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Rising volatility: Ufuk Boydak: "That was a warning shot to investors"

At least $ 3 billion was lost to losing bets in February 2018, according to Ufuk Boydak, Loys chairman and fund manager. This is the money that is missing mainly from the professional investors. But that's just the tip of the iceberg.

Passive investments determine trading activity

Despite recent massive losses, even larger sums of these bets are dormant in the deposits of institutional investors. However, most private investors have other concerns. Given the rise in US interest rates and recent political developments, it is also necessary to be prepared for stronger price fluctuations in other asset classes.

Meanwhile, passive investments are still on the rise. In the US, an almost symmetrical picture can be seen: the cash outflows in the active products form the net inflows on the passive side. This significantly changes the structure of the market.

For example, if you look at the trading volume, 7 of the top 10 securities are already passive instruments today. What does this mean for the market? Only passive ETF trading now accounts for around 30 to 35 percent of total US trade.

These products are simple: they buy when money goes in and out, when money runs out, so they trade pro-cyclically. As a result, they are significantly strengthening the prevailing market trends.

Chain reactions by relative strength

The passive ETF trade is joined by other computer-aided investment strategies, such as quantitative or momentum-driven strategies, all of which seek to take advantage of mutual inefficiencies.

Nearly all daily trading is based on relative strength. That is, when the market rises and we get positive news, the money flows into the market and it is bought vigorously. This reinforces trends.

Unfortunately, this effect is of course also in the other direction. We were allowed to observe exactly this scenario in the February correction of this year. Nearly three times in a day, the CBOE Volatility Index, which measures volatility in the US market, rose on February 5, 2018.

Not only did it lose at least $ 3 billion in betting against price swings that day. Approximately $ 250 billion of equivalent in US equities also disappeared overnight from the investor deposits. The Dow Jones lost 1.600 points in a matter of minutes without price-sensitive news, closing the day at just over 4 percent loss.

No chance for price recovery

This time it met the former owners of short-volatility certificates. Due to special contractual clauses, one of the major providers of short-vola securities ended the issue of the shares on the day after the fall of the stock price and later paid the remaining amount to the remaining holders of the certificates. Good for the bank, because that was one of her many obligations.

Certificates are known to be promissory notes, which may be repaid prematurely under certain conditions. But those who invested in this as investors experienced the near-complete loss of invested capital - but without the chance of a price recovery, as is the case with investing in sound stocks.

Warning shot for other investment markets

We do not see a turnaround in the stock market sell-off, but you could see it as a warning shot to investors not to worry too much. This bang has also been heard in other investment markets.

Particularly in the case of bonds, the signs of a change in the general weather conditions have been observed for months. The rise in yields to almost 3 percent in US Treasuries has been fueled above all by rising inflation concerns. For Europe, although lower levels apply, but also in this country, long-term bonds have responded to an alleged increase in inflation. An increase in volatility can therefore continue in other asset classes.

High rating level in the short term

In the short term, it is clear that the fall on the stock market has increased significantly due to rising valuations. If, for example, the Schiller price index is used as a basis for assessment, it can be seen that average valuations have almost doubled in recent years.

This development is in step with the development of interest rates until the zero interest rate environment. If, in the future, interest rates rise again, these valuation levels can no longer be maintained on the stock market. If interest rates rise, stock prices must fall. For the informed investor, this is where great opportunities arise.

Durable values

Even though the financial markets have become a hub for very different capital flows and the general weather conditions have clouded over somewhat, share prices in the long term reflect the value of the underlying economic activity.

As a result of the economic cycles, a number of companies succeed in adapting their business model to economic change and generating sustainable added value. It should be remembered that any share price can fluctuate widely, regardless of how well its business model works, and use these fluctuations for counter-cyclical investment.

The described change in the market structure in recent years increases the inefficiency of the markets and offers great opportunities. With the necessary risk tolerance to market fluctuations and clarity over the long-term prospects of the companies, it is easy to decide which companies would like to be involved in the long-term success, in order to gain courage in course corrections.

At Loys, we look forward to a well-stocked stock picking strategy that will prepare us well for the coming more volatile market, as value-based, active stock selection will be very important in the market phase ahead.