A Warning That the Biggest Risk for Markets Could Be Too Much HarmonyBy
Risk parity funds are crowded and in danger of selling: Brean
Quant input of stock-bond correlation sits near two-year low
How will the world end? Not in quakes of discord, but with an excess of harmony.
That’s the new take on how the quantitative strategy called risk parity will collapse the financial system, as its multitude of bets start moving as one. Apocalyptic predictions tied to the investment programs are popular -- billionaire hedge fund manager Paul Tudor Jones warned they’ll be “the hammer on the downside” when markets are laid low.
Briefly: risk-parity funds operate simultaneously in a bunch of different asset classes, weighting their stakes in each according to volatility. If one category of holdings swings around a lot, like stocks, it gets a smaller slice, while quieter bonds get a bigger one. Diversification like this is supposed to balance influences.
Theories have abounded for years that because volatility itself is a sell signal for the levered investment vehicles, sudden bouts of price turbulence pose a latent risk that will one day ignite torrents of selling and melt markets. To date, there’s been plenty of turbulence, but not so many meltdowns.
Undaunted, critics are trotting out a new theory on what the future holds.
Turns out, a bigger threat than volatility to the strategy is cross-asset correlation, the possibility that assets like stocks and bonds start to move in unison. When that happens, diversification-minded risk parity algorithms will sense a threat and start to deleverage, says Brean Capital LLC’s Peter Tchir. Markets may be charting healthily independent courses for now. But if and when that changes, look out, his theory holds.
“The biggest risk, as I see it, isn’t that volatility increases – it is that the correlation between Treasuries and stocks increases (they move in the same direction),” wrote Tchir in a note to clients Wednesday. “That shift would have the largest impact on returns and need to reduce position size for these strategies.”
Plenty of managers say correlation risk is overblown. It’s a much smaller input into the programs’ investment decisions than volatility, they say. Most risk-parity funds use a long-term measure of concerted movement, and any sudden change wouldn’t cause significant deleveraging, said Roberto Croce, managing director of quantitative strategies at Salient Partners LP.
“Because our forecasts for correlation move much more slowly than for volatility, the rate at which changes in these things show up in the portfolio is radically different,” said Croce. “If the market is more volatile for several days, we may sell some of our exposure. But if correlations rise, it will have almost zero short term implications for our holdings.”
A risk parity fund might use a year-long measure for correlation, since shorter-term indicators are noisy and impossible to act on, said Croce. The correlation between the price of the Bloomberg Barclays Global Aggregate Bond Index and the S&P 500 over the past 250 days is negative 0.66, a moderately strong inverse correlation, and the most negative in nearly two years.
Should the negative relationship between stocks and bonds begin to wear off and their correlation rise to as little as 0.1, a hypothetical risk parity portfolio of just those two assets would cut its leverage by 87 percent, according to Salient estimates. That compares to a 120 percent reduction should volatility measures double.
If Tchir’s concern is valid, similar acting risk-parity strategies would have to be backed by large sums of money to exert any significant market impact.
“I think risk parity, always an important strategy, has become one of the dominant strategies out there,” Tchir said. “In fact, I think risk parity in all its forms is a very crowded trade.”
Weirdly, nobody’s totally sure how big risk-parity is. Estimates vary from as much as $150 billion to $500 billion. AQR Capital Management, one of the biggest practitioners, says the automated strategies simply aren’t big enough to overwhelm the $27 trillion U.S. equity market.
“There are scenarios in which risk parity funds sell equities, but the possible magnitude of that is very small,” Michael Mendelson, a risk-parity portfolio manager at AQR, said last month in response to Jones’s criticism. “Some reports have grossly exaggerated the potential impact.”