The Pain Trade is a Melt Up



One of the absolutely biggest investment themes over past months has been the crowded trades implosion. The aggregate investor has been caught wrong in all market directions, both down and up. Leading into October people were short vol and long equities. We all know how this went down.

In late October we got the bounce, which was actually terrible for hedge fund performance, mainly the momentum chasers, who had turned bearish in their momentum models.

Ironically, most of these hedge funds gather assets, collect high fees and trade max risks, instead of focusing producing returns. The entire model is flawed and built around the fallacy of being fully invested, irrespective if they are losing or making money. If they utilize say only 50% of the invested money, but still charge 2% fixed fee, this fee is then actually much higher on the invested amount and no investor wants to pay 4% fixed fees (not to talk about reducing risk exposure to say 10% of capital which would translate into a 20% fixed fee).  

Instead of focusing on the p/l, the aggregate hedge fund focuses on maxing out risk and trying to be correct about market direction. This is according to us totally wrong, more on the topic of risk and p/l management here.

Below is the chart of SPX (orange) versus the CTA index (representing top model funds). Note how the CTA index moved in tandem with the SPX since June. The aggregate fund was clearly long the equity market. Note how the CTA index fell when markets sold off in October. Lately the CTA index has underperformed when markets have bounced higher, indicating the models have turned bearish the market. This could, ceteris paribus, magnify a possible squeeze higher. The crowded pain trade continues.



As we all know, VIX positioning was extremely short leading into the October sell off. Note how this extreme net short VIX has now turned into rather long VIX positioning (white). Do also note that major spikes in VIX longs have market local lows in the SPX over past years. The “smart” crowd seems not only short equities, but also long volatility. This could prove a lethal combination should markets calm down/go up from here.


Below is a chart of SPX (orange) and the CBOE put call ratio (white). Note that spikes in the put call ratio often mark local lows in the SPX index, that has been followed by gains for the SPX.

Given the fact “smart” hedge(ed) funds seem all bearish, long volatility and have loaded up on puts relative to calls, the pain trade looks to be a bounce higher in equities.

Source: charts by Bloomberg