For Wall Street’s professional money managers, the biggest “pain trade” right now is the ongoing rally in stocks following a two-year bull run.
That’s according to Nomura’s Charlie McElligott, who explained in commentary shared with MarketWatch on Monday how hedge funds, systematic traders, CTAs and other sophisticated investors have been so focused on protecting their portfolios against the risk of a selloff, that they have neglected to prepare for the “right tail” outcome — that is, an ongoing, powerful rally.
Elevated levels of the Cboe Volatility Index, along with other gauges of demand for hedges like the skew on options tied to the SPDR S&P 500 ETF, speak to this sense of caution, likely foisted on portfolio managers by their firms’ risk-management officers. Given the myriad risks that could crop up to bulldoze stocks, and the two short-lived shocks stocks have endured in recent months, that’s hardly a surprise.
Still, this cautious posture will drag on funds’ performance, even as history suggests that forward returns for stocks up to one year later look pretty good when implied volatility — which is what the VIX aims to capture — is at or higher than it is right now.
If stocks continue to climb, firms will eventually be forced to chase the rally, likely through purchases of out-of-the-money calls (McElligott highlighted one notably large order for $615-strike SPY calls that hit Nomura’s trading desk shortly before he fired off his latest missive to clients and the media).
As old hedges expire worthless and traders open new bullish positions, options dealers will likely be forced to hedge their exposure by buying S&P 500 futures, pushing the market higher still. Eventually, systematic funds and CTAs — and even long-short discretionary managers — will be forced to boost their exposure to stocks, adding more fuel to the melt-up rally.
In Wall Street parlance, a “pain trade” occurs when the market takes an unexpected turn, leaving many professional money managers to play catch-up.