Concerns about Russia’s escalating tensions with Ukraine, the Federal Reserve’s plans to raise interest rates, and how aggressively the central bank will fight inflation, are among the top risks driving stock market volatility in 2022.
While Russia’s invasion of Ukraine has caused turmoil in global markets and pushed geopolitical risk into the foreground, some of the newer risk trends that hedge funds and asset managers are monitoring include data misinformation and crowdsourced volatility, according to a virtual panel, “Data Minds: The Risk Outlook for 2022,” sponsored by data provider Wall Street Horizon.
Experts looked at the shifting landscape for risk trends that institutional investors are facing and how they can bring in new alternative data feeds alongside traditional risk models to make more informed decisions.
According to a live poll during the webcast, close to a third (32%) of the attendees picked geopolitical risk as their number one risk concern, while 7% chose macroeconomic risk, 18% picked misinformation and data risk, 9% of attendees selected environmental, social, governance (ESG) issues and greenwashing as a risk, while 5% selected regulatory risk, and another 5% selected “other.”
Panelists also cited the boom in cryptocurrencies and digital asset trading where there is uncertainty around federal regulations. Another risk factor that is being considered in the investment process is diversity risk and the reality of inequality, noted a panelist with a data marketplace.
“One of the major concerns is how do we deal with these new risks that frankly we haven’t seen before,” said Melissa Brown, managing director of applied research at Qontigo.
Even a traditional risk such as inflation hasn’t been seen at such high levels in 40 years, said Brown. When the Labor Department reported that consumer prices surged 7.5% in January on a year-over-year basis, it caused stocks to end the day sharply lower, reported Reuters on Feb. 10. “Many of the participants in markets today haven’t seen inflation,” said Brown, who said she gets questions about how to navigate inflation, how long will it last, and how to hedge inflation.
Lessons from GameStop
As a result of the meme-stock trading frenzy hitting its peak last January, a key risk on the radar screen is crowdsourced volatility, said one speaker. “At the beginning of last year, a mistake was not necessarily thinking outside-the-box in terms of where the traditional volatility vectors were coming from and what could be the new ones,” said Jon Trowbridge, Senior Director of Risk Management at online brokerage firm TradeStation Group.
Retail investors that used sites like Reddit Wall Street Bets.com were able to band together and drive up the price of video game retailer GameStop and other companies like AMC Entertainment Corporation, against short sellers. This caused major losses for some hedge funds such as Melvin Capital Management in January 2021, which is still recovering, reported The Wall Street Journal.
Among the lessons learned from the Reddit meme-stock case are that brokers need to monitor for crowdsourced volatility. “It’s very difficult to this day to preemptively detect where the sources of that volatility are coming from, and this is especially true in the cryptocurrency space,” added Trowbridge.
“With the efficiency of frictionless communications, a very small group of people can connect with a huge number of people and that creates a new type of volatility event,” he explained.
While the frenzied trading from a year ago has subsided, professionals are keeping an eye on meme stocks. “What risk teams need to decide is whether to play in these names at all,” said Chris Petrescu, Founder of CP Capital, a data consultancy that advises hedge funds and previously worked for Exodus Point and World Quant. Petrescu has some clients that want to be active in the top 10 stocks talked about on Reddit, while others want to avoid it and have taken the position to zero.
To stay on top of retail investing and crowdsourced activity, hedge funds and asset managers are analyzing new data sets on Reddit and Twitter and incorporating them into their risk models.
Between news and social media and other data, firms are gaining a view into the retail market. Some firms have built an algorithm where every time someone buys an odd lot, defined as less than 100 shares, it is flagged as a retail trade. “That type of data is here to stay,” predicts Petrescu, adding that it will ebb and flow.
Though investment professionals once derided small-time day traders as “dumb money,” that is no longer the case. Fund managers “are scouring social media posts for clues as to where the herd might veer next,” according to the Wall Street Journal. Based on a survey by Bloomberg Intelligence, about 85% of hedge fund and 42% of asset managers are tracking retail trading message boards, reported the WSJ in the same article.
Some data experts advise funds to get this type of data inhouse in case they need it, because if they wait to get it, it could be too late. Another risk to keep an eye on is SPACs (short for special purpose acquisition companies). Also known as “bank-check companies,” SPACs are formed to raise capital in an initial public offering (IPO) with the intent of acquiring a new company or merging with an existing business. SPACs soared in popularity, but investor sentiment changed in 2021 as evidenced by a high rate of redemptions, reported Axios last April. Institutional funds should “either have a strategy for these names or avoid them completely,” said Petrescu.
ESG Regulatory Risk
Investors are also grappling with the thorny issue of ESG standards on what constitutes an ESG investment fund, and the specter of greenwashing when funds give a false impression or misleading information on their company’s products as being eco-friendly. For example, on Feb. 10, MarketWatch reported that some broad-based passively managed ESG ETFs (exchange traded funds) have exposures to fossil-fuel companies and “sin stocks” such as gambling and tobacco firms.
Virginie O’ Shea, Founder and CEO of Firebrand Research, who moderated the virtual panel, pointed out the challenges of adhering to an ESG policy with lack of agreement from regulators on what is included in the green bucket. For example, O’Shea noted the European Commission said it’s using nuclear and gas in its green bucket, “which I don’t think every regulator is going to agree to globally,” said O’Shea. “You’re going to have to look at greenwashing aspect per jurisdiction, per regulator, per entity, so it’s very complicated from that aspect,” said O’Shea.
Regulators are working on standards to prevent greenwashing. SEC Chairman Gary Gensler asked the SEC’s staff to review whether fund managers “should disclose the criteria and underlying data” they use to brand themselves with the green or sustainable investments label, reported Bloomberg.
According to Qontigo’s Brown, one simple solution for fund managers is to start with meaningful metrics. Funds “need to have a stated objective, disclose the metrics they’re going to use, measure it and then use those measurements in their investment process,” said Brown.
To move away from greenwashing, Brown predicted that one of the trends for fund managers this year will be modeling climate risk, monitoring financial impact, and being able to stress test the impact of climate change. “Investors want to know the cost of climate change at the portfolio and individual company level,” she said.
Another precaution is to have internal oversight, such as an internal ESG audit committee or ESG governance committee. “I don’t think greenwashing is inevitable; I think there are ways to avoid it using data and using things like a governance committee to ensure that it’s being put in place,” said Brown.
ESG Data Risks
Acquiring the data that is necessary to make informed ESG investment decisions carries its own set of risks. “While portfolio managers and traders need to know about climate risk and diversity risk, the ability to normalize data feeds in a standard fashion is a challenge,” observed Jose Cortez, Vice President, OEMS Sales at FlexTrade.
Part of the risk is that a lot of data is unstructured and needs to be integrated with other data sets and risk models, he said. “Scrubbing the data and making sure that its clean and applicable to your investment process is also a big challenge,” said Cortez. In addition, there are nuances in the way that fund managers apply ESG data to structuring their investment products. Some funds use third-party or proprietary ESG scores to screen out bad actors from an index, while another might do fundamental, bottom-up research to construct an ESG fund, he said.
From a technology standpoint, the first step is to identify which risks need to be neutralized, and the second step is to bring data on risks like ESG into their risk analytics and trading infrastructure, Cortez advised.
“But when firms are seeking to mesh all that data together, they are basically trying to marry traditional factor models with climate risk models or with ESG data. It’s akin to comparing apples, oranges, and bananas,” said Cortez. “While firms want to put all this data into one place and use it altogether to make investment decisions or at least stay one step ahead, they also need to give it to front office users – analysts, portfolio managers, and traders in a meaningful fashion. That’s kind of the name of the game with all this data.”
Crypto Regulatory Uncertainty
Another corner of the market to watch is the $2 trillion market for cryptocurrencies, including bitcoin, known for its volatile price swings, and joke currencies like dogecoin, which was up more than 1,400% in January 2021, buoyed by meme-traders. Retail investors have also piled into the new marketplaces for nonfungible tokens or NFTs.
Citing ambiguous federal guidance on cryptocurrencies, TradeStation’s Trowbridge said that the U.S. government has pushed all the regulation through inaction to the states, so brokers must follow the state cryptocurrency regulations based on where their customers live.
In February, Rustin Behnam, Chairman of the Commodity Futures Trading Commission, testified before lawmakers to ask for the agency to be given authority to regulate cryptocurrencies such as bitcoin, arguing that it’s full of individual investors, reported the WSJ. Neither the CFTC nor the SEC has “undisputed oversight” over the two largest cryptocurrencies, bitcoin, and ether, which account for 60% of the market.
This has made it difficult for brokers to deal with a “hodgepodge of rules” in the U.S.; furthermore, regulatory guidance across the world is constantly,” evolving, said Trowbridge. For example, Estonia was one of the most crypto-friendly nations, but recently flipped from one spectrum to another, becoming more draconian in its regulatory guidance, he said. In February, Estonia planned to enact a sweeping set of changes to its definition of virtual asset providers (VAPs), a move that could affect bitcoin owners in the country, reported CoinTelegraph.
As a result, brokers like TradeStation, which serves customers throughout the U.S. and from across the world, need to manage the risk of not knowing where things stand in the crypto-asset regime. Though brokers have a grasp on “know-your- customer” (KYC) rules in traditional markets such as equities, they are casting a wide net on collecting KYC data for crypto since the regulations can change fast, said Trowbridge.
Looking ahead, it remains to be seen if other risk factors will emerge in 2022. Panelists urged traders and asset managers to think outside the norm.
“While brokers still have the status quo mindset of looking at equity-based indicators, or indicators for interest rates and currencies, which is very important to do, we missed this entire sector,” said TradeStation’s Trowbridge, referring to crowdsourced volatility.
Escalating tensions in Ukraine and the prospect of higher interest are expected to stir up more volatility in 2022, suggesting that asset managers and hedge funds should prepare for a bumpy ride.
“In terms of risk management, it’s filling out these blind spots and there will be more blind spots this year,” said Petrescu.