It's like an Agatha Christie story: the crime is obvious and the culprit appears to be too. But the great detective reveals that someone else is to blame.
Stocks have been murdered, and China seems to have been caught red-handed. But Leon Cooperman, Marko Kolanovic and other financial luminaries are pointing to a surprising defendant: the risk-parity strategy pioneered by Ray Dalio, founder of the hedge fund firm Bridgewater Associates, some form of which now guides trillions of dollars. Who's guilty? And what's next?
Risk parity seeks to equalize the risks that each asset class in a portfolio contributes to an overall risk budget. For example, in a simple 60/40 portfolio, equities are, historically speaking, the much riskier asset class. So if you lever up the fixed income side, its risks are magnified so that stocks contribute 50% of the risk and the leveraged bond portfolio does too. In a five-asset class portfolio, after leveraging appropriately, each of the five would contribute 20% of the overall risk.
It's worked well, not least because it has naturally ratcheted up fixed income returns during the seemingly perpetual bond rally. The whole idea has a natural appeal. After all, equalizing risks across the board resonates with a common-sense understanding of “diversification.”
So how could this innocuous, even wholesome sounding, approach become an anti-hero of the recent nastiness? Well, to understand that, you have to remember that risk parity, modern portfolio theory and almost all current investing formulas and performance metrics depend on two critical, related ideas. First, “risk” and “volatility” are the same thing and second, recent volatility tells you how “risky” an asset is going forward.
From this point of view, on the evening of the day in which stocks take a hit, they are riskier than they were that morning. So they suddenly are contributing an outsized, and unwanted, percentage to the portfolio's overall future risk.
So a drop in stocks would typically trigger some stock sales, but the peculiar nature of recent events puts those sales on steroids (says the prosecution). In previous stock selloffs, bonds have risen — diminishing cross-asset correlations and keeping the overall risk budget in line. Tinkering was needed, but no major sales, and no major de-leveraging, resulted.
This time has been different.
China — and the emerging markets world generally — rudely interrupted the parity dinner party. As its own market tanked, and its currency, the yuan, came under more pressure than it intended, China needed to raise cash to support both. So it did what other EM countries have been forced to do as commodity prices sank: sold their most liquid assets, including U.S. Treasuries. And all this selling pressure offset the buying of Treasuries that we normally see in sudden stock swoons.
As a result, bonds barely budged when stocks tanked. Correlations among asset classes increased as volatility rose. Risk-parity portfolios measured themselves as much riskier.
So to reduce that risk, and keep things balanced, the formulas flashed: sell stocks.
CHASING ITS TAIL
And because these strategies have gotten so big, that caused the risk parity dog to chase its tail. Market declines make stocks riskier; which means more selling, which means… you know. (For those of you old enough to recall “portfolio insurance,” this just might sound familiar.)
Mr. Kolanovic deserves much credit, for he predicted this cycle immediately before it commenced instead of just pointing fingers afterward. Unfortunately, he has some more bad news.
As he sees it, the key volatility-centric strategies can be divided into three major groups: volatility targeting (vaguely, a really faster form of risk parity); traditional risk parity; and trend following CTAs. These distinctions matter because the groups rebalance risk on different time cycles. Mr. Kolanovic believes only a portion of the selling the formulas demand has occurred … and that another $100 billion is on the way.
By itself, that's not an unmanageable number, of course but it's plenty big enough to stoke a further leg down in combination with other factors, like huge margin debt levels and a helping push from high-frequency traders. And if there is another big tumble, our friendly spinning dog will be re-energized.
Of course, many things could reverse these dynamics, like a sudden announcement from the Fed that no hike is coming. Or another big central bank move (although the European Central Bank's recent dovish signals earned a yawn). And if the selling just slowly peters out, at some point these same strategies will decide that stocks are “less risky” again, and start buying.
But in the meantime, we're looking at a costly irony: volatility caused by volatility management.
Bob Rice is chief investment strategist at Tangent Capital.