In a market, it is usually the big fish that eats the small fish, and the strong outweigh the weak. But when the resources of the market begin to dwindle dramatically, this competition escalates into a direct duel between the strong, forming a battle so fierce that it can only hurt each other.
Take a recent example, in just four trading days before the Chinese New Year, some quantitative investments** showed extreme performance:
During this time, quite a few ** yields have seen a huge decline of -8% to -10%, which has almost wiped out all the excess gains they have accumulated throughout 2023. Not only did this reflect extreme volatility in the market, but it also set an all-time high for excess return drawdowns within the industry.
Why did the small and medium-sized market capitalization of A-shares suffer a drastic ** in just over a month at the beginning of the year? From November 2023 to early February 2024, quantitative investment, which is dominated by the CSI 1000 and CSI 2000 indexes, has fallen by an astonishing amount in just over two months: the CSI 1000 index has fallen by 3334%, and the CSI 2000 index fell by as much as 4037%。Such a decline is almost close to the cumulative decline of the CSI 300 index in the past three years.
Behind the decline of the CSI 300 index in the past three years, it started from the peak of a bull market. The CSI 300 index in 2019 and 2020 reached an all-time high of 5,930 points on the first trading day of the Spring Festival in 2021, and then started a bear market that has continued to this day.
The "roller coaster" of small market capitalization**: an in-depth analysis
Recently, you may have noticed some strange movements in the CSI 1000 and CSI 2000 indices. To put it simply, these two indices are like going through a big rollercoaster ride, and now they seem to be looking for calm waters, or rather, trying to climb out of the valley bottom.
The CSI 2000 Index, in particular, has been influenced by a strategy called quantitative investing over the past two years. This strategy prefers to invest in companies with smaller market capitalizations, as historical data shows that these players tend to bring higher additional returns. Quantitative investors tend to pick these small-capitalization companies when choosing**, which has led to the CSI 2000 Index receiving special attention.
This, coupled with the more aggressive strategy adopted by some small-scale quant** managers, who invested in micro-cap stocks with very small market capacity, not only affected the CSI 2000 index, but also compounded the liquidity problem.
The combination of these factors has made the CSI 2000 Index stronger than the CSI 1000 Index over the past year. However, after the last two months of rapid**, the gap between the CSI 500, CSI 1000 and CSI 2000 indices has narrowed again, indicating that the previous extra liquidity has largely dissipated.
The most shocking scene occurred on the last trading day before the Spring Festival, when the CSI 2000 index rose 875%, CSI 2000 ETF is a direct limit, all of which points to a phenomenon - the liquidity crisis of small market capitalization.
So, why is this round of small market capitalization experiencing such a drastic situation? To put it simply, it is mainly because there is a "run" on the market to sell and rebalance. This has not only led to a liquidity crisis, but has also caused huge losses in the excess returns pursued in quantitative investment strategies.
Now, let's dig a little deeper into why small caps are facing both a run on selling and rebalancing, and how investors view the current market situation. After all, as the Buddha said, "The fruit of this life comes from the causes of previous lives." Let's take a look back at what the market was like three years ago, and maybe find out.
Recalling three years ago, that is, from the end of 2020 to the beginning of 2021, we witnessed the scene of the crazy pursuit of the first launch by funds, with a single-day capital investment of up to 100 billion. This all happened after a three-year long bear market. In particular, those with a 3-year closure period have been set to expire in the near future. Many investors, after three years of waiting, originally had some expectations for the market, hoping to return to their capital or even make a profit when the market recovered.
However, the market has disappointed in recent months, with growth stocks-led by growth stocks suffering a succession of net redemptions, and investors' mindset shifting from waiting to fleeing, with more losses the later they run.
At this critical juncture, a management decision – to limit the net selling of large public offerings in August last year – was well-intentioned in an attempt to stabilize the market. However, the actual effect is counterproductive, accelerating the selling pressure in the market. This is because, while large public offerings are restricted, the sale of small and medium-sized public and private offerings** is not. In an ideal world, it would be best for all the best institutions to not net sell, but the market reality is harsh, and the lack of mutual trust and a basis for long-term cooperation has led to more short-term trading and selling.
As a result, the market did not achieve the expected stability and recovery, but continued to flow out of ** stocks, and ** stock indices such as CSI 300 continued to **. Investors have witnessed the continuation of the index amid a series of positive news**, with confidence gradually losing and more and more people choosing to redeem.
By January 2024, management had to ease the net selling restrictions on large public offerings to cope with redemption pressure. This undoubtedly dropped a bombshell in an already fragile market, further weakening the market's bullish sentiment. Another directive from management – prioritising the protection of ** stocks in the event of reduced liquidity – meant that small market capitalization** had to be sacrificed to cope with redemption pressure.
At the beginning of January 2024, the decline began to hit small and mid-cap caps, triggering the knock-in mechanism of snowball products linked to the CSI 500 and CSI 1000 indexes. In this process, many networks have exaggerated or wrongly reported the impact of Xueqiu products on the market in order to attract attention, which has exacerbated the panic of investors. This panic in turn accelerates the index, forming a vicious circle: snowball products knock in, self-amplification panic, and further indexing.
At this critical juncture, the market would have needed management to intervene to break this negative cycle. However, management's interventions failed to achieve the desired results. What we have seen is that there is a "big money" in the market to pull up the big state-owned banks and state-owned enterprises, but this approach does not directly solve the problem, but rather pours oil on patients with high fever, exacerbating the instability of the market.
In the A** market, investors have a muscle memory for the "big money" to pull up this kind of **: once it happens, small and medium-sized growth stocks tend to **. This kind of rally has led to the flow of funds from small and medium-sized market capitalization** to large state-owned banks and large enterprises, which has exacerbated the market's risk aversion and dealt a major blow to small market capitalization**.
Subsequently, the small and mid-cap indices such as the CSI 500, CSI 1000 and CSI 2000 index** further triggered the knock-in of snowball products, which led to the rapid expansion of the basis of the stock index**, bringing short-term profits to the quantitative hedging neutral products. This prompted some quantitative hedging products and leverage-neutral** to close positions and realize profits. However, this liquidation operation also requires the need to sell***, which further exacerbates the small market capitalization**.
This series of events shows how the panic in the market has been amplified and how management intervention has failed to respond effectively and may have exacerbated the instability of the market. In this complex market environment, it is critical to understand how each step affects the market as a whole.
If, during those turbulent days, the strategy adopted by management was not to invest large sums of money in large state-owned banks and large enterprises**, but to choose to go long the CSI 500 and CSI 1000 indices with relatively little money in the ** market, this approach could have brought unexpected positive effects. Through this operation, the negative spread of the stock index ** can be effectively narrowed, and it may even be turned into a positive spread, which not only avoids the large-scale liquidation of neutral hedging**, but also may improve the sentiment of the entire market, attract new investment into hedging**, and achieve a situation where small investment brings big benefits. If this strategy is adopted, a series of subsequent risks may be avoided.
The acceleration of small and medium-sized market capitalizations has brought new risk points to the market. For example, some quantitative index enhancements** have a set of 07 stop loss line, when the market touches this line, the closing operation must be executed, which further boosts the index's **. Interestingly, the closing operation of the CSI 1000 Index on February 6 and the partial stop-loss line triggered by the *** occurred precisely on the eve of its imminent **.
Then the management took another puzzling step to limit the liquidation of DMA (hedging products with 3-4x leverage). This decision, which appears to protect the market on the surface, can actually cause greater losses to DMA products with large holdings of small market capitalization**, as they face huge losses in the case of equity indices** and **double**.
In order to reduce risk in the case of restricted liquidation, many DMA products can only sell small capitalization** that are not components of the CSI 500 and CSI 1000 by rebalancing** and instead buy the constituents of these two indices. This shift in strategy, while potentially reducing losses, actually exacerbates the negative cycle in the market, putting all market participants at a disadvantage.
During those few days, small caps** experienced unprecedented turmoil. On February 5, the CSI 2000 Index, a broad-based index representing small-capitalization companies, scored an astonishing 949%。This is not only because of the collective sell-off caused by stop-loss, but also because investors have adjusted their positions and transferred funds from the small market capitalization of non-CSI 500 and CSI 1000 index constituents to the constituents of these two indexes.
However, in the following two days, on February 6 and February 7, we saw a strong increase in the CSI 500 and CSI 1000 indices, with gains of around five or six points per day. This reversal was partly due to the intervention of the "national teams", who ** ETFs in both indices, and if this operation had been carried out a month earlier, it might have avoided the tragedy that followed.
In this market environment, many quantitative strategies are failing. Quant experienced the largest excess drawdown in history in these three days, and some lost all of their gains over the past year in just three days.
On 7 February, the big news came – the new village chief took office, bringing a turning point in the turmoil. Much of this confusion was caused by management's inability to respond to risk events, and many people's wealth evaporated as a result. Clearly, someone needs to be held accountable for this mess.
On February 8, the first day of the new village chief's tenure, the restriction on DMA's leverage-neutral** liquidation was lifted. When I heard the news, my friends in the industry and I were discussing it, worried that the small market capitalization **would continue**. But personally, I see an opportunity for a small-cap style reversal.
There are two obvious reasons for the turning point in the market. First of all, despite the previous measures to limit net selling, before February 8, most of the managers who used DMA leveraged strategies, ordinary neutral strategies, and ordinary index enhancements** had completed their rebalancing operations. These rebalancing operations are mainly to sell the small market capitalization of the CSI 2000** and exchange for the constituent stocks of the CSI 500 and CSI 1000 Index, which is also the reason why the constituent stocks of the CSI 500 and CSI 1000 Index generally rose sharply on February 6 and February 7.
Secondly, the new village chief lifted the restrictions on selling on his first day in office, and this decision is likely to be carefully planned. It is expected that there will be funds to undertake the possible sell-off, alleviating the panic in the market.
As a result, the CSI 2000 Index began to continue shortly after the opening of trading on February 8, and finally soared by 875%。At the same time, some CSI 2000 ETFs with a trading volume of only about 100 million have also directly increased the limit, such as 563300 ETF, which has a single-day ** amount of more than 5 billion.
Compared with the situation where a huge amount of money is invested in the CSI 300 but encounters a large number of sell-offs, only a small part of the funds invested in the CSI 2000 index can significantly push up its index, which is not only from the perspective of increasing the overall market value of A-shares, but also from the perspective of emotional catalysis, which is very efficient.
Over the past two years, small market capitalization** has shown relative strength because market money has always tended to flow to places where it is easier**. This is a natural law of the market, showing the cyclical changes in the style rotation of A-shares in the big cycle. Trying to force a change in this trend will only lead to greater market chaos.
Some may attribute the current round of small- and midcap indices** and huge excess drawdowns to the quantitative strategy's preference for small-cap stocks over the past two years. However, it is inaccurate to simply attribute this phenomenon to the "huddle" of quantitative strategies. In fact, quantitative strategies tend to favor small market capitalization when choosing, which is based on market trends. After experiencing the 2019-2020 ** stock bull market, naturally, when the market enters a bear market, the ** stocks that have performed strongly before will be relatively weak, while the small market capitalization and specific styles of ** that have previously performed weakly will be relatively strong. This is just one part of the cyclical nature of the market.
During periods of strong growth stocks, many quantitative strategies will also tend to choose this type. In short, the goal of the quantitative strategy is to find the market that is easy to rise, the pursuit of excess returns, and the selection of this strategy is based on market dynamics and trends.
The ** with a small market capitalization occupies a special position in the ** field. Considering that the total market capitalization of the 400 micro-cap stocks is only 489.4 billion, the average market capitalization is about 1.2 billion, which is in stark contrast to those large companies with a market capitalization of more than 500 billion. The data shows that even in November last year, when micro-cap stocks were the most popular, the proportion of large-scale quants** invested in companies with a market capitalization of less than $1.5 billion was only 448%, much lower than its investment ratio of 6 in companies with more than 200 billion yuan11%。
The sharp decline in the small cap index this time involves both a change in market fundamentals (beta) and a double ** beyond normal returns (alpha). This situation is triggered by a series of market risk events, which have not been dealt with in a timely and effective manner. In the so-called "prisoner's dilemma", the rational decision-making of individuals ultimately leads to collective irrational behavior, causing a liquidity crisis in the small-cap sector, which in turn triggers a major decline in both beta and alpha of quantitative enhancement strategies.
It is worth noting that the U.S. market has experienced similar crises in its more than half century of quantitative trading history. In particular, in the week of August 2007, most of the high-performing quantitative hedges** lost anywhere from 5% to 30% in just a few days. These losses are mainly concentrated in the ** of the long and short hedging strategy, while the *** of the other strategies did not suffer much loss. After a series of hedges, the quantitative long-short hedging began to rapidly after August 10, and the crisis subsided. Although the crisis came and went quickly, it also provided a huge opportunity for some investors to take advantage of this short-lived market volatility and earn handsome returns when the market was ** through large-scale leveraged investments.
In the aftermath of the quantitative crisis in the United States, which lasted only a week, experts believe that the main reason is that a large quantitative institution suddenly liquidated its neutral strategy portfolio for a specific reason, which triggered a series of chain reactions, resulting in many similar strategies ** suffering heavy losses at the same time. The sharp decline in performance is not a problem of the strategy itself, but is caused by short-term changes in market liquidity, which triggered investors to panic sell in search of relatively "safe assets".
Looking back at the week leading up to the Chinese New Year, we witnessed a tragic sell-off in quants. In the first three trading days, many quants** rushed to sell the small capitalization of the CSI 2000 Index** and turned to the constituents of the CSI 500 and CSI 1000 Indexes in search of the liquidity haven provided by the "national team". However, on the fourth trading day, that is, on February 8, we not only saw the "big money" entering the CSI 2000, but also the trend of the CSI 500 Index on the same day, and it can be seen that there are funds withdrawn from the constituent stocks of the CSI 500 and re-invested in the CSI 2000, seizing the opportunity.
This kind of style timing operation based on quantitative analysis usually occurs in small and medium-sized quantitative managers, who try to make investment decisions in the short term according to market style changes. At the same time, some large quantitative managers chose to remain steadfast during the four volatile trading days, despite excess losses of more than 10% in the face of the CSI 2000 sell-off.
With the end of the Chinese New Year, we have reason to expect a more rapid fix at the beta level. However, as for the speed of alpha recovery – whether slow or fast – we need to be patient and wait for the subsequent market performance. Investors may face a new decision-making dilemma after the holiday: should they choose to redeem their quantitative** investments, or continue to hold them? If the market can be quickly ** after the Chinese New Year and investor sentiment can be repaired, then this new "prisoner's dilemma" will be naturally lifted.
Judging from the current A-share quantitative ** crisis - or the huge drawdown of excess returns caused by the liquidity crisis, the impact on the excess returns of the future quantitative index enhancement**, in the medium and long term, for individual investors who hold such **, there is actually reason to be optimistic. In the last two years, the scale of proprietary DMA leveraged hedging products has expanded dramatically, and the current crisis has hit these products particularly hard. It is expected that the regulatory control of such products will be stricter in the future.
If the metaphor of mining is used to illustrate the acquisition of alpha income from quantitative indexing, then the reduction in the scale of DMA leverage-neutral products is like the reduction of competitive mining machines. At the same time, the crisis has also led to the exit of some small quantitative managers, and for the remaining investors, there are fewer competitors. Just like the rapid growth of quantitative scale in the first half of September 2021, and then experienced a purge period of beta and alpha double whammy, which lasted for about half a year, and bottomed out at the end of April 2022, and then entered a good period of alpha returns for nearly two years. The crisis took only two months to complete a drastic market cleansing, much faster than before.
The last round of market bull market dominated by ** growth stocks began in February 2021 and took a three-year adjustment period to complete a round of market purging. This rapid correction may be a more optimistic income opportunity for investors who can stick to it.