Market Volatility: Friend or foe?
Joseph Mariathasan explores whether risk parity contributes to turmoil in the market
At a glance
• Market volatility does not follow a normal distribution.
• Volatility targeting within risk parity funds can create a herding effect.
• Risk parity is unlikely to be a cause.
• But risk parity may cause problems in the future.
What has become known as the active-passive debate is now a foundational discussion within the investment industry. It raises fundamental questions about the proper role of asset managers. Should they be using their superior skill to outperform the market, or should they accept the more modest role of simply tracking indices?
Trying to model the behaviour of equity markets has become increasingly difficult. It is clear they do not follow a ‘normal’ Gaussian distribution. The existence of fat tails seems to be conclusive and hence a higher-than-expected frequency of black swan-type events. But are the trading strategies that have become popular in recent years adding to market volatility, and is risk parity at least partly to blame?
The S&P 500 returned -6.26% in the month of August 2016 in dollar terms, its worst return since May 2012, which many hedge fund managers that were forced to sell equities as market volatility rose attributed to risk parity strategies. A JP Morgan analyst, Marko Kolanovic, quantified the volume of possible selling by risk parity strategies in various market scenarios and concluded that this could be in the hundreds of billions of dollars. Such comments resulted in a vigorous defence of risk parity by its major proponents, including Bridgewater and AQR Capital Management.
What is clear, is that technical selling does appear at times to overwhelm any fundamental valuations, creating large short-term movements leading to sharp gapping in prices: “We have seen, over the past year to 18 months, an increasing number of these big multiple standard deviation one-day moves in bonds and currencies,” says Stephen Coltman, a senior investment strategist at Aberdeen Asset Management. “But these big one-day gap moves haven’t been sustained. You have a flurry of short-term activity and then the market normalises.”
Has market volatility been exacerbated by particular types of investment strategies? As Coltman argues, volatility targeting has become an increasingly widespread way of managing assets, and that has implications: “Looking at your risk in terms of the realised volatility of your profit and loss has become popular. But those strategies, by their nature, will be pro-cyclical in terms of adding risk as volatility goes down and reducing risk as volatility goes up, which typically means extending a move that has already started.”
So, as Coltman explains, if the euro starts rallying and the daily volatility is declining, CTA (commodity trading advisor) hedge funds will build up exposure in a market over the course of the trend, as markets that are trending will often exhibit declining volatility. When the trend starts to falter, there is a change in direction and an increase in volatility. CTAs that follow that trend will cut their positions. First, because the trend has finished, and second, because they have to reduce their position size as volatility has increased.
“The combination of those two elements, and the fact that they respond quite quickly to market movements, means that you get these gaps,” Coltman concludes. As he points out, CTAs can be 3-5 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.
In contrast, a risk parity fund 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 may 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.
Managers run risk parity strategies in different ways, but Coltman argues that these approaches are essentially passive and that they tend to rebalance without taking a negative or positive view on assets, always trying to maintain a long portfolio across different assets. So, even if a risk parity manager 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 exposure. 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 might not be a significant enough strategy to be a problem in this case. Bridgewater’s Ray Dallio argued last autumn that US pension funds have allocated about 4% of assets to risk parity strategies, amounting to around $400bn (€354bn), of which Bridgewater’s own All Weather Fund accounts for $80bn. He 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 in US equities, so a 25% reduction would only amount to $4bn, while the overall trading volume in US equities for the period of high volatility was $200bn per day. Relative to overall trading volumes, the impact of risk parity trading would appear 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: “You have an increasing number of other types of trading such as high-frequency trading and model-driven systematic strategies that respond very quickly,” says Coltman.
As he points out, there are huge problems arising from central bank policies, which are driving considerable flows in the market. The European Central Bank (ECB) is buying €80bn every month and investors are positioning themselves in anticipation of central bank action, which leads to crowded one-way sentiment in the market. Coltman continues: “There have been a couple of times with the euro and the yen when central banks were heading into meetings with investors positioned for further quantitative easing which didn’t happen, leading to very large moves counter to what had been expected. That’s largely due to positioning by short-term traders.”
Should investors then feel secure with risk parity in the knowledge that it does not increase market volatility significantly? Probably, but they may face other more serious issues – such as the future performance of risk parity strategies and the correlation between asset classes, including stocks and bonds, and the ability for managers to generate returns. Risk parity may not be contributing to market volatility significantly, but it might not prevent risk parity investors from having a rough ride in the future.