When we put together the mandate for our Emerging Opportunities Fund, our decisions were guided by one fundamental line of reasoning: that the functioning of markets as they are now bears little to no resemblance to what we were taught they would be like.
We were taught early on in our careers that markets worked as a mechanism for price discovery, with the fundamental idea of “value” at its base. Mechanically, the principle was that if something was priced at anything other than its intrinsic value, traders in the market could make a profit by buying or selling the mispriced asset until its “correct” value emerged.
For most of our professional lives, therefore, our aim was simple: to get ahead of the curve and be positioned where we thought the rest of the world would eventually follow. Own the companies that had the relevant drivers to push their stock prices up before everyone else did, and sell stock to the buyers when they came along; likewise, be short companies that we believed would fall in value, buying in the short when the rest of the market came around to our view and wanted to sell out of their holdings at a much lower price.
The same applied to every other investment manager out there. As a result, allocators and investors created categories and sub-classes, “buckets” into which managers could be classified: “Emerging Markets”, “Tech”, “Thematic”, “Healthcare”, “5G”, “Value”, “Growth”, “Risk Parity”, “Market Neutral” etc. The list goes on. It was convenient, and it made sense: no one could be everything, it would be too much of a hassle and more critically, it would cause massive cognitive dissonance – after all, if one believed in “value” (i.e. buy undervalued companies and avoid overvalued companies), one would necessarily be ideologically opposed to “growth”, a style which effectively buys companies a premium valuation in expectation that earnings growth eventually “catches up”.
Everyone belongs to a bucket. Except us.
In this note, we explain why.
Don’t assume everyone is seeking value.
The embedded assumption of most market participants is that there is an army of market participants, human or otherwise, out there seeking out opportunities to make that coveted profit by arbitraging away pricing discrepancies. These decisions imply some degree of volition: the participant wants to make the trade only if a profit may be made. These trades are voluntary – no one’s forcing you to make any trade, although there may (hopefully) be a compelling reason to do so.
As we’ve written extensively before, these days not everyone is out there looking for value. Passive funds, for example, have absolutely zero consideration for value. They are built to track the index. Their trading decision is “inflows = buy the basket; outflows = sell the basket”. To a large extent, these are involuntary trades – there is not a shred of discretion in them. While the allocation to passive is a voluntary choice, once allocated, the individual market trades are completely involuntary.
This led us down the path of trying to work out how much more of the market is involuntary. And we very quickly stumbled upon another recent phenomenon: options.
Specifically, the hedging of those options. Now of course option hedging from dealers is not a new phenomenon. But the size of it is. In recent years, the explosion of accessibility to markets via retail brokerage offerings like Robinhood has been a boon for traditional market makers: retail flow is not only high margin, it is also high volume in aggregate, making it a highly lucrative business. Most of this retail flow never makes it to the actual trading floor and is crossed up internally within brokers’ systems against other retail flow. But access has grown not only to traditional stocks, but also to sophisticated derivatives including the ability to buy and sell options on both single stocks and market indices.
How big is this market? According to GS research, just under US$200bn of notional is traded per day in small options trades (i.e. retail).
More importantly, just like Passive investing is no longer “passive”, given its flow dictates how the underlying market behaves, the “derivatives” market (including options) is now so big that it is no longer a “derivative” of their underlying. Rather, the underlying is now the derivative of the derivatives market. Consider that for a second.
Two tails wagging one dog
If the irony isn’t already obvious, let us state it clearly here: most investors in equities think that they’re investing in the “underlying”, and that derivatives and passive trackers are cryptic complications that detract from the “fundamentals”. We think that view became increasingly incorrect as the past decade wore on.
This dog is being wagged not just by the tail of passive investing; it is also being wagged by its other tail of derivative hedging – with both tails substantially bigger than the proverbial dog itself. If a ridiculous image is forming in your head, you’re probably on the right track.
The hedging of options flow in the market is big business, but just like passive instruments, hedging trades placed by options dealers are involuntary. Without going through the mechanism of delta and gamma hedging, not to mention the rest of the greeks, the short story here is that meteoric growth in options volume (largely long) from retail investors is leading to dealer hedging behaviour that exaggerates moves in the underlying: if the market is moving up, hedging activity makes it move up more; if the market is moving down, hedging activity makes it move down more.
Of course, there is also the reverse effect if clients are net short options (i.e. selling optionality), in which case dealer hedging activity acts as a dampener to market moves, attenuating the volatility from an initial trigger. This had been the case since 2010-11, when investment banks sniffed an opportunity to sell mutual funds the idea of writing calls in exchange for a premium, to help bulk up the yields on their funds which were getting increasingly compressed by QE. No surprise then that we enjoyed almost an entire decade of falling volatility that everyone all the way to the retail investor was selling volatility for yield. That trade came to an abrupt end in 2018 with “volmageddon”, with investors realising that shorting volatility wasn’t that great an idea after all.
They’ve now gone full circle.
Combine the effects of these two massive tails wagging a relatively small dog of underlying assets and one can start to see how nonsensical (and tricky) such a set up becomes. Not only does the underlying direction of market moves no longer depend on active, value-based fundamentals (driven by passive’s inflows = buy, outflows = sell mechanics), the magnitude of the moves manifesting in the market also varies as a result of the relative positioning of the options market.
“How”, rather than “What”
We’ve named our fund the Emerging Opportunities Fund. But as it is with naming children, a child grows into its name and the name becomes synonymous with the child’s nature and personality, rather than the other way round. What a child grows up to be – and what his/her name stands for – is a function of how the child is brought up.
Likewise, we focus on our process; our “How”. Our fund is built around a process that acknowledges that the state of play in the market is constantly in flux: the big play, the small play, the charts and the stop losses. Our stop losses are key, because they tell us when our theses – whatever they may be – are going wrong, allowing us to take risk off the table, avoid cataclysmic loss and re-evaluate why the market has moved against us. In other words, they keep us in the game.
This is not to say that we trade like maniacs and throw all fundamental work out of the window. On the contrary, we take a view that fundamentals alone are inadequate: decisions on risk allocation must be made on many more factors than simply company fundamentals. Hence our process, as well as the stop losses that signal to us that we could be wrong for reasons we haven’t even managed to articulate – the unknown unknowns, the error term.
And when it comes to fundamental ideas, as a team that looks forward to the future, our interests lead us to the world of Emerging Opportunities. These are the ideas that excite us and make for good evening conversations and have structural tailwinds (or headwinds) that help our investment cases, but at the end of the day they are subordinate to the process: we are here to make money for our investors, it’s that simple.
We don’t manage a growth, value or momentum strategy; nor an EM vs DM one; nor a thematic vs sector-focused one; nor risk-parity vs market neutral vs trading focused. These labels involve invoking some degree of certainty about how the world is to pan out – a luxury one can scarcely afford these days. It involves assuming that things stay a certain way for the foreseeable future so that a specific approach to investing, whether buy the dip, buy the high, long/short pairs etc, can play out for long enough to generate the expected returns. The bottom line is markets hate (read “are short”) uncertainty.
At the same time, we understand that our investors need something to classify us by. Here’s our suggestion (credit to Chris Cole at Artemis Capital Management, who articulated in this podcast what we’ve struggled to articulate for months):
We are long uncertainty.
We are and will be anything and everything that’s needed to make returns for our investors in an environment that is far from constant.
And that’s where our view differs from the crowd. We think that uncertainty is not only unavoidable, it’s growing, exacerbated by the changing mechanics and structure of markets. As a secondary consequence, the traditional rules for identifying mispricing don’t seem to apply as much either. Our immediate answer when asked to look into our crystal ball and predict the future (or give a stock tip) is “we don’t have a crystal ball”.
Consequently, our focus isn’t on “what” we take exposures in – it’s not about our top ten ideas long or short, nor our view on where the markets will go over a certain future time period. Rather, we focus on the “how”: how we execute trades, how we map out the possible outcomes in the market and how we respond to whatever transpires. Hence, we spend our time exploring the potential paths that markets and narratives can take and prepare for as many eventualities as possible – but we let the market, wagged by at least two wild tails (there could be more!), be our guide.
The fund is the process, and we’ve built our process to thrive under uncertainty. Rather than trying to avoid it, we embrace it and optimise for it.
That’s our bucket.