Given what we’ve seen this week in terms of DM yields spiking and that spilling over into equities, this is probably a good time to remind you that the 800-pound gorilla in the room is risk parity and the potential for a deleveraging episode.
As I’ve noted on several previous occasions, the gorilla analogy probably isn’t the best when it comes to the risk parity crowd because in that analogy, the gorilla’s weight is known.
One of the biggest problems with risk parity is that no one knows exactly what we’re talking about in terms of size, although we do know it’s somewhere between a half trillion and a trillion dollars.
Of course when it comes to deleveraging, the extent to which it will be “beautiful” (to quote the risk parity “zen master” himself) as opposed to “hideous” depends on a number of unknowns. Here’s how BofAML put it earlier this year:
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.
All of this is contingent on rates and equity vol. sustaining a spike, and it goes without saying that sustainable spikes in vol. are to come by these days.
Whatever the case, do keep in mind that the unwind does indeed appear to be underway – if only in a mild, and orderly fashion:
Take that for what it’s worth and here’s Cameron Crise to tell you why “it’s probably nothing”…
Asset Prices Fall, But Don’t Worry About Risk Parity: Macro Man
The coincident decline in stocks and bonds over the past couple of weeks has started to ignite concerns about potential selling from risk-parity funds. The notion of a large and disorderly liquidation of asset holdings is an enticing one for macro traders — and a frightening one for long-only investors. However, the reality is that markets would likely have to fall substantially further before risk-parity funds become a legitimate market factor.
In the investment management business there is a general belief that you have to work very hard to generate returns. This in turn leads to a revulsion against strategies that simply buy assets and hold them. In the equity space this manifests itself in the tilt between active and passive management strategies. Among macro traders, meanwhile, it produces a revulsion against risk-parity strategies.
Whenever equities and bonds decline together, traders start musing about a possible dislocation in risk-parity strategies, with potentially explosive consequences in the event of a disorderly unwind. Given the “taper tantrum” currently unfolding in Europe (with knock-on effects in the U.S. and elsewhere), punters are wondering whether the risk parity guys are going to hit the “eject” button.
Of course, it’s an open question as to how much money these types of strategies run. Those looking for a blow-up cite staggeringly large numbers, while the proprietors of the strategies unsurprisingly downplay the size of the risks. At the very least, we can examine the P/L stream of risk-parity strategies to get a sense of when pain thresholds are reached.
I looked at three measures of risk-parity performance: the JPMorgan risk-parity index, the Salient risk- parity index, and AQR’s risk-parity mutual fund. An interesting trend emerges when we plot the year-to-date performance. The fund handily outperforms the passive indices, which suggests that risk-parity practitioners may be a little more savvy than is commonly supposed.
Ultimately it will be an uptick in volatility that could cause a significant reduction in risk- parity holdings. The volatility of the Salient index has turned a bit higher recently, but is still below the levels of the past few years. A vol-induced risk reduction doesn’t appear to be imminent.
Markets have a lot of wood to chop to the downside before risk-parity funds will become a factor. For now. concerns over their impact look to have more bark than bite.