Like many investing innovations, the risk-parity approach has its roots in the institutional world of pensions and endowments. The institutional pioneer was hedge-fund firm Bridgewater Associates, which launched its All Weather fund in 1996. Today, there are 14 risk-parity mutual funds.
Risk-parity mutual funds resemble balanced funds in some respects. A traditional balanced fund might allocate 60 % of its assets to stocks—to capture market appreciation—and 40% to bonds—to provide income and a cushion for market dips. The argument against traditional balanced funds is that, because stocks are more volatile than bonds, overall such funds are riskier than investors realize.
Risk parity funds, on the other hand, allocate their money based not on asset classes but on risk. Take Invesco's Balanced-Risk Allocation Fund, which has gathered nearly $14 billion of assets since its launch in 2009. The fund deploys its assets in order to equalize risk between stocks, bonds and commodities.
Risk-parity funds are complex. One way their managers equalize risk across asset classes is through the use of leverage and derivatives.
This is what Goldman, which last week downgraded the S&P 500 and Stoxx 600 to a “sell” citing the spike in risk of systematic leverage as one of the reasons for its bearishness, said about the sharp hit to risk-parity.
The bond sell-off since last week illustrates this: equity/bond correlations have increased sharply (Exhibit 4). This likely led to a day of very poor returns for traditional balanced funds and risk parity portfolios: the latter have likely suffered more, as the significant decline in equity volatility over the summer has likely led to increased equity allocations. Exhibit 4, which shows daily returns of a simple risk parity portfolio (using 3-month volatility to scale weights), suggests that they would have had a similarly bad day recently to during the ‘taper tantrum’, ‘Bund tantrum’ and the two China/commodities drawdowns (August 2015, December 2015). Performance pressures in the event of a pick-up in volatility and correlations could drive more de-risking from risk parity investors and vol target funds.
BofA’s Shyam Rajan released on Friday, the credit strategist explains why from being long US real rates, the bank switched to a real rate short last week; the primary reason: concern about risk parity exposure. Here is what he said:
One of the most talked about themes recently has been the impending unwind of levered risk parity portfolios. Our equity analysts estimate that the recent moves (bond and equity sell-off) could trigger as much as $50bn in bond selling from risk-parity type investors. While data on holdings is minimal, the influence of risk parity deleveraging on real rates is clear from Chart 4 and Chart 5.
Rajan then points out that as the correlation between equities and nominal bond yields turn negative, the risk parity community delevers, resulting in a sustained underperformance of real yields. While one can assume that this is because risk parity performance mirrors nominal bond yields, as BofA shows in the next chart, there is a compelling case that this is purely a real rate phenomenon.
the best indicator of just how [de]stressed risk-parity funds are, keep an eye on the performance of the world’s biggest hedge fund, Bridgewater, which suffered sharp losses during all previous instances when correlations across asset-classes soared, due to either VaR shocks or taper tantrums. Which brings us to the troubling question of the day: with nearly $200 billion in AUM, how soon until a sharp hit to Bridgewater’s risk-parity exposure “forces” Ray Dalio’s massive, and systematically important, fund to become the next “too big to fail” assured of a taxpayer bailout when "unthinkable" LTCM-type moment finally hits? Is The Latest Risk-Parity Blow Up Just Starting | Zero Hedge
BREAKING DOWN 'Risk Parity'
The risk parity approach to portfolio asset allocation focuses on the amount of risk in each component rather than the specific dollar amounts invested in each component. In other words, risk parity focuses not on the allocation of capital (like traditional allocation models), but on the allocation of risk. Risk parity considers four different components: equities, credit, interest rates and commodities, and attempts to spread risk evenly across the asset classes. The goal of risk parity investing is to earn the same level of return with less volatility and risk, or to realize better returns with an equal amount of risk and volatility (versus traditional asset allocation strategies).
A traditional 60/40 portfolio can attribute 80 to 90% of its risk allocation to equities. As a result, the portfolio's returns will be dependent upon the returns of the equity markets. Proponents of the risk parity strategy state that while the 60/40 approach performs well during bull markets and periods of economic growth, it tends to fail during bear markets and economic slumps. The risk parity approach attempts to balance the portfolio to perform well under a variety of economic and market conditions.
The first risk parity fund, the All Weather hedge fund, was introduced by Bridgewater Associates in 1996. Risk Parity Definition | Investopedia
For equity markets, the risk associated with risk parity funds is their programmatic nature and the sheer amount of levered capital allocated to the strategy which can result in substantial selling pressure when risk measures exceed pre-defined parameters. As BofA pointed out about a year ago, volatility swings in August 2015 likely resulted in $28 - $48 billion in equity selling pressure from risk parity funds alone resulting in a massive equity selloff that wiped out the YTD performance of a couple of prominent hedge funds.
Based on typical characteristics in many popular risk parity funds, we can assume vol control overlays with
target vols between 6% and 10% vol along with leverage caps from 1.5x to 3.0x. Under these assumptions, anywhere between 40% and 120% of unlevered assets under management could have been deleveraged last week.
A recently published report estimated the size of assets tracking risk parity at $400bn. Based on typical characteristics in many popular risk parity funds, we can assume vol control overlays with target vols between 6% and 10% vol along with leverage caps from 1.5x to 3.0x. Under these assumptions, anywhere between 40% and 120% of unlevered assets under management could have been deleveraged last week.
If we assume $200bn of the purported $400bn risk parity AUM uses vol control, then the above 40% to 120% range suggests that between $80bn and $240bn in levered risk parity notional could have been unwound over the prior week. With a 35/65 split between equities and fixed income, this would have translated to $28bn to $84bn of potential selling pressure in equities and $52bn to $156bn in fixed income.
Which brings us to last week's sharp sell-off in JGBs (chart 7), which in turn raised renewed concerns of forced selling by risk parity funds. Showing just how fragile these funds can be, BofA finds that a mere 2% daily decline in the S&P coupled with a 0.6% decline in the 10Y Treasury could trigger 25% deleveraging by risk parity funds. "Last Friday 10-Year US Treasury futures declined about 60bps. Had the S&P 500 declined 2.0%, we would have expected about 25% of the unlevered notional of a model 8% vol-targeted, 2.0x max leverage risk parity portfolio to deleverage. The S&P 500 was in fact up 86bps on a total return basis which according to the tool falls in the region of no deleveraging."
If BofA is correct, it would mean that a day which sees a -4% SPX drop and +1% bond rally (good diversification) would generate no selling pressure, "underscoring the critical role played by bond-equity correlation in governing the severity of risk parity unwinds." However, a troubling scenario is one where even a relatively benign 2% selloff of the S&P coupled with just a 1% selloff of the 10Y could result in up to 50% deleveraging, which in turn would accelerate further liquidations by other comparable funds, and lead to a self-fulfilling crash across asset classes.
Which incidentally sounds like precisely the scenario that could happen when the Fed tries to raise rates, and is also why asset classes continue to move without fear of any rate hike, as they now realize - very well - just how trapped the Fed truly is. That said, in 4 months we will see if the Fed, for once, has the intestinal fortitude to actually raise rates in the face of the extreme volatility awaiting equities in the event they do... we doubt it.
What's more, the strategist thinks that 'quantitative tightening' — or the sales of foreign, typically U.S. dollar denominated, holdings by central banks (notably China) in an attempt to support their domestic currencies, which were at the heart of the last shock to risk parity portfolios in the summer of 2015 — might be back.
"While the exact source of reserve sales is not clear, the [yuan's] cheapening post Brexit, its stickiness around the 6.70 level and the pickup in custody decline could be an indication Chinese sales of U.S. Treasuries have resumed," the strategist writes. "The continuing gradual unwind of reserve demand should be a headwind for real rates."
The ability of risk parity strategies — which typically rely on bonds moving in the opposite direction of stocks in order to appropriately diversify risk across the portfolio — to withstand the potential end of a multi-decade bull run in debt and simultaneous slump in equities has become a hot topic over the past year. The debate has been revived in recent months as analysts and investors fret over the ability of such systematic strategies to exacerbate swings in the market and worsen losses.
"Our equity analysts estimate that the recent moves — bond and equity sell-off — could trigger as much as $50-billion in bond selling from risk-parity type investors," writes Head of U.S. Rates Strategy Shyam Rajan in a note published on Thursday. "While data on holdings is minimal, the influence of risk parity deleveraging on real rates is clear."
A positive correlation between stocks and bonds during the 2016 rally contributed to the outperformance of risk parity portfolios, which at their basic level employ a long, levered position in bonds with a long position in stocks. But that also means this strategy has taken it on the chin as stocks and bonds sold off in unison on Friday, extending their declines, in aggregate, through the first three sessions of this week.
In a separate report, BofAML equity strategists said that the price action on Friday represented a shock "likely larger than Brexit for quant funds," and suggested massive systematic selling would ensue over the coming sessions.
Head of Global Rates and Currencies Research David Woo, has been pounding on the table that the potential for fiscal stimulus following the U.S. election — particularly if Donald Trump is elected — poses a huge threat to risk parity portfolios.
"However, a troubling scenario is one where even a relatively benign 2% selloff of the S&P coupled with just a 1% selloff of the 10Y could result in up to 50% deleveraging, which in turn would accelerate further liquidations by other comparable funds, and lead to a self-fulfilling crash across asset classes."
Are these one day amounts the 2% sell-off in the S&P and 1% in 10yr Notes?
I included my research helps others who are not familiar with risk parity funds.
Things like what it is, how and why it came into being, how it has prospered are all important to understanding when it will not prosper and when it will be unwound.
If one reads it and understands it one will understand that the high leverage involved and the mandated selling required under certain circumstances make these funds just as potentially catastrophic as LDO - the "weapons of financial mass destruction" Warren Buffet cautioned against in the Great Crash of 2007.
As the bonds have recently fallen hard - post election the equities have been on a Trump tear.
If one reads the research, one will see that without the Trump tear we could have already had a major crash.
Recent events - last two days: Chinese bonds are diving
and the Fed has raised interest rates for the first time in (7+ years).
To speak of the potential calamitous sea change as old news means you were not a trader (or observant trader) in the great crash of 2007.
Many articles and financial writers were warning of the housing bubble and the enormous crash to follow. (they wrote several months before the event). Fed intervention was the only thing that stopped the meltdown and not until Lehman was gone and Aetna (?) fallen from 70 to $2 and bail-out by the Fed as it bankruptcy would have brought down the entire financial system.
ZH compares this potential to the LTCM fiasco. LTCM would have brought down the entire financial system except for emergency intervention by the FED
There were warning signs several months prior to the collapses of:
program trading collapse of Black Monday Oct 1987 -august with Oct Meltdown
dotcom bubble 2000 ("it's different this time") - many writers up to 1 year in advance
the leveraged MBS housing bubble of 2007 - august with Oct peak and Jan meltdown - 5 months
No doubt you would have declared the warning eruptions of Mount Vesuvius as "old news" and been buried in the ashes. Small earthquakes started taking place on 20 August 79 becoming more frequent over the next four days, but the warnings were not recognized.[a]. On August 24, in the year AD 79, Vesuvius erupted in one of the most catastrophic and famous eruptions of all time.
(Mount Vesuvius as seen from the ruins of Pompeii, which was destroyed in the eruption of AD 79.
Thanks to Janet Yellen's rate-hike-hawkishness (but, but, but, we're still ultra-easy), global equity and debt markets lost over $1 trillion in value - the biggest weekly loss since early May (weak China data and huge surge in dollar).
Global bonds lost over $430 billion in market value this week (Yellen hawkishness and China bond carnage) but stocks lost even more ($525 billion) as China financial turmoil added to the world's woes (and "three rate hikes next year" and fiscal stimulus efficacy questions did not help).
Having retraced back to pre-Trump levels before The Fed statement this week, the combination of China turmoil and Janet's un-dovishness sent global stocks and bonds down over $1 trillion on the week - the worst week globally since May 2016 (when the dollar surged amid China weakness and slowing EU growth forecasts)
In fact, while US bank stockholders are ebullient at The Trump presidency-to-be, the rest of the world has lost a combined $1.5 trillion in market value across its bonds and stocks (thanks in major part to Janet's help this week).
and this January 2017 Earning`s period is going to be outright one of the worst we have seen since last January`s massive stock selloff. It is the difference between being able to use a selling algorithm program that gets a decent price for the closing of the position versus taking what the market gives you during selloff and gap down closing of positions where profits are annihilated in a very short timespan. Investors need to evaluate all of the parameters when making tax deferral decisions, and it isn`t as simple as they always mistakenly calculate when making these boneheaded simpleton calculations. No wonder they cannot outperform the market, you have to take profits into strength, not weakness when everybody and their brother is selling.
Why Investors continue to exhibit the same stupid patterns is beyond me, but the smart ones will be selling in the next two weeks to beat the carnage selling that occurs in January due to tax deferral selling, and reality setting in that no amount of Trump Magic can make these pig stocks earnings for the 4th quarter look good relative to the current stock prices. It is going to get ugly folks! January 2017 Earnings Is Going To Be a Bloodbath | Zero Hedge