Kolanovic

Table of Contents
Rpt. 66750667 MARKET AND VOLATILITY COMMENTARY : V-SHAPED RECOVERY, LOW POSI 2-7
14-Feb-2019 JPMORGAN
- KOLANOVIC, MARKO, ET AL
Rpt. 66543024 MARKET AND VOLATILITY COMMENTARY : NARRATIVE VS. FLOWS, LIQUID 8 - 17
16-Jan-2019 JPMORGAN
Rpt. 66454994 MARKET AND VOLATILITY COMMENTARY : DECEMBER POST-MORTEM, SIGNA 18 - 25

03-Jan-2019 JPMORGAN
These reports were compiled using a product of Thomson Reuters www.thomsonreuters.com
1
Global Quantitative &
Derivatives Strategy
14 February 2019
Market and Volatility

Commentary
V-Shaped Recovery, Low Positioning = More Upside,
Commodity Sector Trades
The V-shaped recovery and Positioning Global Quantitative and

In early January we explained the flows behind the Q4 market collapse, AC
Marko Kolanovic, PhD
arguing that market should recover its losses (here, here). After an initial
(1-212) 272-1438
short covering rally, we argued that the market will continue drifting marko.kolanovic@jpmorgan.com
upwards due to structural inflows related to declining volatility (here). The Bram Kaplan, CFA
December-January V-shaped move was one of the most prominent in a (1-212) 272-1215
century, and occurred despite no improvements in the fundamental bram.kaplan@jpmorgan.com
outlook. Following the January rally, our S&P 500 price target (3000) is J.P. Morgan Securities LLC
no longer considered outlandish by most. Calls from various strategists for

a 1929-style recession, rolling bear market, or imminent retest of lows are
now getting quieter.
How does the equity positioning look now? With declining volatility and
rising prices, Hedge Funds increased their gross exposure, but they did not
significantly increase net exposure. For instance, our prime brokerage data
show net equity exposure in only the 6th percentile, and the equity beta of a
broad global HF index is in the ~15th percentile. Multi-asset risk
controlled portfolios still have very low exposure to stocks. Modelling the
risk control market based on our survey of quantitative clients’ volatility
targeting practices implies that the equity exposure and overall leverage of
this market is still very low (~10th percentile, risk controlled assets include
insurance products, various multi manager platforms, dealer structured
products, etc.). Another group of managers invest based on price trends.
Interestingly, these investors are still short equities, despite the recent rally.
With various trend signals turning positive (e.g. 3M and 12M for S&P 500,
and 1M for various international indices) one would expect these investors
to start adding equity longs. Note that trend following investors are
currently long bonds, and the low equity position of volatility targeting
investors also implies high bond allocations. This can help explain the
current low bond yields despite an impressive equity rally. After record
mutual fund outflows in December, the data doesn’t show any meaningful
inflows in January. Given the market rally, dealers’ gamma positioning is
neutral or long – this is favoring low and declining volatility, and further
re-levering of various investors. In summary, important groups of
systematic and fundamental investors did not re-risk and missed a
significant portion of the rally. This includes volatility sensitive managers,
trend followers, and to a large extent hedge funds and retail. If volatility
stays contained (and this is favored by gamma positioning), re-risking
should continue.
See page 3 for analyst certification and important disclosures.

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2
Marko Kolanovic, PhD Global Quantitative & Derivatives Strategy
(1-212) 272-1438 14 February 2019
marko.kolanovic@jpmorgan.com
In terms of flows, liquidity and volatility, there is a parallel between the

Feb-April 2018 and Oct-Dec 2018 selloffs. Following Feb-April, we
entered a re-risking period in May-October 2018 (we forecasted that re-
leveraging in our ‘buy in May’ note, see here). Absent a negative outcome
from the ongoing trade negotiations with China, we could have a similar
re-leveraging period stretching from January to May this year. This should
work as a positive feedback loop between options gamma that is
suppressing volatility, systematic inflows (on account of trend and low
volatility managers), and fundamental inflows (HFs/retail). What are the
risks? In addition to various tail risks, by far the largest risk would be a
failure in trade negotiations with China. A decline in the President’s
approval rating (e.g. see here) on the back of the government shutdown and
Q4 market selloff, may result in some market stability near term and may
improve the likelihood of a positive outcome from trade negotiations. If the
rally continues, investors would need to monitor the pace of re-leveraging
and start hedging once the leverage of various investor cohorts becomes
high. For instance, we are now in the ~10-20th percentile, and one could
run long until exposure reaches the ~70-80th percentile, when the risk of
another market seizure increases. This re-levering cycle could last between
now and e.g. May (in which case, we could go back to the normal ‘sell in
May’ seasonal schedule this year).
Commodity Sector Trades

Clients that missed the nearly 20% market recovery since the December
bottom are asking which market segments present the best opportunity for
a ‘catch up’ trade. We believe one such market segment is Energy and
Materials (e.g. see this note and our year ahead sector ratings). While a
catalyst for the commodity decline in Q4 was the growth slowdown, moves
were exaggerated by geopolitical developments (e.g. Trump ‘phone calls’)
as well as speculative and systematic investor flows such as trend followers
(and to a lesser extent risk parity portfolios). A positive outcome from
China negotiations could prompt these investors to reverse positions and
lead to a sharp reversal of Q4 losses. For instance, looking at the history of
CFTC data for managed money (and/or non-commercial) positions in Oil,
we note a decline in positions that is unprecedented in history (~400K
contracts last year, and ~250K in Q4). Just the passage of time would cause
1-3M Oil momentum to turn positive in the near future, and likely lead to
closing of some trend following shorts. Additionally, a decline in volatility
and correlations would result in increased GSCI allocation by e.g. risk
parity funds. If even half of the decline in speculative open interest is
reversed, it would likely result in ~$10 upside for Oil, prompting trend
investors to go long. A similar setup has developed in other commodities
such as industrial metals, and this could present an opportunity to capture
potential progress on China trade negotiations.
3
(1-212) 272-1438 14 February 2019
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Completed 14 Feb 2019 12:10 PM EST Disseminated 14 Feb 2019 12:10 PM EST
7
16 January 2019

Commentary
Narrative vs. Flows, Liquidity-Volatility-Flows
Feedback Loop, QE/QT and Liquidity
Narrative vs. Flows Global Quantitative and

Since our last note, the market continued moving higher from heavily oversold AC
levels and low investor positioning. Positioning has somewhat increased but still Marko Kolanovic, PhD
remains subdued (all HF beta: ~9th %ile, Volatility Targeting Beta: ~1st %ile, (1-212) 272-1438
CTA beta ~15th %ile, Equity HF beta ~8th %ile, JPM PB HF net exposure ~7th
%ile, gross exposure ~10th %ile). S&P 500 options gamma imbalance subsided Bram Kaplan, CFA
(1-212) 272-1215
from an average ~$50bn towards puts (dealers short gamma) in December to
bram.kaplan@jpmorgan.com
slightly long gamma now. This creates a necessary condition for market volatility J.P. Morgan Securities LLC
to decline and continue driving equity inflows from volatility-sensitive strategies.
These strategies are currently adding ~$1bn per day (e.g., volatility targeted
insurance portfolios), which will accelerate if volatility stays subdued. While fixed
weight portfolios (e.g., pensions) increased risk the last week of December, they
may reduce risk the last week of January. Trend investors could close some
shorts/add longs if the market moves a bit higher to reclaim short-term signals
(e.g., 50d MA, 1M return). Two key risks that we highlighted in the past (Fed’s
monetary policy and trade war) have subsided, but new risks have emerged: US
government shutdown and signs of additional slowdown outside the US. Risks
around the upcoming earnings season are balanced, in our view. On one hand, we
could see further downside for Q1 guidance, but on the other hand already reduced
expectations and low positioning can result in upside moves. Low positioning
could manifest itself as stocks moving higher on underwhelming results (e.g.,
stocks open lower and drift higher).
Bearish sentiment and narrative are currently consensus among investors, and
positioning is very low. Investors should keep in mind that the narrative is often
driven by price action, and price action is driven by flows and positioning. For
instance, during the May-October period last year, there were strong inflows on
account of declining volatility in the aftermath of the Feb-April turmoil. These
flows pushed the market higher, despite negative seasonality, the fact that the trade
war was escalating, and that there were expectations for a continuation of the
quarterly rate hikes at the time. Once deleveraging started in Q4, stocks were
moving lower regardless of the narrative (e.g., many stocks sold off on decent Q3
earnings and the market sold off after the G20 and Powell pivot). At the very end
of the year, stocks first crashed and then strongly rallied on virtually no news but
large flows (mutual fund selling, pension fund buying). One should keep in mind
that if volatility stays low, inflows may result in the market drifting higher, which
could in turn change investor sentiment and the whole market narrative.

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(1-212) 272-1438 16 January 2019
Liquidity-Volatility-Flows Feedback Loop

In our previous note we described in broad terms the feedback loop between
volatility, liquidity, and flows. We call this feedback loop market fragility. Several
clients asked us to explain in more detail these effects (e.g., how, how much?).
Interest for this topic comes from various clients – those that are assessing the impact
of flows to the broad market and their portfolios (fund managers), those that position
for and anticipate these flows (speculators), and those that are assessing the
robustness of different systematic investments (investors). As we mentioned in our
last note, systematic flows come from different parts of the financial industry (market
making, buy side, insurance), and can result in different flow patterns.
First we want to demonstrate the link between Volatility and Liquidity, and show
how market depth – the key measure of liquidity – got worse over time. Figure 1
shows the relationship between S&P 500 futures market depth and the VIX. One can
notice that this relationship is very strong and nonlinear (e.g., market depth declines
exponentially with the VIX). Given that an increase in volatility often results in
systematic selling, this relationship is the key to understand market fragility and tail
events. The second question was if this relationship was always the same or the
situation got worse over time. To answer this we show the historical relationship
between liquidity and the VIX over time (Figure 2, rolling regression slope between
liquidity and the VIX). One can see that the negative relationship between liquidity
and the VIX got worse over the past decade (note that an exponential relationship can
be locally approximated with a linear relationship and tracked over time). Finally, we
note that at times of high volatility, the VIX is almost the sole driver of market
liquidity. Figure 3 shows the % of liquidity variation that can be explained with the
VIX over time (rolling R-squared). The higher the VIX, the more liquidity is driven
by the VIX, and recently up to ~80% of liquidity variations were explained by the
VIX. To conclude, we showed that there is a negative relationship between volatility
and liquidity, that this relationship is getting stronger over time, and that it is
particularly strong during times of elevated volatility.
Figure 1: S&P 500 E-mini futures depth shows a strong (exponential) Figure 2: The regression slope between liquidity and the VIX got
relationship to the VIX larger over time
8000 1000 0
7000 S&P 500 Futures Depth vs VIX

0 -500
6000 2009 2011 2013 2014 2016 2018
-1000
5000 -1000
-2000
4000
-1500
3000 -3000
-2000
2000 -4000
1000 Liquidity - Slope to Implied Vol (VIX) -2500
-5000
Liquidity - Slope to Realized Vol (1M)
0
5 10 15 20 25 30 35 -6000 -3000
Source: J.P. Morgan QDS. Source: J.P. Morgan QDS.
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Figure 3: The VIX explains a larger proportion of liquidity when the Figure 4: Comparative size of ‘short gamma’ strategies*
VIX is high
100%
% of Liquidity explained by VIX 24 800 S&P 500 Put Option Delta
CTA AUM
80% 22
600 Volatility Targeting AUM
VIX (1M Avg.) 20
60%
18 400
40% 16
200
14
20%
12 0
0% 10 1997 2001 2005 2009 2013 2017
2015 2016 2016 2017 2018 Source: J.P. Morgan QDS, BarclayHedge. *Volatility Targeting AUM time series is purely
Source: J.P. Morgan QDS. illustrative/very approximate
We will next show that volatility also plays a significant role in determining the
flows from various systematic strategies (note that we define systematic flows to
include derivatives hedging flows, passive and quantitative investment strategies
flows, insurance industry and programmatic market making flows). An increase in
volatility typically leads to an increase in systematic selling, which happens in an
environment of reduced liquidity, and hence can produce outsized market impact. As
mentioned above, we refer to this feedback loop between volatility, liquidity and
flows as market fragility. We do note that during times of high volatility/low
liquidity, not only systematic strategies but also discretionary managers sell, albeit
typically they tend to sell slower and/or later during the sell-off episodes (see further
below).
Let’s look at the various examples of systematic flows, their impact on the market
and their own performance, and speculative activity related to these flows. The
largest of all systematic flows by size and impact is that of index options hedging.
Figure 4 shows the delta weighted open interest of S&P 500 index puts, in
comparison with an asset estimate of two other ‘short gamma’ strategies –
CTAs/Trend-Following and Volatility Targeting strategies. One can see that the
largest component of systematic flows comes from option hedging, but given the
increase of trend-following and volatility targeting these components cannot be
ignored.
We have extensively documented the impact of index option hedging flows in our
previous research (see here, here). We also closely follow the speculative activity
around these flows. At the onset of volatility, these flows can significantly impact the
market near the close. It takes a few days before speculators establish the positioning
and hedging patterns and start anticipating these flows (see here).
Another systematic strategy with predictable flows is levered and inverse exchange
traded products – similar to index options hedging, these products are short gamma
(note that levered/inverse ETF gamma is typically much smaller than index option
gamma). Given that levered and inverse ETFs are short gamma, their rebalancing
results in systematic flows that can be anticipated by speculators, which negatively
affects the performance of these products (see here and here). A recent example is
the demise of the inverse volatility product XIV. When volatility increased in
February, the size of rebalance could not be digested by the market. Liquidity
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(1-212) 272-1438 16 January 2019
providers, with knowledge of large rebalance flows, were not eager to step in until
the product self-destructed. Figure 5 shows rebalance flow as % of average daily
VIX volume as well as the level of the VIX at which product ‘self-destructed.’ As
soon as the VIX “tagged” this level, volatility quickly subsided.
Figure 5: Rebalance flow for inverse VIX ETPs, as a % of 3M ADV, Figure 6: Difference between the beta of long-short HFs and CTAs to
into the Feb’18 blow-up the VIX
60% 50 30 1
Inverse VIX ETP Rebal % of ADV LS HF Beta over CTA Beta
50% 45
VIX 1M Future Level (Right) 25
40 0.5
40%
Threashold to wipe out inverse VIX
ETPs (Right) 35 20
30%
30 0
20% 15
25
10%
20
10 VIX -0.5
0% 15
-10% 10 5 -1
Jul, 17 Aug, 17 Oct, 17 Nov, 17 Jan, 18 Feb, 18 2011 2013 2014 2015 2016 2018
Source: J.P. Morgan QDS. Source: J.P. Morgan QDS, HFR.
Trend following and volatility targeting strategies are also typically short gamma.
Volatility targeting can be applied to any portfolio (e.g., 60/40, risk parity, factor
portfolio, a platform of fundamental PMs, etc.). Volatility targeting is explicitly short
gamma in a mean-reverting market. The strategy reduces risk when volatility is
rising and increases risk when volatility is falling. This is by design (risk exposure
~1/volatility), and in that way flows from these strategies are closely related to option
hedging. Note that we estimate the notional amount of these strategies at ~$300bn in
mutli-asset portfolios, which is much smaller than the delta weighted put open
interest in Q4 of ~$750bn notional just for the S&P 500 index. In addition, these
strategies sell over several days (unlike option hedges that sell within a day). CTAs’
short gamma exposure is not explicit, but still intuitive as they sell when an asset
price declines, and buy when it goes up (additionally, many CTA strategies volatility
target). Of course, not only systematic investors sell into VIX spikes. Equity long-
short hedge funds also sell into VIX spikes, but perhaps less programmatically and
aggressively. An indication for this is the sensitivity of funds’ beta to the VIX. For
instance, CTAs’ beta to the VIX is about ~4 times higher than equity long short HFs’
beta to the VIX (e.g., -3.5% vs -0.9%). Figure 6 shows the difference between the
beta of equity long-short HFs and CTAs and the VIX. When the VIX increases,
CTAs are quicker in reducing beta (selling stocks) than equity long-short hedge
funds.
The analysis above by no means passes judgment on the merits of various short
gamma systematic strategies that are often used for hedging or risk control. We do
note that these strategies require adjustments due to the changing market
environment (e.g., liquidity-flow-volatility feedback loop, speculative flows, etc.). If
systematic flows are significant enough to impact the market, they will impact their
own performance via speculative flows and market impact.
Which strategies may be impacted – some simple checks would include:

 Strategies where the asset base and flows are large relative to market
liquidity (i.e., crowding).
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(1-212) 272-1438 16 January 2019
 Strategies where the flows are correlated to volatility. The reason for this is
the volatility-liquidity-flow feedback loop, which makes the effective asset
size ‘appear larger’ than it is. Strategies that are inherently short gamma are
affected more.
 Strategies that are entirely transparent and don’t adjust along the way (e.g.,
if a strategy is documented in a prospectus or academic whitepaper, it will
more likely invite ‘copycats’ or speculative flows).
 In addition to the above, poor performance of a strategy may indicate
crowding or damage from speculative flows or short gamma exposure.
QE/QT and Liquidity

Given the recent collapse in liquidity and the feedback loop of flows-liquidity-
volatility, investors are very attentive to monetary policy measures that may affect
liquidity. The most closely watched metric is the pace of the Fed’s balance sheet
reduction. For instance, a recent example is the negative market reaction on the
comment that balance sheet reduction (QT) will be on autopilot (and positive
reaction when this statement was later modified). Even passing remarks on the
balance sheet can have visible and significantly negative intraday impacts on markets
(e.g., recent remarks that the balance sheet should be substantially smaller).
Why is there such a focus on the Fed’s balance sheet from investors? Adding
liquidity in the form of QE had a positive impact on asset classes over the past
decade. We estimated the impact of QE to be ~20% of equity prices based on
causality tests (see our report here). The questions investors struggle with are how
negative was/will be the impact of the QT. It is plausible that dollar for dollar, QT
has a significantly larger impact than QE. The reason for that may be the above-
explained fragility feedback loop. During QE, both central banks and investors more
broadly buy assets in an environment of low volatility/increased liquidity when the
impact is small, and during QT assets are typically sold while liquidity is removed,
compounding the negative impact of other outflows.
To our knowledge, there is no broadly accepted understanding of the exact

mechanics and magnitude of QT’s impact (e.g., how much it is a signal to the
market, vs. mechanical supply/demand and price impact). There is a significant
relationship between the Fed’s balance sheet changes and the market, but the big
drivers of this relationship are points when the large QE programs were announced
such as March 2009 (e.g., when this point is taken out, the relationship no longer
appears statistically significant; Figure 7 shows the weak contemporaneous
relationship since the start of 2010). Whatever the real mechanical impact is, likely
the impact on market sentiment is much larger (i.e., self-fulfilling impact). In support
of that are recent intraday movements on balance sheet mentions, as well as the price
action of the S&P 500 during Q4 shown in Figure 8. While there may be little or no
mechanical impact on equity prices, most macro traders are not ‘fighting the Fed’ –
when liquidity is added they are buying assets, and when liquidity is removed they
are selling assets. Over the past months, we have heard a large number of anecdotes
where investors avoid buying risky assets during (or actively sell into) weeks when
there is a significant balance sheet reduction (e.g., traders taping the schedule to their
screens, blogs and email chains, etc.).
In this way, balance sheet reductions put significant strain on market sentiment, on
flows and on the weakest link in the market – the liquidity-volatility-flow feedback
loop. If the balance sheet reduction is a signal to sell, volatility increases, liquidity
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(1-212) 272-1438 16 January 2019
decreases, and additional systematic flows are triggered. Balance sheet driven market
fragility is thus increasing the risk of market disruptions and ultimately the risk of a
recession – which is in contrast to policy makers’ intentions.
Figure 7: Fed weekly balance sheet change (x-axis, $Bn) vs. S&P 500 Figure 8: S&P 500 performance and Fed w/w balance sheet changes
returns (y-axis) was not statistically significant (since 2010) 2900 20000
10% 10000
8% 2800 0
6%
R² = 0.0062 -10000
4% 2700
-20000
2%
0% -30000
2600
-60 -40 -20-2% 0 20 40 60 80 100 -40000
-4% S&P 500 Balance Sheet Chg.
2500 -50000
-6%
-60000
-8%
-10% 2400 -70000
Jan'18 Mar'18 May'18 Jul'18 Sep'18 Nov'18
-12%
Source: J.P. Morgan QDS, Bloomberg.
Source: J.P. Morgan QDS, Bloomberg.
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(1-212) 272-1438 16 January 2019
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03 January 2019

Commentary
December Post-Mortem, Signals from Fund Flows,
Role of Systematic Flows and Reversion
December Post-Mortem Global Quantitative and

Over the past month, the confidence of equity investors virtually collapsed. The AC
month of December proved us wrong in the view that the market would rise into Marko Kolanovic, PhD
year-end and in 2018 overall. Our call for a year-end recovery was based on near- (1-212) 272-1438
record low equity positioning (HFs and systematic investors), near five-year low
in valuations (forward P/E and PEG), positive seasonality, and two positive Bram Kaplan, CFA
(1-212) 272-1215
catalysts (G20 and the Fed’s dovish pivot). All of this was “too little, too late”
bram.kaplan@jpmorgan.com
amid the liquidity collapse, retail investors fleeing the market, weakening J.P. Morgan Securities LLC
fundamentals, and more uncertainty coming from Washington. Continued signs of
economic slowdown reinforced investors’ fears that a recession is around the
corner, which is not our house view. In 2017, we published a report about the
potential onset of a liquidity crisis in 2018 that could evolve at the back of QT,
rising rates and volatility, systematic selling, a collapse in market liquidity, and
social and political tensions (here). We highlighted the scenario during the summer
as well, but given the solid Q3 GDP, strong corporate earnings, and record
consumer activity, we did not think a significant liquidity crisis scenario would
play out on such short notice in Q4 2018. Q4 turmoil appeared amid selling from
systematic and discretionary hedge funds, the largest fund outflows since 2008,
and an unprecedented collapse in market liquidity. Despite being wrong on the
overall market direction, we had several correct predictions in 2018: we forecasted
volatility and tail risk to rise, accurately predicted local market bottoms on Feb 9,
May 1, and October 30, argued for EM-DM convergence, and pointed to US
administration policies and the Fed as the key risks (here, here).
Following the selling from systematic investors in mid October and hedge fund
deleveraging in late October, positioning was lightened significantly. Indeed,
during November, flows stabilized and the market managed to produce a small
positive return. It seemed briefly that the G20 and Powell’s speech would be
sufficient to prod the market into a December rally. Instead, already fragile
sentiment was undermined by political uncertainty from the US administration, the
December FOMC meeting, a slowdown in economic data, and a viciously negative
news and social media cycle. These developments brought a large amount of
selling from mutual fund investors in an environment of poor liquidity. Figure 1
shows monthly fund flows (mutual funds and ETFs), which in December posted
the largest outflows since 2008. A complete disaster was averted by fixed-weight
portfolio rebalances (e.g., pension funds) that were buying a significant amount of
stocks during the last week of the year. Figure 2 shows model equity flows for
fixed-weight portfolios (% of equity assets, left axis). In these charts, one can see
that both retail outflows and pension inflows were among the largest in history
(only 2008 and 1987 saw larger flows). The impact of these flows was exacerbated
by the collapse in liquidity (dashed lines on right axis shows the equivalent % fund
flow, when adjusted for prevailing market liquidity). We believe that these flows
and the volatility they unleased were significant drivers of the poor price action in
December.

18
(1-212) 272-1438 03 January 2019
What can these flows signal for future returns?

Retail flows are generally considered to be a contrarian market indicator. More often
than not, retail investors tend to buy at times of exuberance and sell at times of panic.
Figure 1 (inset table) shows market performance after significant fund
inflows/outflows, and one can see that buying after large mutual fund outflows was
historically profitable. On the other hand, institutional fixed-weight portfolios (e.g.,
pension funds) tend to have a better track record of market timing. While fixed
weight portfolios generally underperformed risk-based allocations (e.g., risk parity)
on a Sharpe ratio basis (see here), these portfolios were historically buying at roughly
the right time. Figure 2 shows that a similar magnitude of pension buying occurred
only toward the end of 1998, 2002, 2008, and 2011—near the cyclical market
bottoms. This indicates that for unlevered investors, and those with less sensitivity to
MTM volatility, pension fund buying is likely a positive market signal. Indeed,
Figure 2 (inset table) shows that buying after pension fund inflows was historically
profitable. In summary, both mutual fund and pension flows suggest positive market
performance in the future. That said, we do recognize that the risk of a negative
feedback loop (e.g., wealth effect of declining stock market) has increased
meaningfully since December.
Figure 1: Monthly fund flows as % of AUM un-adjusted (solid line) Figure 2: Estimated fixed asset allocation pension equity rebalance
and adjusted for prevailing liquidity (dashed line) flows
1.5% 8% 40%
Mutual Fund and ETF Flows 4% Perf. After 1M 2M 3M 6M
1.0% Inflow>1% 1.6% 3.2% 3.4% 7.2%
6% Outflow>1% 0.5% 1.3% 2.2% 5.3% 30%
0.5% 2%
0.0% 0% 4% 20%
-0.5% -2% 2% 10%

-1.0%
-4%
-1.5% 0% 0%
-6%
-2.0%
Perf. After 1M 2M 3M 6M -2% -10%
-2.5% Inflow>0.25% -0.7% -1.0% -0.5% 0.2% -8%
Outflow>0.25% 0.3% 2.0% 2.7% 6.0% Pension Fund Flows
-4% -20%
-3.0% -10%
1981 1985 1990 1994 1999 2003 2008 2012 2017
2005 2006 2008 2010 2012 2013 2015 2017 2019
Source: J.P. Morgan QDS, EPFR. Source: J.P. Morgan QDS.
Role of Systematic Flows, Liquidity, and Lack of Reversion

A lot has been written and argued about the role of systematic investors in the
market. Many discussions on how important systematic flows are for the market
involve some level of misunderstanding (telephone game) between analysts, the
press, and quantitative and fundamental managers. Here we would like to summarize
our views on the role of systematic flows and liquidity.
When we analyze systematic flows, we track a number of different market segments:

the insurance industry, derivatives hedging and market making programs,
quantitative asset managers, passive indexers, liquidity provision strategies, etc.
Furthermore, quantitative asset managers (as one of several market segments) run
strategies that can be vastly different from each other. For instance, low-frequency
quant strategies come in different types: equity long-short quant (here), futures-based
and trend following (here), risk budgeting/portfolio construction (here), and big data
19
(1-212) 272-1438 03 January 2019
and machine learning (here) (our primers for each of these types is provided in the
links). In addition, there are high-frequency strategies, many of them related to
liquidity provision, short-term arbitrage of indices, co-movement of stocks, etc. For
these reasons, it would be wrong to classify all these vastly different parts of the
industry and related flows under one term such as “quants,” “algos,” “machines,”
etc., and collectively blame them for certain positive or negative market effects.
There were market crises and rapid sell-offs happening long before the proliferation
of systematic strategies, derivatives, and electronic trading. For instance, we find that
correlation between volatility and mean reversion, which is today largely driven by
option hedging, was present long time before options were invented (e.g., in the
1930s). At that time it was a result of “stop-loss” trading; the invention of options
just provided a product that enabled a more flexible stop-loss strategy (here).
Similarly, many other systematic strategies do what discretionary investors have
done for decades. For instance, the century old saying “cut your losses short and let
your profits run” has found application in CTAs, equity long-short factors, and even
risk-based portfolio approaches such as volatility targeting. “Don’t put all your eggs
in one basket” found its application in risk parity, multi-factor models, etc.
While it is incorrect to say that systematic flows are the sole driver of recent market
moves, it would be equally incorrect to say that systematic flows don’t have a
meaningful impact. This has now been broadly accepted, and many analysts are
forecasting various systematic flows (with various degrees of accuracy).
Collectively, flows from strategies such as CTAs, volatility targeting, option
hedging, passive rebalances, CPPI structures, etc. can represent a large part of market
flows and may appear as an unknown force to some fundamental investors. Perhaps
even more than flows from systematic strategies, the marketplace has been impacted
by changes in the structure of market liquidity (as provided by electronic market
makers). Similar to systematic strategies, liquidity has become to a large extent
driven by market volatility, thus reinforcing a negative feedback loop between
volatility and liquidity. The most recent examples include an unprecedented drop in
futures market depth (alongside an increase of the VIX, Figure 3), currency flash
crash on Jan 2, or the equity market “upside crash” on December 26. Equity markets
could benefit from a rethinking of the current state of liquidity provision and of
market reversion forces. The depletion of market reversion forces was driven by a
decline of value investors (as money moved to passive and systematic strategies), a
shift of assets from public to private equity (private equity has a more favorable mark
to market treatment, thus creating arbitrage between public and private equity), and a
reduction of human risk taking activity after the 2008 crisis (e.g., block traders, prop
desks, etc.).
20
(1-212) 272-1438 03 January 2019
Figure 3: Liquidity is strongly negatively correlated with volatility

Monthly average # of ES futures contracts within 1 index point of the top of the order book
10,000 0
5
8,000
10
6,000 15
20
4,000 25
30
2,000
35
0 40
2008 2010 2012 2014 2016 2018
Emini Market Depth (Left) VIX (Right, inverse scale)
Source: J.P. Morgan QDS.
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Table of Contents

Rpt. 66454994 MARKET AND VOLATILITY COMMENTARY : DECEMBER POST-MORTEM, SIGNA 18 - 25

These reports were compiled using a product of Thomson Reuters www.thomsonreuters.com

Market and Volatility

The V-shaped recovery and Positioning Global Quantitative and

no longer considered outlandish by most. Calls from various strategists for

See page 3 for analyst certification and important disclosures.

In terms of flows, liquidity and volatility, there is a parallel between the

Commodity Sector Trades

J.P. Morgan Equity Research Ratings Distribution, as of January 02, 2019

Legal Entities Disclosures

Country and Region Specific Disclosures

"Other Disclosures" last revised January 19, 2019.

Market and Volatility

Narrative vs. Flows Global Quantitative and

See page 7 for analyst certification and important disclosures.

Liquidity-Volatility-Flows Feedback Loop

7000 S&P 500 Futures Depth vs VIX

Which strategies may be impacted – some simple checks would include:

QE/QT and Liquidity

To our knowledge, there is no broadly accepted understanding of the exact

J.P. Morgan Equity Research Ratings Distribution, as of January 02, 2019

Legal Entities Disclosures

Country and Region Specific Disclosures

"Other Disclosures" last revised January 01, 2019.

Market and Volatility

December Post-Mortem Global Quantitative and

See page 5 for analyst certification and important disclosures.

What can these flows signal for future returns?

-0.5% -2% 2% 10%

Source: J.P. Morgan QDS, EPFR. Source: J.P. Morgan QDS.

Role of Systematic Flows, Liquidity, and Lack of Reversion

When we analyze systematic flows, we track a number of different market segments:

Figure 3: Liquidity is strongly negatively correlated with volatility

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