Is Risk Parity Deleveraging The Biggest Risk To Markets?

Not too long ago, BofAML called risk parity deleveraging “the one trillion dollar question.”

It’s actually part of a larger question about what would happen if systematic strats were all forced to deleverage at once on a large (and sustained) vol. spike.

The CTA component of that equation is to a certain extent quantifiable. Earlier today, we brought you “A Nightmare On Wall Street – Updating The Feedback Doom Loop” in which Deutsche Bank’s Rocky Fishman noted that CTAs have continued to increase their exposure to equities and US Treasuries. Indeed, that exposure is at 3-year highs and the equity component is in the 91st percentile versus the last 5 years:


“With CTA betas to SPX and EFA growing, a sharp equity selloff could be exacerbated by CTA selling,” Fishman wrote, in a note out earlier this week, adding that “CTAs would have to sell futures into a declining market on a selloff, the higher the beta to an asset class the more CTAs would likely have to sell.”

Back in April, BofAML attempted to put a number on CTA equity deleveraging in a worst case scenario. You can view the math on that here.

But what BofAML couldn’t put a number on was model driven selling in risk parity and equity vol. control strats. For his part, Fishman notes that while vol. control funds are fully allocated, they won’t sell rapidly on a selloff.

As for risk parity, the question remains an open one. Here’s what BofAML said a couple of months ago:

Model driven equity selling pressure via risk parity and equity vol control strategies is often also considered alongside that of CTAs as they all (1) use rules-based models that can at times make them price-insensitive buyers or sellers, (2) typically increase leverage when volatility is lower, and (3) can deleverage in response to a shock from low vol levels.

As with CTAs, estimating potential equity selling pressure from risk parity and equity vol control funds requires first knowing how much of their assets are purely rules-based and second modelling how they could operate in a stress event. However, relative to CTAs there is much less transparency on the total size of assets in risk parity and equity vol control strategies let alone the subset of which is completely rules-based.

The bank attempts to peg the number (again, you can see the math in the post linked above) but ultimately concludes that it’s unknowable.

What we do know is that equities and bonds are suddenly looking like they want to sell off together and that’s a recipe for a risk parity unwind.

Remember, falling yields and soaring stocks is a bonanza for risk parity – both equities and bonds are rallying simultaneously.

The big question is what happens in a “tantrum” scenario where a rate shock effectively flips the script and rising yields are no longer seen as a risk-positive sign of reflation optimism, but rather as a risk-off signal tied to central bank hawkishness? 

A related question is this: has the “tantrum” threshold for yields move materially lower over the past couple of years? This scatterplot (although it’s a bit dated) suggests the answer to that question is definitively “yes” (note that the visual depicts rates-stock correlations):


The bottom line is that you might be seeing the following chart show up more and more over the next couple of weeks/months so get acquainted now…


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