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Summary Various people from both the sell- and buy-sides have blamed risk parity funds as well as trend-following CTAs and certain “smart beta” practitioners for recent market volatility. While these techniques certainly could contribute to volatility in crisis periods — there are few investment techniques that couldn’t — to single them out is misleading and self-serving. Risk parity has its place in the markets, and its place may well be increasing, as investors understand it better. But it still is not fully tested. In particular, how it behaves in crisis situations is not fully understood. Its behavior over the last few weeks has, however, been reassuring. There is mounting and quite vocal criticism of risk parity and other investment techniques that seem to display option-like sensitivity to changes in market volatility. The argument against them is that, in certain conditions they can destabilize the market: as volatility increases, they may respond by trading in ways that increase volatility further. While this accusation may not be entirely unfair, this characteristic is hardly unique to these funds, and it is unreasonable to single out these investors for recent market volatility. Feedback loops between volatility and selling pressure have been built into many aspects of modern markets as well as human nature. The contribution of risk parity and similar products to the recent spasm of market volatility was not even a fraction of the tip of the iceberg. Without further investigation, this might have been ascertained simply by looking at risk parity AUM. In addition to somewhere between $400 and 600 billion in worldwide institutional assets managed according to risk parity principles, there are a handful of publicly-available mutual funds practicing variants of this technique, none of them very large. These include Salient Risk Parity Fund ( SRPAX ), Putnam Dynamic Risk Allocation Fund ( PDRFX ), AMG FQ Global Risk-Balances Fund ( MMAFX ), Invesco Balanced Risk Allocation Fund ( ABRZX ), and Columbia Active Risk Allocation Fund ( CRAAX ) and the AQR Risk Parity Fund ( AQRIX ). Background There are numerous bells and whistles that can be incorporated with risk parity techniques, so that the concept has become rather diffuse and easily slips over into “smart beta.” The basic idea grew out of dissatisfaction with the standard, mean variance optimization approach to portfolio construction, with its paraphernalia of efficient frontiers, etc . The objection was simple: optimization relies on return forecasts that are rarely realized by actual asset class behavior, and it tends to craft portfolios in which the most volatile asset class ─ typically the equity component ─ accounts for the overwhelming majority of their volatility. This suggests that diversification according to the standard formula is doing little to mitigate risk. Since it is precisely the returns on the most volatile component that have most consistently confounded forecasters, proponents of risk parity argue that mean variance optimization has led consultants, trustees and CIOs astray. They claim that portfolios with more consistent performance can be constructed by targeting volatility rather than targeting forecast returns. Assumptions must still be made about future standard deviations and coefficients of correlation among assets, but at least the shakiest assumptions, about returns, can be eliminated. In its simplest implementation in a two asset portfolio, this insight would drastically reduce equity exposure and substantially boost fixed income holdings compared to the rule-of-thumb 60/40 portfolio: to contribute the same level of volatility to the portfolio as fixed income holdings, equity exposure would have to be cut back to about 24%. Without leveraging the portfolio, however, in most circumstances this implementation would also produce drastically reduced returns and would attract few buyers. Naturally, things become more complicated as more assets are included in the mix, but the principal remains essentially the same: each component is weighted and if necessary leveraged so that it contributes the same amount of volatility as each of the other components. If expected returns for a targeted level of volatility are not satisfactory, performance is boosted not by overweighting the riskier assets, but by including more risky asset classes or leveraging the less volatile ones, for instance through the futures market. Thus risk parity portfolios often include commodities and real estate as well as equities, and are typically leveraged 1.5x to 3.0x. The example shown below on the left is unleveraged, which accounts for its somewhat lower expected returns than the example of mean variance optimization on the right. (click to enlarge) There is no agreement among risk parity practitioners as to how return objectives should be set, and consequently, what the “appropriate” level of portfolio leverage is. This is hardly surprising: any such decision is completely exogenous to the theory, as it should be . Theory is getting into dangerous territory when it attempts to dictate investors’ risk tolerances. It is clear, however, that reasonable leverage of the less volatile components of this sample portfolio could raise its projected returns to the levels expected of the portfolio on the right. The Root of Recent Criticism Obviously, a proposal as radical as risk parity has attracted considerable criticism from virtually all sides ─ after all, it rejects most of the basis of Modern Portfolio Theory, dating back to 1952 and enshrined in all finance curricula. It is not my intention to review these criticisms, which is far too technical an undertaking for a short article, and many of them are unpleasantly contentious or self-serving. Rather, I confine myself to discussing the recent criticisms offered by Chintan Kotecha and Marko Kolanovic, sell-side analysts at Merrill Lynch and J.P. Morgan respectively, as well as some investors, including the well-known hedge fund manager Lee Cooperman of Omega Advisors. Their criticism has been given wide currency through the attention they have attracted in The Financial Times , Barron’s , Bloomberg , the Wall Street Journal and elsewhere. The issue involves rebalancing in crisis conditions. If the volatility of one asset class included in a risk parity or similar portfolio suddenly jumps, while that of the others remains more or less as before, this will inevitably trigger sales to rebalance the portfolio. The critics argue that these sales are destabilizing for the asset that is already suffering from heightened volatility. The implicit warning is that further increases in assets managed according to risk parity principles, in addition to those managed according to trend-following and some (but not all) “smart beta” strategies, could result in a death spiral of rebalancing giving rise to liquidations, which raise volatility, catalyzing further liquidations which in turn raise volatility and so on. The critics claim to have seen evidence of precisely this sort of behavior during the recent market drama; Mr. Cooperman goes so far as to blame some of his fund’s weak August performance on it. Otherwise, it would be difficult to see why this alleged problem should so suddenly crop up as an issue. After all, trend-following strategies are at least as old as Dow Theory, and I have found evidence for them in Dutch trading practices in the first half of the seventeenth century. While the commissars of MPT orthodoxy were never able completely to stamp out technical analysis and similar heresies, they drove them into narrow and secretive corners, out of sight of polite society for most of a generation. A few firms, such as Merrill Lynch, even continued to employ technicians in their research departments. Their return to respectability is something comparatively new to equity markets, developing gradually since the introduction of equity index futures in 1982 attracted people who had never had much use for portfolio theory (after all, Fisher Black did not believe that commodities are investments) into the equity community. The modern instantiation of trend following as algorithmic trading strategies is only a difference in degree rather than in kind from the days of eyeshades, sleeve garters and three New York baseball teams. “Smart beta” is an even more amorphous concept than risk parity, embracing portfolio construction techniques from equal weighting to fundamental indexing (for detailed discussion see this article ). However, the critics are presumably directing their fire toward those strategies which focus their efforts on maximizing a portfolio’s Sharpe Ratio. Since the denominator of the Sharpe Ratio is standard deviation, the sensitivity of such approaches to changes in volatility is obvious. Even though they may differ significantly from risk parity strategies, they share the need to rebalance if heightened volatility manifests itself in one portion of the portfolio but not the rest. Analysis of the Criticism The critics have, in fact been rather equivocal in their criticism: they do not make it clear what asset allegedly suffered from a feedback loop between its volatility and sales, nor do they make it clear when this allegedly occurred. Detailed data on the trading of the recently most volatile assets of all, Chinese ‘A’ shares, is unavailable. But surely some of the attempt to rebalance risk parity portfolios must have occurred in U.S. markets. And since there are claims that such sales affected other funds’ August performance, some of must have occurred while volatility was particularly high and markets most vulnerable to forced sales. The August spike in volatility was certainly dramatic, but it was by no means a record, nor has volatility remained at highly elevated levels as it did in 2008/9, 2010 and 2011/2. Coming as it did after an extended period of relative market quiescence, however, the return of volatility came as a considerable shock, for which many investors were unprepared. (click to enlarge) The VIX peaked at 40.74 on August 24th. At what point the alleged forced selling due to rising volatility occurred is unclear, since no one except their managers knows the details of risk parity funds’ rebalancing protocols. Some of the critics’ comments imply that these sales may not even have occurred yet, two weeks after that peak, although this begins to look implausible. In any case, the behavior of that portion of U.S. volume reflected in NYSE statistics, while reflecting the usual sharp increase in trading that accompanies a volatility event, does not suggest an abrupt, destabilizing flood of selling: Average Value of Transactions % Change in NYSE Volume % Change in SPY ETF Volume 8/14/2015 $8,739 8/15/2015 $8,863 3% 9% 8/18/2015 $8,511 0% -9% 8/19/2015 $8,370 22% 141% 8/20/2015 $8,677 9% 12% 8/21/2015 $9,599 41% 78% 8/24/2015 $7,937 26% 46% 8/25/2015 $8,332 -23% -27% 8/26/2015 $7,754 4% -8% 8/27/2015 $8,056 -5% -19% 8/28/2015 $8,158 -20% -41% 8/31/2015 $8,937 5% 2% sources: NYSE, State Street Granted, it is not clear to me how a flood of volatility-induced selling is to be distinguished from rising volatility as a result of a flood of selling. But the evidence I can see for U.S. stocks does not suggest that, this time around, things were notably different from what has occurred during other sudden bouts of heavy selling. The decline in the size of the average trade on the day of maximum volatility suggests that the selling pressure was not, or at least not entirely institutional. This view is reinforced by changes in the trading activity of the SPDR S&P 500 Spider ETF (NYSEArca: SPY ), which of course attracts a great deal of retail attention. The critics do not mention this, but volatility-induced ETF liquidation is likely to be at least as destabilizing as the behavior of the trading strategies with which they are at pains to find fault. And without the aid of algorithms it is as likely to result in a toxic feedback loop, as dropping prices encourage panicky holders to sell, pushing prices down further. During the period shown in the chart above, SPY suffered $10.2 billion in net redemptions ─ and that was just from a single ETF, albeit the world’s largest. Other ETFs, and some conventional mutual funds, had similar experiences. Different risk parity, “smart beta” and trend-following CTAs are each likely to handle portfolio rebalancing in different ways. Some may even apply judgment to the problem: Salient says that its portfolio management “…attempts to capitalize on momentum…” which it does through algorithms, but this suggests an overlay on the rebalancing signals it receives. More explicitly, AQR notes that it reserves for itself “…the ability to exploit tactical opportunities by making modest adjustments, or “tilts,” toward assets that we believe are relatively attractive…,” a practice that might even involve human beings. However, second-guessing can create difficulties of its own ─ as a systematic investor once remarked to me, “If I ignore the machine, from where will I receive the signal to pay attention to it again?” It is likely that all these sorts of investors build some measure of tolerance for changes in relative asset volatilities into their thinking, if only to keep transaction costs in check. A few, such as Columbia, engage in periodic rebalancing ─ once a month, in its case ─ rather than responding immediately to every observed change in volatility. How the critics purport to disentangle these threads is unclear to me ─ I frankly doubt that they can. And if volatility-induced selling only occurs well after the maximum volatility event, it is unclear to me how it can be especially destabilizing. Conclusions, Cautions, and a Thought from Lord Byron I am always willing to bow to contrary evidence, but I have seen none that really suggests that risk parity, either on its own or in combination with trend-followers and “smart beta” aficionados, is any more responsible for recent equity market volatility than other instruments that, in a crisis, are likely to be forced to sell portions of their portfolios. Mr. Cooperman in particular should be aware that restrictions that Chinese authorities imposed on sellers may have forced some of his hedge fund brethren to sell elsewhere, simply in order to meet margin requirements. And I am not aware of any touchstone by which a forced sale can reliably be identified as such from outside the premises of the seller. The unfortunate truth is that panicky human beings are quite able to destabilize the markets without help from machines ─ they have managed to do so since markets were first invented, and doubtless will continue to do so. Risk parity, trend-following and “smart beta” have attracted criticism because they are easy targets: generally misunderstood if they are known at all, mysteriously computer-driven and, worst of all, associated with hedge funds. Risk parity is the brainchild of Bridgewater Associates, the largest hedge fund of all. Since the Crash, populists have ensured that anything that they feel requires discrediting need only be associated with any one of these bogeymen. Stock-pickers such as Mr. Cooperman feel unappreciated, after a long period during which their undoubted talents have gone comparatively unrewarded. And they have a right to object to the fact that markets have been so unrewarding for them, if not perhaps to feel bitter. The markets depend on them: if fundamental values are not ultimately recognized, there is no rational basis for investment at all. But as Keynes noted, macro conditions can swamp the influence of security-specific fundamentals over surprisingly long periods of time, and that has been our unfortunate situation for most of the period since the Crash. Global fiscal irresponsibility, regulatory overstretch, mounting social and military tension, ever more imaginative monetary experimentalism and a host of other issues: why should investors be surprised that their investments have tended to react more to the exogenous market environment than to their own fundamentals? Yet this cannot last forever: fundamentals will out, even if it is a matter of a company surviving Fall of Rome conditions when hundreds of others fail to. Before the China crisis broke out there were signs that the returns to stock-picking were increasing relative to macro trading strategies. I believe that China is merely an interruption in, rather than the death-knell for the recovery of fundamentally-based investment strategies. Not the least of the gifts that recent market volatility has given us is a general reduction in valuations. Judicious picking among them, rather than frantic trading in and out of risk, is the way forward for investors. Which may include risk parity investors. The technique is a method for allocating among various asset classes, and for heuristic purposes is usually discussed in terms of indices for each asset class, but that does not mean that it actually requires a passive investment approach within any given asset class. Asset allocators can be stock-pickers, too, and in fact few of them, in normal conditions, are very active traders. The Putnam Dynamic Risk Allocation Fund provides an example of an active investment implementation of something resembling risk parity, while Salient, AQR, AMG, Invesco focus their portfolios primarily on derivatives, and Columbia combines derivatives with a fund of funds approach. Of all these managers, Sapient and AQR have the “purest” approach to risk parity, which would cause me to favor their funds over the others, all of which apply various tweaks and twists to the basic risk parity insight. But AQR is not accepting new investors, and of course, they and Salient will both miss out on any alpha to be obtained from stock-picking. I think a dose of risk parity or similar “smart beta” strategies will benefit most portfolios, although I would take a wait-and-see attitude toward total conversion of a portfolio to these techniques. The criticisms, however tendentious, indicate a real, if only potential problem for such strategies, and I would like more evidence on how they behave during crises before committing the entire portfolio to them. My preference for a “pure” approach to risk parity is in the spirit of empirical investigation: I want to learn more about how the strategy behaves. August has been tough, and it does not look as though the rest of the year will be a great deal easier. Some readers may recognize that my title borrows from a reference to Lord Byron. Among that poet’s many valuable pieces of advice was, “Always laugh when you can. It is cheap medicine.” Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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