A lot has been said this week about the rise of volatility in markets and its causes; not just equities, but bonds, currencies and commodities. For months, at MitonOptimal client presentations, we have been saying that the only cheap asset class in town was volatility. Well not anymore, as one of the “blame” candidates appears to be risk parity funds (RP or RIP funds).
On August 23rd, Alliance Bernstein – a very large US asset manager – warned that the swelling popularity of an investment strategy, known as ‘risk parity’, is exacerbating the fragility of financial markets and worsening sell-offs. So called ‘risk parity’ is a next generation passive strategy – originally pioneered by Bridgewater, the world’s largest hedge fund group – that seeks to give equity-like returns, whilst providing the relative stability of bonds in a crisis.
The executive summary is that RP funds typically invest in a basket of stocks, bonds and commodities, but leverage the traditionally safer fixed income bond bets through derivatives, to ensure each asset class contributes equally to the portfolio. Ideally, the “juiced up” bond positions will help in a stock slide.
A recent Alliance Bernstein report, as reported in the Financial Times, concluded that RP funds could possibly control US$400 billion of client funds and, when leveraged to embrace the strategy, could climb to US$1.4 trillion of assets. For this to work, one needs a low cost of leverage, low volatility and modest correlations between the different markets over time.
When turbulence strikes, RP funds sell assets to reduce short term volatility targets, but if large enough, it could intensify sell offs. Should correlations turn positive, with stocks and bonds declining at the same time, the risk contributions of each one would rise and affect a ‘double whammy’. What is fundamentally a sound idea, that has benefited from falling volatility and falling bond yields, is however not a magic bullet or the Holy Grail.
We are entering a period of increasing volatility and eventually bond yields will rise. Whilst our research shows correlations may remain more consistent over the longer term, in the short term it can all potentially head to 1:1.
Risk parity has had a cruel northern hemisphere summer, suffering four consecutive negative months. As the RP funds de-leverage and clients redeem, potentially causing even more de-leveraging, this could undoubtedly cause further volatility in markets, due to their US$1.4 trillion size. This week, everyone is blaming RP funds for increased volatility. As one stockbroker put it, whilst stocks are cheaper today “there just aren’t enough human buyers in the market to generate enough buy orders“.
RIP Funds
