A couple of days ago, we chronicled a short-lived “disagreement” between Jim Grant and Ray Dalio.
Basically, Jim suggested that Bridgewater’s lack of transparency could mask conflicts of interest. This is a touchy subject, so we’re not going to dive back down that rabbit hole, but for those who need the backstory, you can learn everything you need to know from the post we did on Friday afternoon after Jim performed the ritual mea culpa live on CNBC.
While that was all very amusing, we contended that the real problem with Bridgewater is that it could very well pose a systemic risk, right along with other systematic strats in the event some kind of horrendous vol. spike starts tipping dominoes and forces the programmatic crowd to deleverage into a falling market. Here’s what we said:
And of course, our critique of Bridgewater remains the same as it ever was. For markets in general, the only question re: Bridgewater is this: will the correlations that underpin risk parity hold up? And if not, what happens when risk parity unwinds? Will it be, as many commentators have suggested, an aggravating factor that exacerbates an already bad situation? What happens, for instance, to a levered bond position in an environment where rates vol. suddenly spikes?
And here’s Jim underscoring that:
I THINK IT — I THINK ITS SYSTEMICALLY IMPORTANT BRIDGEWATER DENIES THAT, BUT I THINK ITS SYSTEMICALLY IMPORTANT. AND I THINK THAT ITS – IM GOING TO SAY IN A CONSIDERED WAY, ITS OBSESSIVE SECRETIVENESS IS NOT TO ITS BENEFIT AND EXCITES THE SUSPICION OF THOSE WHO WATCH IT WHICH IS NOT TO DIRECTLY TO ANSWER YOUR QUESTION, BUT DIRECT ANSWER, YES, I THINK IT WILL PLAY IN SOME WAY IN THE PEAK OF THE NEXT CYCLE, IT WILL BE SEEN AS, YOU KNOW, AS A FIGUREHEAD OF THIS PARTICULAR UPSWING IN CENTRAL BANK LEVITATED MARKETS AND IN, YOU KNOW, ABNORMALLY, IN FACT, UNIQUELY LOW INTEREST RATES. SO, YES, I DO THINK THAT BRIDGEWATER WILL BE THE FIGUREHEAD OF THE NEXT CRISIS.
Well, to the extent you were concerned that the guardians of the financial universe don’t appreciate the risk posed by risk parity, rest easy because Dallas President Robert Kaplan is “watching carefully”.
“I’m also watching carefully the growth in these so-called risk-parity funds, or risk-parity trades, that basically take low-volatility assets and put leverage on them to create more returns,” Kaplan told reporters Wednesday following a talk in New York. “From what I can tell, the level of that appears to be manageable, but I’m watching that,” he continued, before summarizing just how vigilant he is as follows:
I don’t see undue imbalances, but I’m continuing to look for them, and I’m aware that with rates this low, it will cause people to take more risk, and it may cause these imbalances to build. And I’ve learned when they do build, they can build very quickly, so we have to be very vigilant about this.
Got that? I’m not sure describing risk parity in the same terms Donald Trump describes federal judges (“so-called”) inspires much confidence.
But again, don’t worry, because Kaplan is “continuing to look for undue imbalances” – in that kind of way like O.J. Simpson is “continuing to look” for Nicole’s murderer.
For those in need of a refresher, below are excerpts from a BofAML piece out earlier this year that sought to quantify the risk posed by risk parity…
Risk parity & vol control, the one trillion dollar question
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.
Regardless, we can estimate how rules-based risk parity and equity vol control funds would respond in an Aug-15 like stress event where equities were subject to multiple days of large declines and bonds did not offer sufficient diversification. Our models estimate that in shocks similar to Aug-15, some rules-based risk parity strategies could sell equities in the amount of 25% of their total assets under management. In addition, we estimate that some rules-based equity vol control strategies could sell equities in the amount of 120% of their total AUM.
However, due to model diversity, we would not expect rules-based risk parity and equity vol control funds to all unwind within a day. Rather, in an event similar to Aug-15 in which equity markets were subject to consecutive days of large declines, we expect these funds to deleverage over the course of a few days or a week depending on how stress unfolds. In this case, as we discussed earlier, equity index futures volumes over the week could be expected to double from current levels to an amount north of $3tn.
The key question is how big would these quant fund assets need to be to represent a significant portion of futures volumes? When considering that unwinds during stress could take upwards of a week, the asset size required to be invested such that they would represent even 20% of total weekly volumes seems far larger than what we believe exists in the market.
To account for 20% of expected weekly volume of $3tn, equity selling flows would need to equal $600bn. Earlier in this piece we accounted for a worst case $175bn equity selling pressure from CTAs (which we think is an overestimate). To get to $600bn in total selling pressure would require rules-based risk parity to have upwards of $500bn in assets with an additional $250bn in equity vol control. Therefore, it would take $1 trillion (far higher than any estimates we have seen in the market) in completely rulesbased assets across CTAs, risk parity, and equity vol control funds for the trio to account for even 20% of expected weekly equity index futures volume in severe stress. This would be in one in which equity vol spikes from ultra-low levels, markets decline for multiple days in a row, and in which bonds fail to sufficiently diversify equities. However, this amount of assets is far beyond any reasonable estimate in our view.
Again, it’s important to recognize that markets could react negatively to model driven flows in today’s fragile environment, particularly as there is little transparency about how they operate or their potential size. However, appreciating the likely limits of their impact is key to better navigating stress events, and identifying how to take advantage of a potential overreaction from investors scared of what they don’t understand.