March 2021

Flow World Reloaded

Key takeaways

  • Large-scale issuance is reloading the opportunity set available to flexible strategies designed to capture dislocations and benefit from flow-driven effects.
  • US Treasury issuance is likely to remain elevated in 2021 with the recent passage of another large stimulus and an infrastructure bill expected to follow. US IPOs are at a 20-year high, while option trading volumes have tripled since the start of 2020.
  • The post-COVID boom creates a favourable environment for flexible, flow-driven approaches. But harvesting price anomalies requires experience, access and infrastructure.
“We are always in a process of becoming and nothing is fixed. Have no rigid system in you, and you’ll be flexible to change with the ever changing. Open yourself and flow, my friend.”
– Bruce Lee

At the start of 2021, we published Welcome to Flow World to introduce and explain our view that markets were in a regime where flows would dominate fundamentals.

If you haven’t read it – here’s the two-line summary:

In this sequel, we discuss how the current “Flow World” environment is broadly positive for flexible strategies that can step in as price makers to intermediate flow mismatches. We also show why we believe the opportunity set for such strategies is improving as underlying markets expand and issuance grows.

Flows impact prices

Most passive strategies have largely fixed rules to minimize tracking error. For example, net inflows to ETFs and other tracking funds result in the underlying basket being bought while outflows drive asset sales. Thematic funds that focus on a particular sector typically have much higher turnover than “vanilla” index funds. This is because their flows are usually more volatile, and they require larger rebalancing trades compared to broad market-cap weighted indices. Other popular strategies are rule-based as well; factor/smart beta exposures need to be adjusted not just for flows but also for changes in the factor basket. Similarly, volatility-target products are forced buyers when realized volatility is falling but forced sellers when volatility is rising.

Importantly, other market activities indirectly create directional flows – e.g. retail investors have been active buyers of equity call options. Market makers generally need to buy more of the underlying asset when its price is increasing, and vice-versa. In the bond market, mortgage convexity affects interest rates as hedgers need to rapidly adjust their duration exposure via swaps or futures. Finally, new financial products also create flows – e.g. when a company goes public or sells a convertible bond, a bank sells a structured note, or a government issues debt.

All of the above flows impact prices although their effect can vary from unobservable to significant. The size of this price adjustment depends on many factors including the size and urgency of the transactions, the depth of the underlying market, the level of volatility, and the availability of flexible buyers/sellers that can match with these inflexible flows.

There was a substantial pickup particularly in issuance and option flows in 2020 and this momentum has continued strongly into 2021. Higher activity levels are generally a tailwind for flexible strategies that capture dislocations and benefit from flow-driven effects.

Large-scale issuance is reloading the opportunity set available to these strategies. In this article, we will show visual examples of this rapid flow growth.

US Treasuries

Exhibit 1 shows gross US Treasury issuance of all types – bills, notes and bonds. It is not adjusted for repayments of existing issues that matured or US Federal Reserve (Fed) purchases. This is because all issuance has price impact; even when the proceeds go toward repaying prior bonds or the bond is later bought by the Fed. Moreover, the Fed’s bond buying schedule also creates a separate transient impact on different maturities around the purchase windows.

Further, Treasury issuance is likely to remain elevated in 2021 with the recent passage of another large stimulus bill and an infrastructure bill expected to follow. Finally, although the US is adding the most debt, similar dynamics are playing out across other major markets. Most countries are boosting their fiscal spending to fund COVID relief programs while taking in less revenue via taxes. This creates larger budget deficits that are being funded through a combination of higher issuance and central bank purchases.

Equity IPOs and secondary offerings

Activity in the equity market is similarly strong. Despite the interruption due to COVID, initial public offering (IPO) activity roared back in the back half of 2020 to the highest level since 1999. Well over 200 US IPOs have been issued in just the first two months of 2021, marking the quickest start to a year ever, and already surpassing the annual totals of many other years.

Activity begets activity. Typically, a pickup in IPO issuance (as Exhibit 2 shows) will drive subsequent flows. For example, post-IPO, options get listed and the stock is a potential addition to various ETFs and indices. Following lockup expiration, there are often block trades and secondary offerings as early holders seek to monetize their gains. Newly public firms also often do other financing transactions and are possibly an acquirer or acquisition target.

Robust flows have already extended into follow-on and other equity offerings (Exhibit 3), and this is likely to continue while investor demand is strong and deal pricing is attractive to companies.

Option trading

Option trading volumes have also exploded. For many years, about 10 million call option contracts traded per day in the US. This has tripled since the start of 2020 as retail investors pile into option trading. Exhibit 4 speaks for itself.

Convertible bonds

The combination of low interest rates and high demand for options makes it very attractive for corporates to issue convertible bonds. Consequently, issuance in 2020 surged to the highest level since 2001 (Exhibit 5). This trend has continued in 2021 as well.

Opportunities in a flow-driven market

The current market regime is also driving other important flows that touch our strategies. Examples include:

  • Merger announcements have picked up and this trend will likely continue as strong companies look to grow via acquisitions.
  • The US structured note market is growing as wealthy investors seek products with higher yields.
  • Robust demand for high yield bonds has tightened spreads, making credit default swap (CDS) protection worth consideration as a portfolio hedge.

Broadly, the post-COVID boom creates a favourable environment for flexible, flow-driven approaches to benefit from the rigidity of other strategies. But the mere presence of large flows is not enough – harvesting price anomalies requires experience, access and infrastructure. Strategies should seek to capture a statistical edge at the portfolio level even if the outcome of any single trade is quite varied. This makes sizing, diversification and risk management crucial – topics that we will cover in the next and final edition of this Flow World trilogy.

Finally, the current regime is not permanent. Eventually excesses build up, a crisis hits, and issuance slows down when volatility spikes. Then a new equilibrium is reached, and the cycle starts anew. But, for now, we are all living in Flow World.

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