London: The Bank for International Settlements sees rising debt issuance as potentially destabilising for global markets, and points to a curious suspect — index funds.
In a report issued last week, the BIS warned that borrowers may be tempted to ignore the interests of their bondholders and take on additional leverage to meet demand from index trackers. That’s because the most widely used benchmarks allot larger positions to companies that have the most outstanding bonds, thereby rewarding companies that become more indebted, the report argues.
A higher share of passive investors could “weaken market discipline and alter the incentives of corporate and sovereign issuers to act in the interest of investors,” the Basel, Switzerland-based institution said. “From a financial stability perspective, there is a concern that this can act pro-cyclically and encourage aggregate leverage.”
The BIS is tapping into a long-held concern about bond indexes, which — in mimicking the skew of traditional equity benchmarks toward larger companies — end up tracking the biggest debt issuers. Bond sales have certainly exploded over the last decade and investors have ploughed more and more into funds that passively invest in them, but arguably both have more to do with the decade of ultra-low interest rates than one another.
Regardless, when the so-called central bankers’ bank speaks, it’s worth a listen. As its report points out, for every 1 per cent increase in debt, a company’s weight climbs 0.025 percentage points in the Merrill Lynch Global Broad Market Corporate Index. By contrast, a company’s size plays a much less significant role, with a 1 per cent increase in total assets only resulting in a 0.005 percentage point increase in its weight in the benchmark
Issuers of passive funds are already taking note and starting to favour bond indexes that tilt toward factors like duration risk or credit quality, rather than a company’s debt burden. Of the 48 US fixed-income ETFs launched last year, 27 chose an alternative weighting, data compiled by Bloomberg show.
Over the past six years, investors have ploughed more than $650 billion (Dh2.4 trillion) into passive exchange-traded and mutual funds in the US that invest in bonds — more than double the inflow for active products, according to Bloomberg Intelligence data.
Bloomberg LP, the parent company of Bloomberg News, owns the Bloomberg Barclays-branded bond indexes, the most widely followed measure of fixed-income performance worldwide.
Robot takeover stalls
Chalk one up for the humans.
Hedge funds that use artificial intelligence and machine learning in their trading process posted the worst month on record in February, according to a Eurekahedge index that’s tracked the industry from 2011. The first equity correction in two years upended their strategies as once-reliable cross-asset correlations shifted.
While computerised programs are feared for their potential to render human traders obsolete, the AI quants lagged behind their discretionary counterparts. The AI index fell 7.3 per cent last month, compared to a 2.4 per cent decline for the broader Hedge Fund Research index.
The slump even surpassed a more traditional category of quants, commodity trading advisers or CTAs, which posted near-record losses as the equity reversal hammered the automated trend-following strategies.
The degree to which quant funds can exacerbate sell-offs has been hotly contested, with some managers arguing they are too small to spur such an impact. JPMorgan Chase & Co, however, suggests last month might be an exception, citing their torrid performance of late.
“In all, we find that AI funds, similar to CTAs, likely played a big role in February’s correction by being forced to de-risk given an unprecedented 7.3 per cent loss over the past month,” strategists at the bank, headed by Nikolaos Panigirtzoglou, wrote in a Friday note. Adoption rates have also increased, making AI strategies more crowded, they said.
Strategies tooled for one-direction markets may have doomed managers, according to Quest Partners’ Nigol Koulajian. Practitioners likely turned complacent after optimising models to a calm bull market, creating strategies ill-suited to market shifts, the $1.4 billion quant fund’s chief investment officer said in a recent interview with Bloomberg News.
Still, the Eurekahedge index — which tracks about 15 funds — is only a partial representation of the industry. Since artificial intelligence and machine learning are somewhat broad categories, the funds may employ vastly different techniques. Some draw from traditional statistics but can analyse more complex data sets, while others, like deep learning, parse data through multiple layers of analysis akin to the workings of the human brain, the theory goes.
