China has had it with risk parity, apparently.
According to the ubiquitous “people with knowledge of the matter”, the country’s $941 billion wealth fund recently cut its RP exposure in half, which helped it “avoid some of the recent turmoil” across assets, Bloomberg said Wednesday.
You’ll recall that risk parity was the last domino to tip in what’s been variously described as the biggest VaR shock (at least) since Lehman.
Over the past 30 days (give or take) every chapter of the “doom loop” ghost story came true. From dealer hedging flows exacerbating swings to CTAs piling on, propagating their own negative momentum to vol.-targeting funds de-leveraging as trailing realized was pulled higher to risk parity unwinds in the final, nauseating act as cross-asset correlations “went to 1″. It was all there. Everything that could have gone wrong did go wrong.
By most accounts, things started to unravel for risk parity in earnest during the week of March 9. By March 13, it was readily apparent that RP deleveraging was underway. By Thursday of last week (March 19), exposure had been slashed dramatically.
“As the ‘bonds as your risk-asset hedge’ correlation runs into the ‘liquidate to cash at all costs’ buzzsaw, we see an unprecedented forced-deleveraging from risk parity, from 555% gross exposure (100th %ile) to 240% (0.1%ile)”, Nomura’s Charlie McElligott wrote, marveling at the rapidity and scope.
“The simultaneous downward pressure on equities, bonds and commodities placed immense pressure on risk parity funds and other multi asset investors which rely on low correlation between asset classes to contain risk and drawdowns”, JPMorgan’s Nikolaos Panigirtzoglou said, in a note dated March 20. “Instead, over the past week risk parity funds were hit on all of their asset holdings at the same time and were thus forced to de-lever”.
And you needn’t have been a quant to see the pain unfolding in real time. A quick look at a chart of a hypothetical S&P/TLT portfolio shows the “EKG” (as it were) going nuts.
“This is a liquidity crisis, so people sell everything; it is a classic ‘correlation = 1’ event”, Harley Bassman said Monday, in the e-mailed color accompanying his latest commentary, excerpts from which you can read here.
How big was the risk parity drawdown? Well, if you’ve followed my coverage (which draws heavily on McElligott’s granular models) you know the answer right down to the asset breakdown. But panning out a bit, JPMorgan’s Panigirtzoglou notes that through the end of last week, the forced deleveraging had “exacerbated the cumulative drawdown which reached 20% since mid-February”.
Given the severity of this “correlation = 1′ event”, and the fact that the writing was on the wall at least a week ahead of time, you can perhaps understand why China decided to ditch part of its risk parity portfolio.
According to Bloomberg, China Investment Corp. began trimming its positions “around March 10, and completed the move within a few days”.
Good timing. And you have to wonder if that may have played a role in some of what we saw across assets over the period mentioned above.
“As VIX went up to 80 and rate volatility doubled, risk parity funds have been likely forced to reduce the size of their positions by half or so”, JPMorgan said Friday. The bank assumes AUM of $150 billion (which excludes pension funds), 2x leverage and a 60% bond allocation. If that notional ($300 billion) is cut in half, the implication is that risk parity sold $90 billion in bonds, $30 billion in stocks and $30 billion in commodities.
“These are not huge numbers”, Panigirtzoglou writes, but reminds you that they “can have significant market impact in an environment of very low market depth and trading liquidity”.