Joseph Mariathasan: Market volatility, and coping with crowded trades
Trying to model the behaviour of equity markets has become increasingly difficult and as the Brexit vote has so dramatically illustrated, markets can be thrown completely off-course by unexpected events. It is clear they do not follow a normal, Gaussian distribution. The existence of fat tails seems to be pretty conclusive and hence a higher than expected frequency of ‘black swan’ events of which the Brexit vote is a clear example. The volatility seen post-Brexit vote is understandable, but other periods of extreme volatility are often not.
A good example of recent unexplained volatility were occurrences in August 2015, when US stocks went down almost 7%.This was attributed to risk-parity strategies that were forced to sell equities as market volatility rose. A JP Morgan analyst, Marko Kolanovic, quantified the volume of potential selling by risk parity strategies in various market scenarios and came up with the conclusion that selling could have been in the hundreds of billions of dollars. Such comments resulted in a vigorous defence of risk parity by its major proponents, including from Bridgewater and AQR Capital Management.
Whilst Brexit-induced volatility may be a good example of a dramatic change in fundamentals, what is also clear is that technical selling can appear at times to overwhelm any fundamental valuations creating large short term movements leading to sharp gapping in prices. The issue for the stability of financial markets is whether this market volatility has been exacerbated by particular types of investment strategies.
Volatility targeting, for example, has become an increasingly widespread way of managing assets and that has implications: Adding risk as volatility goes down and reducing risk as volatility goes up can be pro-cyclical, extending a move that has already started. As one manager argued, if the euro starts rallying and the daily volatility is declining, then CTAs will be building up an exposure in a market over the course of a trend as markets that are trending will often exhibit declining volatility. When the trend ends, you see a change in direction and an increase in volatility. CTAs who follow that trend will cut their positions, first because the trend is finished and secondly because they have to reduce their position size because volatility has increased.
The combination of those two things and the fact that they respond quite quickly to market movements means that you can get gaps. As he points out, CTAs can be three-to-five times leveraged and in contrast to risk parity a trend following strategy will be aggressively long an asset and then move to be short an asset. That does suggest risk parity strategies may not be the cause of volatility. They will always have a long exposure to an asset but just trim and manage that exposure to keep it in proportion to other exposures in the portfolio without a wholesale change in direction. But there can also be other big players including banks hedging structured products and derivative exposures which again will respond to short term changes. In contrast, risk parity tends to rebalance monthly or a different frequency depending on the manager.
Risk parity approaches are essentially passive and would tend to rebalance monthly without taking a negative or positive view on assets but always trying to maintain a long portfolio across lots of different assets. So even if a risk parity approach has some leverage, it is usually tweaking at the edges to get the desired allocation. Risk parity is an example of a volatility controlled strategy that responds to changes in market volatility by increasing or decreasing leverage, so increasing equity volatility and correlation to other assets would lead to risk parity portfolios reducing equity exposures. In that sense, there is clearly a theoretical problem that when there is a bout of increased equity market volatility, there may be a case of too many elephants trying to squeeze out of the exit door. But risk parity may not be a large enough strategy to be an issue in this case.
Bridgewater’s Ray Dallio argued in the wake of August 2015’s turmoil that US funds have allocated around 4% of assets to risk parity strategies, amounting to around $400bn (€360bn) – of which Bridgewater’s own All Weather Fund accounts for $80bn. Dallio estimated that if external managers cut their risk by 25%, it would result in a sale of $20bn spread across global equities, bonds and commodities. Typical equity holdings are 35%, with half being US equities so a 25% reduction would only amount to $4bn, whilst trading volumes in US equities for the period of high volatility was $200bn daily. Relative to overall trading volumes, then the impact of risk parity trading appears to be miniscule.
If risk parity is not to blame for increased market volatility, then what is? Other forms of systematic trading could certainly have contributed more than risk volatility. There are certainly an increasing number of other types of trading that are possible culprits such as high frequency trading and model-driven systematic strategies. The actions of non-profit oriented players such as the ECB may also be an issue. There are immense issues being caused by central bank policies driving a lot of flows in the market. The ECB is buying tens of billions of bonds every month and investors are positioning themselves in anticipation of what central banks are going to do and that leads to very crowded one-way sentiment in the market. But for the next few years, how the UK copes with Brexit may provide a structural reason for increased volatility even if the distribution is very far from normal.