Is Risk Parity Driving The Market?

Authored by Brean Capital’s Peter Tchir via Forbes.com,

I am have more and more discussions about Risk Parity.

While Bridgewater is the best known and largest advocate of Risk Parity – it can be implemented in a simple form by virtually anyone.

Sophisticated Risk Parity strategies involve balancing multiple asset classes (global bonds, global equities, commodities, FX, etc.) in the ‘correct’ proportions to achieve a desired level of portfolio risk while still have positive expected returns.

At its most basic level – it is buying stocks AND buying bonds under the assumption (hope) that when one goes down, the other goes up, dampening volatility while generating positive returns over time.

There is an appeal to buying bonds as a ‘hedge’ against equity risk rather than buying options or buying VIX based ETFs and ETNs.  In an ‘ideal’ world, buying treasuries as a hedge generates income while offering some ‘risk-off’ protection; whereas, buying options tends to just drain money time and again.

One big question is ‘why are treasuries doing so well and stocks not reacting?’

There are a lot of potential answers, but one thing that would explain some of the more perplexing market moves would be that more investors are allocating money, directly or indirectly into Risk Parity strategies.

• Investors wouldn’t need to sell stocks out of fear as they would be hedged – check
• Investors wouldn’t be buying options so the price of volatility, or VIX, would be low – check
• Investors would be buying bonds, particularly ‘safe’ bonds – check

Three things that are happening in the market, that are not easy to reconcile, can be explained by a growing interest in Risk Parity.

Because this strategy can be implemented in so many ways, it is difficult to detect whether I am right or not, but there are some indications that this might be occurring

• IEF, TLT and LQD (treasury and investment grade bond ETFs) have all had inflows
• Risk Parity and ‘Adaptive Risk Allocation’ Funds, like CRAZX (one of my favorite tickers) have had inflows

If I am correct, the risk in the  market is not to increasing volatility but something that changes the relationship to stocks and bonds that causes them to both drop.

The strategy has had long periods of success – not surprisingly up until the Financial crisis as bond yields were high and reasonably stable while equities rallied.

In the Quantitative Easing Period when Central Banks helped inflate the price of all assets – which was rudely interrupted by the Taper Tantrum and again in the post Brexit era of more central bank support.

It is far from clear how well this strategy will do going forward, especially if central banks are scaling back their support and it is becoming a crowded trade in a world where liquidity often seems fickle.