AllianceBernstein, a big US asset manager, has warned that the swelling popularity of an investment strategy known as “risk parity” is exacerbating the fragility of financial markets and worsening sell-offs.
Equity and bond markets have been hit hard by fears over sliding commodity prices, China’s economic slowdown and the resulting emerging market struggles this month, heightening concerns of hidden faultlines in markets caused by certain strategies.
So-called risk parity is a next-generation passive strategy — originally pioneered by Bridgewater, the world’s biggest hedge fund group — that seeks to give equity-like returns, while providing the relative stability of bonds in a crisis.
Risk parity funds typically invest in a basket of stocks, bonds and commodities, but “leverage” the traditionally safer fixed-income bets through derivatives to ensure each asset class contributes equally to a portfolio. Simplified, the theory is that when equity markets are buoyant the extra leverage will ensure that the bond portfolio does not drag on performance, and when markets are jittery the juiced-up bond positions will ameliorate a stock slide.
The robust and consistent returns of risk parity funds in recent years has helped them swell in size and number since the financial crisis, led by hedge funds including Bridgewater and AQR. Big asset managers such as BlackRock, Invesco and AllianceBernstein itself, have also embraced the approach.
A report on bond markets by AllianceBernstein estimates that the total assets under management of RP funds could now be about $400bn, even excluding in-house RP funds in pension funds and insurers that have also embraced the strategy. With leverage that means that the RP industry now controls about $1.4tn of assets, the report estimated, not including in-house vehicles.
Douglas Peebles, head of fixed income at AllianceBernstein, compares the rise of risk parity to the invention of “portfolio insurance” in the 1980s, a tactic that was supposed to protect stock investments by using derivatives, but played a crucial part in the “Black Monday” Wall Street crash of 1987.
“It’s a core, structural change in the marketplace. Each investor is making a rational decision, but put them all together and it has caused a dramatic change in markets,” he says. “It has made the system more fragile.”
AllianceBernstein — as well as other asset managers including Pimco and GMO — point out that risk parity depends on leveraging bond investments, low volatility and modest correlations between different markets over time.
When turbulence spikes, RP funds automatically sell assets in response, but that can intensify sell-offs. Some analysts say the strategy played a crucial role in aggravating the 2013 “taper tantrum” when investors were alarmed by the Federal Reserve preparing to end its monthly bond purchases.
“Should correlations turn positive, with stocks and bonds declining at the same time, the risk contribution of each one would rise. Managers would then have to sell both to maintain their risk targets. In other words, selling begets selling,” the AllianceBernstein report said.
Mihir Worah, one of PIMCO’s chief investment officers, is less concerned about the broader dangers but warns that it is a “case of buyer beware” for investors unappreciative of the fact that the outlook for the RP strategy is dimming.
“People think risk parity is a magic bullet, but it’s not,” he said. “It’s a fundamentally good idea, but it has benefited inordinately from falling volatility and falling bond yields. But we are now entering an environment where bond yields are probably going to rise, and volatility is going to increase.”
Another risk parity fund manager argued that the strategy was misunderstood and overly maligned, pointing to tests that show that it performed well under almost any scenario. But he admitted: “Strategies that mitigate risks to make themselves more secure might make the overall system more dangerous.”
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