by Adam Butler, GestaltU
Bank of America Merrill Lynch recently released a research note suggesting that Risk Parity investment strategies currently represent a substantial source of systematic risk in global markets. The note was picked up breathlessly by several media outlets and posted under sensationalist headlines employing eye-catching terms like “spectre,” and “mayhem.” The introduction to the actual report says:
Last week’s sharp sell-off in JGBs renewed concerns of forced selling by risk parity funds. While the drawdowns in US Treasuries, US equities, and ultimately risk parity portfolios were small and short-lived, the latent risk remains worth monitoring, as (i) leverage is still near max levels across a variety of risk parity parametrizations, (ii) bond allocations are historically elevated, and (iii) markets continue to be skeptical of a 2016 Fed hike.
The same day, Business Insider reported on the BAML note, adding:
Now, this isn’t as straightforward as watching volatility in one asset class, as risk parity funds focus on “the relative dynamics between component volatilities and correlation.” With that in mind, the note includes a scenario tool to help investors assess what moves in the S&P 500 and 10-year US Treasury futures could trigger “significant deleveraging by rules-based, vol-controlled risk parity funds.”
In plain English, they’re trying to help clients figure out what might trigger widespread forced selling.
The grey bar is the zone in which the risk parity funds aren’t forced to sell. So, for example, if there was a -2% drop in US Treasury futures and a 5% jump in the S&P 500, risk parity funds wouldn’t react.
The orange zone includes the events that would presage a dramatic deleveraging. Their model suggests that, for example, a -1% drop in US Treasury futures and a -4% drop in the S&P 500 would trigger forced selling.
Source: Bank of America Merrill Lynch
Unfortunately, this characterization of how Risk Parity works is misguided for a number of reasons. Let’s examine how Risk Parity actually works, and address the most important misapprehensions from the article in turn.
What is Risk Parity?
Risk parity is characterized by three primary features. First of all, Risk Parity implementations almost always invest in a diverse basket of asset classes which react in different ways to various economic environments. That means they are more than just traditional portfolios of stocks and bonds. Rather, they include assets like commodities and gold, inflation protected securities, assets denominated in a wide variety of currencies, and more obscure assets like emerging market bonds. So it is incorrect to state that Risk Parity implementations will react exclusively to changes in risk and correlations in stocks and bonds.
Second, Risk Parity is about balancing risk. To balance risk, high risk assets like equities must necessarily receive a smaller allocation in portfolios than lower risk assets like bonds. For this reason, Risk Parity portfolios allow assets with diverse risk profiles to contribute equally to the portfolio. This means the portfolio doesn’t rely on just one or two sources of returns, but rather accrues returns from many sources, which as stated above, produce their best returns in different economic environments.