Risk Parity Drawdown Among Largest Ever, Goldman Says

Risk parity strategies are currently witnessing one of the largest drawdowns in 40 years.

For those steeped in the market zeitgeist, that goes without saying, but it certainly bears repeating. So, I’ll repeat it. Verbatim, actually, by recycling some language from a March article.

Time and again over the past 12 months, I mused about the ramifications for multi-asset portfolios in an environment of rising inflation. Returns seemed destined to be lower, at best. If inflation persisted, IG fixed income would suffer, as would long-duration equities which dominate US benchmarks.

After a 40-year bull market, government bonds were surely a bubble, and various distortions brought about by trillions in central bank intervention raised the odds of disorderly price action. The read-through: Not only could bonds become a source of risk, they might also increase portfolio volatility. As Macro Risk Advisors’ Dean Curnutt put it, “the risk-free asset is itself the sponsor of the event, forcing equity markets to reconsider assumptions used to discount cash flows and sometimes creating a VaR shock.”

That VaR shock is here, and the simultaneous selloff in stocks and bonds is a nightmare two decades in the making. The idea that a balanced portfolio (wherein IG bonds hedged the equity risk) was akin to a foolproof strategy rested on the assumption that the stock-bond correlation would be negative most of the time. And it was for nearly 20 years. But nothing lasts forever.

As the figure (below) shows, the implied losses have almost no historical precedent.

“With rates rising on the back of hawkish policy and inflationary concerns rather than better growth, equities have been selling off alongside bonds, triggering a ‘Balanced Bear,'” Goldman’s Cecilia Mariotti and Christian Mueller-Glissmann said, noting that “this has particularly weighed on risk parity strategies.”

Notably, the sheer magnitude of the bond rout suggests risk parity would’ve underperformed a portfolio comprised of all equities since the lows hit during the initial pandemic selloff (figure on the left, below).

As you can see, the implied shortfall versus US stocks is particularly pronounced.

The figure on the right (above) underscores the scope of recent de-risking by target vol / vol-sensitive cohorts. “The allocation to equities of a levered risk parity strategy is close to one of the lowest levels on record,” Goldman’s Mariotti went on to write.

So, what does one do when everything sells off simultaneously? Well, there’s not a lot you can do during some sessions. On Monday, for example, nearly everything that wasn’t the US dollar was lower.

But, if you’re not ready to completely resign yourself to strict capital preservation mode, Goldman reiterated that “real assets such as commodities, energy equities and infrastructure” may be good diversifiers for multi-asset investors given onerous inflation realities.

Ultimately, though, the bank struck a cautious tone. Although a recession still isn’t Goldman’s base case, Mariotti noted that markets are increasingly disposed to pricing “somewhat above-average” odds of a downturn. Given that, some investors may want to “reduce tail risk in portfolios.”