Is the market its own worst enemy?

By: John Christofilos • December 12, 2018

The structural transformation of markets and trade dynamics in recent years could add fuel to the next big selloff in stocks.

Equity markets have been anything but dull this year. After a long stretch of unusual calm in 2017, volatility has spiked and a number of hair-raising pullbacks have occurred, leaving the bull run in stocks bent but not quite broken. While growing fears about rising interest rates and trade wars are largely to blame for the turbulence over the past 12 months, this alone does not explain the full risk now facing investors.

Exacerbating current macro threats is the vast transformation in market structure and daily trading practices, which, combined, have proven their potential to accentuate losses and may be what ultimately fuels the next big selloff when it happens.

Chief among these structural changes is the rise of trading algorithms and increasing influence of high frequency traders (HFTs) and quantitative models that can now buy and sell securities in nanoseconds.

This facet of the market’s ongoing technological innovation has helped improve the speed and accuracy of trade execution, while also supporting the interconnectivity of the numerous exchanges and trading platforms now operating around the world. But their prevalence has also created new challenges in areas such as liquidity and they have been linked to a number of so-called “flash crashes” this decade including the first and most famous which occurred on May 6, 2010, resulting in a loss and recovery in the Dow Jones Industrial Average of over 1,000 points in about 15 minutes.

More recently, algorithmic trading played a large role in the Dow’s steep drop in early February of this year. Precipitated by a strong U.S. jobs report, the correction was driven by several contributing factors beginning with a necessary rebalancing by many large pension funds following an abnormally strong rally in stocks the previous month.


By the numbers

In 2007, passive investing’s overall size amounted to about 26% of actively managed large and all-cap funds’ assets under management (AUM) in the U.S., and about 15% outside of the U.S. Eleven years later, those figures have jumped to 83% and 53%, respectively.


Source: Bloomberg LP and JPMorgan Chase & Co.


Last-minute trading spurts have hit record levels. This year on the New York Stock Exchange and the NASDAQ, 22% of trades were concluded in the final half hour of each day, on average, up from 19% in 2014.



Source: Bloomberg LP and Investment Technology Group.


From there, algorithms triggered even more selling from trend-following strategies that trade strictly on market technicals without considering context of the greater economic backdrop. And as losses continued to mount, panic set in – particularly among self-directed retail investors – only leading to further losses.

This type of scenario is only bound to repeat – especially given some estimates that show algorithmic trading accounts for more than 50% of all trades that take place in certain marketplaces. But what’s being traded may have just as big of an impact on future stock prices as does the changing ways in which trades are being executed.

The rise of passive investing, for example, is being increasingly scrutinized as it continues to eat up market share. Index funds and ETFs that track market-weighted indices and portfolios have ballooned to US$7.4 trillion in assets under management globally, according to JPMorgan Chase & Co., and are being held more accountable for an uptick in concentrated last-minute trading that is resulting in steep end-of-day volatility with growing frequency.

This stems, in part, from the fact that many passive ETFs are benchmarked to the close, which forces most of the buying and selling required to target benchmarks toward the final moments of the day. And because passive investing tends to be trend following, this may lead to wild price swings in the last hour of trading.

Granted, many ETFs are incredibly useful tools in certain circumstances, but the tendency of passive funds to push equity prices higher during rallies and magnify losses during pullbacks is particularly alarming at this late stage of the economic cycle.

Similar worries apply to the possibility of another flash crash as the result of algorithmic trading. While neither of these risks will likely cause the next bear market, they could easily reduce the ability of the market to prevent and recover from its impact, while potentially eroding investor confidence over time.

Commentaries contained herein are provided as a general source of information based on information available as of December 7, 2018 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Investors are expected to obtain professional investment advice.

AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), Highstreet Asset Management Inc. (Highstreet), AGF Investments America Inc. (AGFA), AGF Asset Management (Asia) Limited (AGF AM Asia) and AGF International Advisors Company Limited (AGFIA). AGFA is a registered advisor in the U.S. AGFI and Highstreet are registered as portfolio managers across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets.

Publication date: December 12, 2018

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