(Bloomberg Business) — After decades of study Ray, Bob, Greg Jensen, Dan Bernstein and others at Bridgewater created an investment strategy structured to be indifferent to shifts in discounted economic conditions. Launched in 1996, All Weather was originally created for Rays trust assets. It is predicated on the notion that asset classes react in understandable ways based on the relationship of their cash flows to the economic environment. By balancing assets based on these structural characteristics the impact of economic surprises can be minimized.
Risk parity is all the rage right now, though not in the way you might think. In fact, the strategy may have just exacerbatedone of the largest selloffs ever as asset managers reduced leverage and rebalanced portfolios during recent swings in the markets, according to Bank of America Merrill Lynch.
But first somebackground.
Risk parity strategies, pioneered by the Bridgewater Associates hedge fund in the 1990s,seek to create “all-weather” diversified portfolios of assets including bonds, stocks and currencies — often adding leverage to fixed-income investments to boost their returns to stock-like levels.
While the assets in risk parity-related fundshave proliferated in recent years, causing someto question their safety and performance, it’s worth noting here that the danger is not necessarily in the strategies themselves but in the particular way they target, forecast and handle both volatility and leverage.
It’s a point brought home on Tuesday by Bank of America Merrill Lynch equity derivatives strategists, led byChintan Kotecha, who write that “Risk parity is not the risk, vol[atility] control is.” As they note, it’s worth differentiating between risk parity investors with a fixed amount of leverage, and those who tie the amount of leverage applied to their portfolios to market volatility. The latter begin life with atarget portfolio volatility level and then apply a certain amount of leverage to their portfolio based on theirforecast of future portfolio volatility. An easy example used by BofAML istwo timesleverage applied toa portfolio with a target volatility of 10 percent and expected to have a volatility of 5percent. Conversely, a portfolio with forecast volatility of 20 percent could achievea target volatility of 10 percent by deleveraging its portfolio to 0.5 times levered.
The assumptions are key here, and unfortunately the world of quantitative finance has a somewhat spotted history when it comes to forecastingthings like correlation and volatility. We know already that low levels of volatility and high correlations across asset classes over the past six years have encouraged many investors to load up on risk — both in terms of duration, leverage andcredit.
With volatility exploding from historically suppressed levels last week, it’s almost certain that some risk parity funds were forced to rebalance their portfolios, but the degree will depend on their particular volatility strategy.
Here’s BofAML:
If the leverage applied to risk parity is via target volatility, then the change incomponent allocations due to dynamically adjusting the portfolios leverage couldpotentially lead to a collective significant deleveraging of assets tracking risk parity.The amount of deleveraging will be a function of the funds target volatility andmaximum leverage allowed. But more significantly, the deleveraging will also be a functionof the prevailing volatility prior to the volatility spike and the magnitude of the daily moveswithin the volatility spike. There are a variety of different target volatility levels andleverage caps that are often applied by risk parity funds. Typically, they tend to target avolatility level between 6percentto 10 percentwith maximum leverage ranging from 1.5x to 3.0x.
Regardless of the target volatility and max leverage limits within a risk parity fund, however, the recent and unusually violent spike in equity volatility from depressed levels… alongside a relatively muted diversification benefit from fixed income …led to a significant spike in the volatility of, and likely a subsequent deleveraging from, some risk parity strategies.
In Charts 7 through 9, we aim to show the sensitivity of the deleveraging of target volatility funds as a function of (a) the funds target volatility, (b) the maximum leverage allowed, (c) the prevailing level of the funds unlevered volatility prior to a spike in vol, and (d) the drawdown in the unlevered fund. Each chart assumes a different level of the funds unlevered prevailing volatility prior to a vol spike and we use 8%, 6%, and 4% respectively.
By BofAML’s estimates, based on a samplerisk parity fund with 10percenttarget volatility andmaximum leverage of two times,last week’s market eventscould have been massively and historically painful.
In this hypothetical example the current deleveragingwould be the 7th largest (Table 3) but could be the most impactful on markets given thegrowth in assets tracking risk parity in recent years.
But there are several assumptions that underpin that claim, not least the funds’ own assumptions and expectations of market volatility. On the plus side, it’s not at all clear that all risk parity funds are using target volatilityto create leverage. On the downside, there are non-risk parity funds that mayhave been using similar volatility overlay strategies.
Overall, BofAML estimates that last week could have seen $30 billion to $80billion of stock selling fromrisk parity funds plus$25 billion to $50billionfrom non-risk parity vol players who had to retool their portfolios thanks to market swings.
Still, the BofAML analysts — unlike some of their compatriots at other banks– remain pretty optimistic, that the summer storm for all-weather funds is over.
The critical assumption embedded in all of these estimates is that the funds in question operate mechanically and are forced to deleverage relatively rapidly, almost agnostic to market impact. While this is certainly true of some funds, and while vol target funds as a whole may rebalance more frequently than risk parity funds, many managers can and do exercise discretion to smooth out their rebalancing. While some have advised remaining on high alert over the coming weeks for the impact of further programmatic deleveraging flows, we believe the risks are in fact much reduced. Funds that operate mechanically with quick triggers have likely already delevered meaningfully, and coupled with now-elevated volatility levels, a secondary shock would necessitate materially less model-driven selling.
Fingers crossed.
To contact the author of this story: Tracy Alloway in New York at talloway@bloomberg.net To contact the editor responsible for this story: Timothy Coulter at tcoulter@bloomberg.net
