Fund managers who focus on economic growth and corporate profitability are growing increasingly skeptical about the sustainability of this US equity rally.
According to data compiled by Deutsche Bank, concerns over elevated US Treasury yields, the Middle East war, and sticky inflation have pushed discretionary investors' equity exposure down to the bottom third of its historical range.
At the same time, quantitative funds have kept buying stocks, benefiting from the benchmark index's sustained climb and falling volatility.
The gap between the two — the former underweight US equities, the latter overweight — is now the second-largest since 2020.
Deutsche Bank strategist Parag Thatte said in a phone interview: "As things stand, this gap can't widen much further, so one side will soon have to give way."
If share prices keep rising, quant funds typically do not care how much the market has already risen, so they will have to keep buying, eventually forcing fund managers to capitulate.
Conversely, if selling returns to the market, discretionary investors who have largely missed this rally will be drawn in and get a chance to prove themselves right.
The Gap Between Discretionary and Systematic Equity Positioning Is the Second-Largest Since 2020
Although systematic funds are not considered the largest participants in the market by assets under management, they are undoubtedly among the fastest movers.
When their algorithms hit a specific threshold, such as a buy or sell signal, they immediately close out or add to positions.
This can trigger tens of billions of dollars flowing into or out of major stock indexes.
Maxwell Grinacoff, head of equity derivatives research at UBS Group, said the S&P 500's one-month realized volatility is currently around 9.9, the lowest level since June.
Under such conditions, volatility-control funds have been buying stocks.
These funds typically increase equity exposure when the market is calm and sell stocks when market volatility intensifies.
Maxwell Grinacoff added: "Only an exogenous shock that causes the S&P 500 to fall sharply for multiple consecutive trading days could force a reversal in systematic positioning and trigger a 'waterfall outflow' of funds from the stock market — but we haven't seen that yet."
Despite concerns about an AI stock bubble and long-term borrowing costs rising to their highest levels in decades, US equities have recently enjoyed smooth sailing.
The S&P 500 has risen 23% since its March low, adding $13 trillion in market value over that period.
The benchmark index has gone 89 consecutive trading days without a drop of at least 2%, while there have been only two such down days so far this year.
According to data compiled by Nomura Holdings cross-asset strategist Charlie McElligott, systematic funds — including volatility-control funds, commodity trading advisors (CTAs), and risk-parity funds — have seen their equity exposure rebound to the 86th percentile, near this year's high.
Parag Thatte said that given how systematic funds operate, a market selloff could first begin with volatility-control funds unwinding extreme positions.
He added that this would increase the risk of a sharp reversal in stocks, though for volatility to spike and stay elevated for a period, the market would need a large-scale selloff — namely, the S&P 500 falling at least 5% from its peak.
Volatility-control funds' buying and selling activity moves inversely to realized volatility: the larger the price swings, the stronger the de-risking signal sent to volatility-control funds.
This happened in the spring of this year, when volatility rose sharply as concerns about the Middle East war and economic conditions intensified.
As their sensitivity to market selloffs increased, these funds reduced equity exposure.
Parag Thatte said that if discretionary investors start selling stocks out of concern about weakening economic growth or deteriorating corporate earnings trends, this could in theory push up market volatility and force algorithm-driven strategies to unwind positions as well.
But that does not mean the market rally cannot continue.
Fund managers' currently low equity positioning means investors still have more "ammunition" to buy stocks in the coming months, potentially preventing a more severe selloff.
Colton Loder, managing partner at alternative investment firm Cohalo, said: "There are indeed investors in the market who are underweight the 'right' stocks, and they will step in to buy on a market pullback. Something will inevitably emerge to push volatility higher or create a negative stock trend. Systematic strategies can last a long time; they keep going until they no longer do."
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