The other day, fabled hedge fund manager Paul Tudor Jones made headlines when he issued a bold warning to Janet Yellen & Co. (from Bloomberg):
The legendary macro trader says that years of low interest rates have bloated stock valuations to a level not seen since 2000, right before the Nasdaq tumbled 75 percent over two-plus years. That measure – the value of the stock market relative to the size of the economy – should be “terrifying” to a central banker, Jones said earlier this month at a closed-door Goldman Sachs Asset Management conference, according to people who heard him.
Jones is voicing what many hedge fund and other money managers are privately warning investors: Stocks are trading at unsustainable levels. A few traders are more explicit, predicting a sizable market tumble by the end of the year.
Nothing really new there. A bunch of smart hedgies have recently been ringing the alarm bell. What was interesting is how Jones thought a crash would manifest itself (from Dealbreaker):
While the billionaire didn’t say when a market turn might come, or what the magnitude of the fall might be, he did pinpoint a likely culprit. Just as portfolio insurance caused the 1987 rout, he says, the new danger zone is the half-trillion dollars in risk parity funds. These funds aim to systematically spread risk equally across different asset classes by putting more money in lower volatility securities and less in those whose prices move more dramatically. Because risk-parity funds have been scooping up equities of late as volatility hit historic lows, some market participants, Jones included, believe they’ll be forced to dump them quickly in a stock tumble, exacerbating any decline. Risk parity,” Jones told the Goldman audience, “will be the hammer on the downside.”
Whoa! That’s a pretty big indictment of risk parity. Them’ sounds like fight’ng words.
Of course the risk parity folks rushed to refute Jones’ forecast, assuring us there was no way risk parity would cause the next crash (from Bloomberg):
For AQR Capital Management LLC, a giant in the risk parity field, the concerns are overblown, with any selling forced by the strategy having an “utterly trivial” impact on the $23 trillion U.S. equity market.
“There are scenarios in which risk parity funds sell equities, but the possible magnitude of that is very small,” said Michael Mendelson, a risk-parity portfolio manager at AQR.“Some reports have grossly exaggerated the potential impact.”
Far be it from me to get in between these hedge fund heavyweights, but I respectfully suspect they might both be wrong.
For those who are not aware, risk parity was the brainchild of Ray Dalio’s firm Bridgewater. I am oversimplifying it, but at its heart, risk parity is based on the idea that assets have varying volatlities, so when constructing a portfolio, one needs to adjust the position size to account for this. The easiest example is the difference between equities and bonds. Stocks, by their nature, are much more volatile than bonds. Dalio surmised it was not fair to look at the long run returns of stocks and compare them to bonds. Stocks’ returns would be higher, but there would be all sorts of violent ups and downs. If you leveraged up the bond position to have equal volatility, then bond returns all of a sudden became much more attractive. Not only that, but during times of stress, bonds and stocks have negative correlations, making the use of leverage far less dangerous, and overall, reducing the volatility of the portfolio. This was the essence of Bridgewater’s All-Weather portfolio that has ultimately become the largest hedge fund in the world.
Paul Jones’ risk parity crash thesis is based on the idea that, because the positions are volatility weighted, risk parity managers buy more in times of low volatility (which almost always coincides with a rising market), and then are forced to sell when volatility increases (which usually accompanies a decline). It sounds suspiciously like the dreaded portfolio insurance strategy that contributed the ‘87 crash (which Jones accurately forecasted and secured his place in the hedgie hall of fame).
OK, here goes my argument on why Jones might be wrong, not about risk parity causing a market dislocation, but instead the market in which risk parity will cause problems.
Risk parity was created in 1996. Since then, interest rates have only gone one way – down.
Not only that, but Dalio founded BridgeWater in 1975. Although the first few years were ugly for the bond market, since then, Dalio has grown his firm in the shadow of the greatest bull market in bonds that America has ever experienced.
Here’s what the total return profile looks like for the broad bond index during that period.
It’s not difficult to spot why Dalio’s strategy of adding a leveraged bond position to his portfolio has been so successful.
Yeah, yeah, I know, there is a lot more to risk parity than simply levering up the bond portion of a balanced portfolio. But what I worry about is the fact that the strategy does not recommend increasing equities exposure because of its volatile nature, but instead advocates for a leveraged fixed income component because of its non-volatile tendency. Risk parity portfolios don’t have significantly more equities than most balanced funds, but they have a lot more bonds.
And then ask yourself, what have Central Banks being doing since the Great Financial Crisis? Buying bonds (they are also buying some equities, but the vast majority of the purchases have been fixed income). What does that do to volatility? It crushes it. And what does lower fixed income volatility mean for risk parity? They buy more.
So although I understand Jones’ argument that increases in equity volatility will cause risk parity funds to lighten up their stock exposure, I am much more worried about increases in bond volatility. Don’t forget, risk parity portfolios use the most leverage in the non-volatile asset classes (like bonds). The genius in risk parity was not increasing leverage in the volatile stock portion, but by cranking exposure to the non-volatile fixed income portion (which also happened to be negatively correlated to risky assets).
Risk parity managers are obviously not the biggest players in the bond market. So maybe all the arguments that risk parity guys make defending their minor influence on the stock market can be equally transferred to the bond side.
But I worry fixed income managers are already suffering from an inability to imagine rates ever heading higher. The boat is lopsided with four generations of portfolio managers who have never seen a real bear market in bonds. While many, like Paul Jones, are positioned to capitalize on lower stock prices, there are precious few who are set up short in the bond market. Forty year bull markets have a funny way of discouraging naysayers.
If we ever get a bear market in bonds, the risk parity guys will make it dramatically worse. It’s always the leveraged positions that cause major market dislocations, and I just don’t see the big excesses being in stocks.
Time will tell if risk parity was truly as revolutionary as many claim, or if it was just a way to justify levering up the greatest bond bull market of our lifetime.
PS: While researching this piece, I stumbled on some pictures of Paul Jones and his wife. I know that most believe that ShowTime’s drama Billions’ main character, Bobby Axelrod, is based on Steve Cohen (even though Bill Ackman desperately wants it to be about him – sorry Bill, you’re nowhere near as cool as Axe), but I can’t help but wonder if everyone is wrong. This season we learned that Axelrod started trading in the commodity pits. Well, that sounds suspiciously similar to another legendary hedge fund manager. Paul Jones was a cotton trader before moving upstairs. If you look, Bobby and Laura resemble a younger Mr. and Mrs. Jones… And by the way, I know Axe would absolutely detest risk parity.