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In this Wednesday, Oct. 8, 2014, file photo, a street sign for Wall Street hangs near the New York Stock Exchange. (Mark Lennihan/AP)
In this Wednesday, Oct. 8, 2014, file photo, a street sign for Wall Street hangs near the New York Stock Exchange. (Mark Lennihan/AP)

Quant wars seen whipping up stock volatility as U.S. election nears Add to ...

There’s a battle going on, and it’s not for the White House. Computer is fighting computer in a hedge fund tilt that could get messy regardless of the winner.

The combatants are professional money managers who throw around billions of dollars each day, taking cues from mathematical models. In one corner are trend-following futures funds known as commodity trading advisers, who use changes in asset prices and volatility as buy and sell signals. They just pushed short sales against U.S. equities to a level that exceeds any time during the bull market other than August 2015.

In the other are speculators in the category known as long-short equities, stock pickers who try to minimize the impact of market moves or add leverage by pairing trades. According to an analysis by Credit Suisse Group AG, their stock bets are bullish, and last week stood at the most in nine months.

It’s the polarization that bothers analysts, who say this kind of positioning has set the table for marketwide volatility in the past and is worrisome when an event like Tuesday’s vote looms. While neither group has built up its holdings with politics strictly in mind, either could be triggered should markets swing as Election Day nears.

“No matter what happens, there’s going to be volatility, because someone is wrong,” said Mark Connors, Credit Suisse’s global head of risk advisory in New York. “Even though we won’t have rate resolution, we will have the look of Congress and there will be some position changes given the positioning is very disparate -- very long and very short. That’s unstable.”

As the quant population exploded, analysts have spent more time trying to pin down how they will react to volatility and other inputs. And with good reason, as long-short funds are sitting on $215-billion in assets, while CTAs oversee some $330-billion, according to BarclayHedge, a database that tracks hedge fund performance.

For its part, Credit Suisse bases its estimates on data from its prime brokerage account, which offers trading and other cash management services to hedge funds.

To Mr. Connors, the situation in markets now is reminiscent of the periods before the two most recent corrections, when funds took similar opposing bets. Trend-following commodity trading advisers and equity long/short funds are currently 47 percentage points apart in their U.S. equity exposure, the largest spread since just after the S&P 500 Index bottomed in February.

Before that, the last time the spread grew to more than 40 percentage points was in August and September of 2015, the worst two-month stretch for the S&P 500 since 2011.

CTAs don’t use stock-by-stock fundamental analysis or political inputs for their models. Instead, the bearishness is being spurred by an event occurring after the election: the Federal Reserve’s December meeting, when rates may rise, Connors said. On the other side, equity long-short managers have been buying neglected companies like banks in anticipation of higher rates, he said.

While traders are pricing in a 78-per-cent chance of a rate hike in December, the election threatens to act as a catalyst before the Fed meeting arrives. While the market has been pricing in a Hillary Clinton victory, if Donald Trump wins or the Democrats sweep Congress, the result may be selling, according to Citigroup Inc.’s Tobias Levkovich.

“The markets aren’t not happy with either a sweep, with Democrats it’s a worry about taxes and stuff like that, or if Trump wins because of the uncertainty factor,” Mr. Levkovich said on a Wednesday interview on Bloomberg TV.

It’s been a difficult stretch for managers in both groups, which may leave them impatient if markets turn. Equity long-short managers returned 0.6 percent this year through October, according to data from BarclayHedge. The SG CTA Index fell 2.1 per cent over the same period, while the S&P 500 gained 4 per cent.

Because they fell behind the benchmark, equity long-short funds have been forced to buy more stocks as U.S. earnings surpass analyst estimates, said James Abate, chief investment officer at Centre Funds in New York. Meanwhile, increased correlations between asset classes have also driven CTAs to ditch stocks, he said.

“The problem with macro-CTAs is they tend not to be anticipatory of anything, they tend to be trend followers,” Mr. Abate said “People are going to react to the election, not position themselves prior to the election.”

Options traders have already begun gearing up for volatility. A spread tracking demand for protective hedges -- implied versus realized volatility on the S&P 500 -- just reached the widest since right before the British vote to leave the European Union, data from Bloomberg show.

“Faced with a binary event like the elections, investors simply cannot go into it unhedged, especially with the memory of Brexit still fresh,” wrote Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors in New York, in a note to clients Wednesday. “The bid to near-term volatility is being driven by hedging ahead of the elections, especially as the polls tighten.”

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