Since the beginning of November last year, Huddlestock* is up +10.77% versus +0.64% for the HFRX Equity Hedge Index**, +2.33% for the MSCI All Country World Index*** and +5.97% for the NASDAQ 100****. Huddlestock was down -1.91% in February.
Performance in February was dominated by a (technical) correction. Concerns of deflation in the US were replaced by concerns of inflation which led to the implosion of several popular inverse volatility products. The rapidity with which US bond yields were rising reflected this growing concern, which was stoked further by the passing of the tax reform bill, talk of a weaker dollar and protectionist rhetoric by the Trump administration.
A cascade of deleveraging was triggered by the event as the algorithms that govern certain types of funds automatically started rebalancing their exposures. This is an instance of the type of risk we’ve been warning about since we started writing these investor briefs and it appears that the regulators have taken note and started investigating the suitability of these products for non-professional investors.
We continue to believe that many exchange-traded products introduce perverse, mechanical cross-linkages that affect the correlation structure of different instruments, and asset classes, and that the large flows of capital into these products will cause a liquidity differential (between these products and their constituents) that has the potential to end the current bull market given a sufficiently material trigger.
* Estimated actual performance of all strategies/themes on the Huddlestock platform on an unleveraged basis.
** The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies.*** The MSCI ACWI Index is designed to represent the performance of the full opportunity set of large- and mid-cap stocks across 23 developed and 24 emerging markets. It covers approximately 85% of the free float-adjusted market capitalization in each market.
**** The NASDAQ 100 is a stock market index made up of 107 equity securities issued by 100 of the largest non-financial companies listed on the NASDAQ. It is a modified capitalization-weighted index.
What does this mean for an investor?
Synchronised global growth and strong corporate earnings growth combined with late-cycle fiscal stimulus, deregulation of banks and a protectionist agenda in the US appear to be resulting in the tech-led, melt-up that we posited would occur in our November brief. Our warning of the potential for sharp pullbacks and a higher level of volatility as the US bumps up against its economic constraints was quite prescient.
Given that financial markets are currently quite sensitive to central bank normalisation it would be realistic to assume that volatility will remain elevated for some time. It appears that if fiscal stimulus doesn’t achieve the desired effect on inflation, that importing inflation via a weaker dollar and protectionist policies might eventually do (or overdo) the trick. Currently, the fundamental backdrop continues to be supportive of our melt-up hypothesis however we are concerned that US government borrowing while the Fed is pushing towards normalisation will precipitate a bear market in bonds that could trigger a selloff in equities. It seems prudent to continue to assume that interest rate hikes will be more aggressive than the market is currently pricing in.
Given these macroeconomic challenges we continue to see the need for being both discerning and disciplined in our investment approach.
Equity Market Correction
This is a chronological account of February’s correction, what we were seeing and thinking at the time and the decisions that we took in real-time.
Thursday, February 1st
The strong upward acceleration of prices at the start of January seems unsustainable, bond yields have been rising rapidly and talk of a weaker dollar makes the market feel somewhat fragile and likely to go lower. In the late afternoon, we chose to close positions in our lowest quality ideas – mostly related to early stage blockchain companies.
Friday, February 2nd
The Bureau of Labour Statistics reports that in January wages rose at a rate that could fuel inflation. The markets interpret this as signalling that the low interest rates behind the bull market will fade away sooner than previously thought and start selling.
Friday evening, February 2nd
We’re unsure whether the wage print has any real meaning at these levels but realise three things:
– The markets are currently particularly sensitive to changes in interest rate expectations;
– Normalisation is going to push up volatility substantially;
– Everything points at the continuation of the melt-up we believe is taking place and we want to take the opportunity to ‘buy the dip’ and invest in stocks that benefit from rising interest rates and volatility
Saturday morning, February 3rd
We sent you an investment idea (called ‘downside protection’) to buy a 2x leveraged exchange-traded product that would benefit from higher volatility. The crowding period for the idea ended just before the US market open on Monday.
Monday, February 5th
We execute the idea just after the open. It becomes clear very quickly that something unrelated to the inflation narrative is taking place. We start hearing news that inverse leveraged volatility products were imploding (these products benefit from a fall in volatility and have been a popular trade for a few years). Our volatility investment spikes in value. The S&P 500 ends the day over 4% down.
Wednesday, February 7th
We’re hearing reports that specific strategies (Risk Parity, Commodity Trading Advisors, etc.) are being impacted by the developments of the last few days. These strategies are typically governed by algorithms which are prone to ‘interaction risk’ where one algorithm causes others to trigger impacting prices in illogical ways.
Thursday, February 8th
It’s time to prepare to ‘buy the dip’ and take advantage of stocks that have become mispriced. We believe corporations in the US are going to spend a substantial part of their tax savings by buying back stocks and paying out dividends, so ‘buying the dip’ makes sense while keeping in mind that we don’t yet have a full picture of what’s going on and we might be misreading various signals. We submit ideas to buy banks. We chose to focus on investment banks in the US who will benefit from higher trading revenues because of higher volatility, benefit from higher interest rates and deregulation of the industry. Importantly, we explicitly avoid several sectors, like basic resources, defence and infrastructure, due to risks related to protectionism and the possibility that the US government will struggle to borrow the amounts of money they have signalled they’ll need.
Friday, February 9th
The market reaches its low point. All major averages are in correction territory on 10 percent drops – we’ve crowded investors into the bank ideas and execute them the following week on evidence that the market has found a bottom. We’re confident that our tilt into technology and bank stocks is the right place to be in the current environment.
What does this mean for an investor?
Corrections are nearly impossible to time. The sand castle can start to crumble for any number of abstract reasons. Making the right decisions with little or no information other than price movement and great uncertainty is difficult. The market tends to weed out overconfidence – modesty and level-headedness are the order of the day.
We’re expecting further corrections as the market continues to melt-up and believe that at this stage of the economic cycle tilting into technology and bank stocks is the right play.
Pro Tip: Participation and Performance Fees
Every month we’ll be focusing on delivering an insight that will help you get the most out of Huddlestock.
This month we would like to discuss how and why we charge fees the way we do. Our two main fees are the ‘participation’ and ‘performance’ fees (see the ‘fees policy’ at the bottom of the Huddlestock website for an oversight of all fees).
The participation fee is a fee charged when you invest in an idea. It is between 0.39% and 0.89% of the amount you invest where the exact amount charged depends on how ‘full’ the idea is at the time the investment is made. Crowding into ideas with other investors ensures that you pay the lowest possible fee. The cost savings that you benefit from by crowding are simply the result of doing things more efficiently (executing 100 investments with 1 investor in each is far more expensive to do than having 100 investors in 1 investment). As more clients join the platform we will have the option of lowering these fees further.
The performance fee is charged when an investment idea is closed. The thinking is simply, if the idea made you money (net of the participation fee) then the vendor (and Huddlestock) will take a slice of the profit. If the idea didn’t make you money, then there’s no performance fee. This means that vendors are incentivised to send you ideas that they believe will make you money and it also means that Huddlestock is incentivised to onboard great vendors. Nobody wins if poor vendors make it onto the platform.
Vendors compete on fees meaning that the ‘explore’ section is a marketplace for investment strategies which we hope will become efficient through time as the field becomes progressively more diverse. This means that at some point special strategies with great track records will command higher fees than simpler, more generic strategies. It also means that you are far less likely to be overcharged for the service.
The combination of the massive efficiencies that benefit everyone, incentives aligned with your interests and an efficient marketplace, is fair for all and a world away from the solutions that are currently out there.
For any feedback, please email us at firstname.lastname@example.org.
Michel van Tol, PhD
Chief Investment Officer
Download this brief as a PDF file here.