Now They're Blaming Another Strategy

Did a strategic cousin of short volatility cause the market to decline?

The Wall Street Journal wrote about risk parity as being a contributor to the declines in equities. The simple version to explain risk parity is that it balances out asset weightings by risk such that it is common to own a little bit in equities and a lot in fixed income to the extent of leveraging up the fixed income exposure to balance the equity risk. There's more to it but that is a pretty good building block of understanding.

Ray Dalio from hedge fund giant Bridgewater is a practitioner of risk parity as is AQR, the investment firm run by Cliff Asness. The way the Journal tells it, all (many?) of the risk parity funds look at the same indicators and sell at the same time and there is enough money in the strategy to move the market. Where the focus a few days ago was on short volatility trades/strategies causing the decline, it might be right to think of risk parity, something that weights exposures by their volatility as being a distant cousin to the short volatility trade.

AQR has a risk parity mutual fund as follows;

It is not an equity proxy, it is an alternative strategy. Since its inception in late 2010 (per Morningstar) it is up about 50%, trailing far behind the S&P 500 but the period captured in the above chart was at a time of heavy market turbulence and sets a reasonable expectation that the fund is capable of a result with little correlation to equities. Like other risk parity pools, AQRIX is a levered fund.

Continuing with the theme of the week, risk parity is clearly a sophisticated strategy, but I don't think it is that complicated. In describing AQRIX, I think Cliff Asness would say there is more to it than how I described it above but not that much more. Please leave a comment if you have a different view. So it is sophisticated and has some track record for a low correlation to equities which comes in handy in periods like now, so does it make sense to use it in the context we've been talking about lately; bear market protection?

Where we talked about trying to spot risk factors before they matter, like from yesterday's post about LJMIX appearing to blow up due to selling puts, the leverage in risk parity is a risk factor. People misuse leverage all the time. A strategy with a lot of leverage is at risk of blowing up in spectacular fashion. That is not a prediction and any given risk parity manager could trade around some sort of blow up. But to the Journal's point, if they are correct, then someone managing a large risk parity pool could do something that creates a butterfly effect that gets magnified because of the leverage.

Layer on top of that, interest rates are not at all time lows but very low by historical standards. A rise in rates could be disastrous for the levered bond position that is common to risk parity. Again a given manager could trade around a spike in rates but higher rates are an obvious risk factor.

Maybe those factors will never matter, I don't know, but I don't want client money on the line to find out,