Photographer: Michael Nagle/Bloomberg

A Sell-Off Pressure 'Larger Than Brexit' Imperils One of Wall Street's Hottest Trades

Danger for volatility-targeting portfolios such as risk-parity funds.

The synchronized slide in global markets is set to unleash a wave of forced deleveraging in the coming days among volatility-targeting portfolios, such as risk-parity funds, that might exacerbate the market sell-off, say analysts.

Volatility-targeting investment strategies — such as risk parity funds which, put simply, take a long, levered position in U.S. Treasuries in tandem with a long position in stocks — have become hugely popular this year as loose monetary policies buoyed bonds and stocks while suppressing volatility.

Now, there's a perfect storm brewing: spiking asset-class correlations and market volatility mean a slew of quantitative-driven funds are now vulnerable to selling pressure.

Equity analysts at Bank of America Corp., led by Chintan Kotecha, estimate that systematic portfolios (with volatility-targets) might be subject to $12 billion in global equity selling pressure in the days ahead. The analysts also foresee $40 billion of near-term selling pressure among trend-following, volatility-targeting Commodity Trading Advisors (CTAs) funds. Friday's sell-off, therefore, represented a shock "likely larger than Brexit for quant funds", the analysts write, citing selling pressures triggered by the abrupt increase in the price gyrations of global bonds and stocks. 

Core risk-parity funds are long-only and seek to outperform the typical funds with a 60/40 split between equities and bonds, while CTAs can assume both long and short positions for either asset class. Though such funds have varying benchmarks, structures and targets, the pressures faced by multi-asset quantitative funds are similar, given their typical focus on volatility-targeting. (Nevertheless, some risk parity funds target other portfolio risks other than volatility levels.) 

The sell-off pressures are particularly strong because of market dynamics that existed before Friday's slide.  

The prolonged period of low volatility this year, amid rising U.S. equity prices, triggered a clutch of quantitative-focused funds to lever up and assume long positions, analysts say. What's more, long positioning is at elevated levels among trend-following managed futures funds that have loaded up on volatility-targeting strategies.

"If volatility spikes in an asset, leverage will need to be lower in order to stay close to the volatility target," says Saeed Amen, founder of macro advisory firm Cuemacro. "When there's a risk event, volatility tends to spike, hence, you get an element of forced selling to meet volatility targets. You can also see something similar, when traders breach their value-at-risk (VAR) limits, and there's forced selling."

Three-month correlation between the S&P 500 and 10-year U.S. Treasury bond prices set its year-to-date low on the Monday post-Brexit vote at -0.66, analysts at Bank of America calculate. "As a result, risk parity-style portfolios likely fared well through Brexit as sharp moves lower in global equities were diversified by the strong performance in bonds."

Now, the correlation has turned to a positive 0.27, which implies there are fewer diversification opportunities for risk-parity-style funds to outperform, which the BofA analysts say is a precursor to higher market volatility as the funds adjust their positioning, 

Bank of America Corp

Nordea Bank AB analyst Martin Enlund reckons a jump in Japanese government bond yields have triggered ripples across portfolios. "Yes, it's a VAR shock or a risk-parity blow-out, or whatever you call it. This dynamic means that correlations can shift very quickly, catching some funds off guard."

Equity markets will disproportionately endure the selling pressure because fixed-income has been less volatile than its counterpart, implying funds have a greater mechanistic obligation to sell stocks, Cuemacro's Amen says.

However, the selling pressure could still have a noticeable impact on bond markets, according to analysts at Citigroup Inc., who note that risk parity funds are more levered than levels seen in August 2015 — just before market volatility reduced the allure of the investment strategy.

"Last year deleveraging coincided with a flight to quality on the back of worries about China economy and a sell-off in commodities," the Citi analysts, led by Jabaz Mathai, wrote on Friday. "The net impact on rates was muted as a result. In contrast, deleveraging due to perceived removal of monetary accommodation should amplify the initial sell-off in rates. We would expect the price impact on rates to be greater relative to last year in this scenario."

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Citigroup Inc.

Even if markets stabilize, there's a political risk for risk-parity funds too, according to Bank of America Merrill Lynch Head of Global Rates and Currencies Research David Woo. On Bloomberg TV today, Woo said the investment approach would be threatened under a Trump presidency since the latter has committed to fiscal stimulus policies that would trigger a sell-off in U.S. Treasuries.