ideally, exterminate.

Whereas baseball encourages physical contact and even indulges brawls, its more sedate brother from another mother is a subtler beast, albeit no gentler. What it most assuredly is not, has never been, is a game for gentlemen. Officially, that word itself denotes English peerage's lowest rank - below 80-odd others, even Master in Lunacy. When one's place in the pecking order is so insignificant, it is nothing if not pragmatic to be respectful, courteous, well-mannered and occasionally even honourable.

Denied the release of physical contact, it was inevitable that a cricketer should coin as dastardly a term as "mental disintegration". Whether it's Fred Trueman bullying a cowering Cambridge undergraduate, Dennis Lillee and Javed Miandad exchanging goads, Glenn McGrath spewing bile at Ramnaresh Sarwan or Merv Hughes foul-mouthing Graeme Hick, when it comes to rubbishing the game's reputation for civility the exhibits are largely verbal.

Trash-talking is all very well for boxers and those muscular clowns who have made WWE our least credible form of athletic competition. Is it naïve to expect ballplayers to rise above the sort of gratuitous personal abuse that would be stamped on in any other socially conscious workplace? Yes. Are we surprised that Darren Lehmann all but laughed off the suggestion of a "sledging summit"? Definitely not. Transgressors should therefore be pilloried as loudly as possible.

The name of the game must be shame. Shame the sledgers. Shame the needlers and the ranters. Shame the cowards. And the best way to achieve this noble end is not only to keep those stump mics on permanent duty but pump up the volume. Censorship is as pointless as it is dishonest. Why should the guilty be protected? Why shouldn't the audience, spectators as well as viewers, hear every sling and arrow of outrageous verbiage, preferably in Led Zeppelin-esque, Dolby-clarified, Marshall-amplified, 5.1 Surround Sound? They are part of the show. If turning the dial all the way up to 11 encourages wit, splendid. If it exposes nastiness and callousness, even better.

According to international protocol, of course, this ought to be a non-starter rather than a no-brainer. Still, judging by SABC's freewheeling deployment of the stump mic during last week's ODI against Pakistan in Port Elizabeth, let alone the 2006 Durban and Cape Town Tests, which saw Tony Greig and Mike Hussey take bilious exception to such eavesdropping, this doesn't seem to bother the state broadcaster unduly. Regrettably, I cannot report precisely what choice words the fielders selected after Quinton de Kock had given Junaid Khan a gentle shove for invading his space; my command of Urdu, shamefully, is on a par with Shane Warne's acumen in the shrinking-violet department.

Such is the precarious mutual dependence between sport and its most industrious sponsor, the reality is that behaviour will only be improved by stealth. Someday soon, a stump mic will be "accidentally" cranked up, not merely at a heated moment but for an entire day. Technical gremlins will be blamed. Innocence will be asserted. Apologies will be tendered. But the damage, with luck, will have been done. If there really is such a thing as the spirit of cricket - or even The Spirit of Cricket - I can't think of a better way to define what it isn't.