Corey Hoffstein, co-founder and chief investment officer at Newfound Research interviewed Aneet Chachra on his experience and knowledge about flow effects.
This would interest readers who have a certain degree of belief that there exist flow effects and they affect the markets in some ways.
I have wrote two articles related to this in the past:
- How the Options Market ends up Controlling the S&P 500 in 2021
- Will the Massive Mid-June Options Expiry Window Bring About Some Relieve to the Markets?
Aneet and Corey also explored related tangents such as position-sizing, entry and exits, diversification, hedging tail risks, insurance firms and their products, index funds and dealing with uncertainties.
If you are not interested in flow effects, there should be some good takeaways for most investors.
Aneet Chachra’s Background
- Grew u in Canada and studied engineering
- Hired by Morgan Stanley to be a programmer. Exposed to many new ideas but if you are in technology, it is not the bank’s main focus and life is tough when things go wrong with the software
- Became a quant at a hedge fund. Learn more on how hedge funds look at different trade ideas
- Became an equity analyst. Learned how long-only managers look at their portfolios and particular stocks, how do they manage their book with tracking errors
- Eventually joined Henderson who has a team working on flows and have been there since
- Aneet’s profile
There are Four Main Ways to Make Money
- Buy and hold assets that have positive risks in them (stocks and bonds). You need a long holding period to be able to get a positive return. Can add a little more through rebalancing, leverage, tilting towards a certain way etc. This is one end.
- High-frequency trading. Great technology, very smart people. Make a huge number of transactions to earn a tiny amount of spread by providing liquidity. This is the opposite end.
- Classic fundamental analysis. Value investing. Generally will take a while for the investment to be in the money.
- Flow effects. Between 1-day to 1-month time frame. Flow effects are trades done by market participants who are inflexible in some ways. Transact at a particular time, quantity or price for some reason. Usually, they are transacting with someone who is more flexible. Figure out the flow effects directionally will be and profit from it.
How Aneet Categorize the Different Flow Effects.
There are three types.
Mandates. This is the strongest. The market participants have to do something.
- When a stock is added to an index, every fund that is tracking the index out there needs to go out there and buy the stock.
- Share buybacks are instituted by companies.
- Buffer funds. Very strict rules, what is the strike and maturity they need.
Incentives. Not quite as strong but still very important.
- Options hedging. A bank or market maker sells an option to a retail investor, the institution is not legally obligated to hedge but would normally still delta-hedge its books. If you are able to get rid of the risk through hedging, it will allow you to run a larger book.
- Share supply. If you are a founder of a startup whose company is going IPO, you are more likely to be selling shares than buying shares.
- Mass selling for liquidity. A good example would be during Archegos when many banks try to front run each other by selling their positions.
Flow Effects Change Over Time
These flow effects do change over time because what people are interested in also changes over time. Meme craze == buy call, bear market == buy put.
This means that the impact of delta-hedging of options changes over time. The second reason is less obvious in that even the same flow can have different impacts depending on who are the holders, this would change over time.
What Impact the Flow Effects?
Two mega trends:
- The sheer rise in the number of inflexible strategies. ETFs, passive mutual funds, volatility targeting, risk parity, momentum, factors, target data, structured notes and balanced funds. More and more styles with rules that dictate what assets are held and when to buy and sell.
- Who is intermediating these flows? Banks used to do more but have dropped significantly. Nowadays more fragmented.
The combination of these two trends can result in big price swings.
When there are less issuance during holidays, a lot of these flow effects are at month-end or quarter-end. Some flow effects are affected when volatility goes up but others like the rebalancing of factor funds will still take place.
Th impact of flows are generally higher when volatility goes up but that also pushes up the risks. Market makers are providing a service by marketing making so when volatility goes up, it also pushes up the compensation required.
Living with Wild Swings During Regimes.
As a trader, you need to understand that you will go through periods of lower volatility, there are less attractive opportunities out there, and you should no go out and chase marginal trades. On the flip side, when the opportunity side is greater, you need to flex your portfolio out to take more trades.
One of the strengths of being on the opposite side of inflexible customers is to be flexible and we need to recognize the importance of being flexible.
The need to be adaptive in what you do depending on the market regime is why it will be difficult to package this into an exchange-traded fund solution.
Dealing with Risks, Position-sizing and Entry Criteria
In most of these flow effect strategies, you have a small edge so you are trying to capture these small edges repeatedly. Your biggest risk tends to be idiosyncratic (non-systematic) risks. There are no unknowns or unknown unknowns.
The best way to defend against the tail risks is to do lots of trades simultaneously and repeatedly. (If we are talking about coin flipping, you would want to be flipping 10 coins together and repeatedly.)
You are diversifying across different things, but also through time.
We do not want to rely on correlation or volatility in terms of position sizing and management because both of these factors can be rather unstable especially when regimes changed.
People say that the worry is when correlations approach 1 but that is not such a bad thing if that is to be expected. What is harder to manage is when correlations keep shifting around.
It is quite dangerous to say that an asset class have always had low volatility and when they end up in another regime where volatility picks up and it wrecks your strategy (e.g. stablecoins in the crypto space). Other good examples of why you would not want to weigh based on volatility profile are traditional blue-chip stocks like Boeing and Meta, which usually have manageable volatility profiles but when there are re-capitalization events, the volatility profile veers very, very far.
In general, we want to be very small in our position-sizing because we do not know the future outcomes to the exact. This is the same as life. The mantra is that we want to survive long enough to be lucky.
Entry and Exits
Most entry and exits in other strategies are price-related but in flow strategies, it is time-horizon related.
This is because the effects of flow usually settled around certain periodic mandates such as rebalancing. Whether we are right or wrong, when the period passes, we have to exit because the flow effects would be diminished.
How do we Construct a Portfolio of Postive Expectancy and Very Wide Variance from Blowing Up in Our Face?
Due to the wide variance in any direction, the Sharpe ratio on each trade is very low. We have to let diversification do most of the work.
Aneet used the example of running a casino. You don’t want to only let the people play one type of game but many games, and for them to keep coming back and playing repeatedly.
The flows would change depending on what the market participants are interested in. Another reason is that sometimes, your positive expected returns may be competed away (e.g. roulette wheel is tilted or someone counting cards).
The nature of statistics is that it would take a long time to figure out if the strategy is not working permanently or just undergoing a period of bad luck.
Corey Hoffstein wrote before that by the time we realize the value factor has stopped working we are likely dead. When we only have one investing style, we cannot diversify enough.
What we want to do is run many strategies so that other strategies can absorb the hit when a few are not working due to crowding, a more savvy competitor.
Social Leverage – Meme Stocks
Buying a meme stock like Gamestop so that you do not miss out is different from buying a lottery ticket.
People that come in early to the trend tend to benefit more than the people that come in afterwards. Those people early have more flexibility when they exist because they are in the money and they can decide the range of positive returns they wish to get, but those that came late are less flexible.
The phrase markets take the escalator up but elevator down is probably more true on the index level but may not be true on an individual stock level due to the flow effects. At some point, the liquidity to a single stock may be so sucked out by inflexible people that the price discovery takes place only by the few people that are willing to transact.
When stock becomes ‘salient’ or a meme, the profile changes because the stock has a completely different holder base, the price impact of flows, and options markets. The fundamental of AMC does not matter already as the stock is determined by the factors listed above.
Aside from meme stocks, the flow matters more than fundamentals can affect a group of stocks, especially in thematic ETFs. The underlying stocks fundamentally should not be so correlated but the share price becomes very correlated due to these dynamics being more important than fundamentals. Think cloud computing companies in a cloud ETF.
What does Aneet mean when he said: “Signal Turn to Noise Because of Arbitrage But Noise Turn to Signal Due to Reflexivity”
Signal turn to noise means that even if you have an edge, that edge might compete away. If your strategy is working for a long time, it is good to be adaptive and evolve your strategy.
A good example is options selling.
For a long time, the implied volatility averages higher than realized volatility. You can buy the index or write a put option on the index. Both strategies end up with roughly similar returns but the options strategy has much lower volatility and smaller drawdowns.
This is the market equivalent of a free lunch.
Then more and more institutions pile into these options selling programs.
If you are able to isolate the returns from options selling from the market risk, you would realize your returns are between zero and negative.
Thus, there was premium-selling options but that was completely grounded out due to the mass pile-on that is more noise right now.
The noise turned to signal
Signals exist because there are people that believe it does exist.
A common signal is the 200-day moving average, which is one of the most often-cited indicators. Why not 225-day or 250-day (which is closer to 1 year)?
Aneet thinks that the 200-day made its name during the crash of 1987. If you have used the 200-day moving average, you would have been out of the market the day before the crash and got back in after the crash.
If you have used a 202-day moving average in the same period, you would be long going into the 1987 crash one day later and the signal would get you out of the market at the bottom.
Aneet thinks that the 200-day worked back then but today, there are enough people who believe that in today’s noise environment, this would still work.
More Examples of How Flow Affects the Markets
If you don’t build your own models, you do not know what assumptions go into the model, and the limitations of your data gathering and analysis.
The systematic strategy players can be very important. We see more of that during March 2020, when those volatility-targeting funds have to massively deleverage and that caused major effects.
The feedback loop:
- They use volatility as a signal
- The signal forces them to sell a huge amount of S&P futures at the close
- This pushes down the price
- Realized volatility increases
- The higher volatility forces them to need to sell more S&P futures the next day
- The cycle goes on.
This is quite similar to 1987 when people are selling portfolio insurance.
There is a big demand for strategies that allow you to capture all the upside but severely limit the downside.
These insurance strategies don’t really work well when everyone is trying to do the same thing because there is an inherent assumption that each of their selling is not going to have much impact on prices. This might be true during normal periods when volatility is low and the selling of stocks is small. But when the numbers get big and volatility is high, their actions have a pretty big impact on prices.
Today, even if you are an investor of individual shares, whether you like it or not if there is a huge order from an ETF, that is going to affect your shares whether you like it or not.
Each of these trades might be small but if you stack them up they can have a meaningful impact.
Applicable Portfolio Tail Hedges in Portfolio Management Strategies
It is important to look at the entire risk to the portfolio and not just individual strategies in the portfolio.
You would want to correctly size your tail hedges.
The first benefit of hedging is that during periods of stress, your portfolio is more uncorrelated, you are taking a smaller loss, and you do not find yourself in a big hole that you have to dig yourself out.
The second benefit is that it allows you to take advantage of the market opportunities that come up. If you are down a lot, you are mentally not going to be in a good position to take advantage of whatever opportunities are coming along your way.
When The Time Comes To Buy, You Won’t Want ToWalter Deemer
The hedges allow you to look for opportunities at an attractive level.
Overall, Aneet does not see its hedges as profit centres. Hedging gives people the mental edge to take on more risks compared to people with financial constraints.
Three types of hedging:
- Gap risk. October 1987 or March 2020. A huge move in the market was accompanied by a jump in volatility. You would want a long volatility hedge that has a nice and meaningful payoff in a crisis period yet during a non-crisis period it would not be a huge drag.
- Gradual and slowly moves up or down. Stocks in 2008/2009. Prices are slowly grinding. Trend CTA strategies work well even when volatility signals are not as reactive.
- Events. Markets are not pricing in the world can look quite different in the future. E.g. Bonds where bond yields were low and implied volatility is also low. This tends to be the hardest to hedge because you need to get the direction and timing roughly right, but also structure it in such a way that the payoff is greater than the odds of it happening.
Definition: What is the opportunity set?
The number of possible pair combinations of expected returns and volatility that are available to you based on the characteristics of the strategy that you run with your selected asset classes.
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