The Theory And Practice Of “Risk Parity” And Your Money
$JPM
Risk Parity, the investment strategy pioneered by Ray Dalio’s Bridgewater Associates, is a strategy, in which funds tend to automatically adjust portfolios of bonds, stocks, and other assets in response to higher market volatility. Lately it has been blamed for exacerbating the recent selloff by shifting major fund holdings into cash.
Bridgewater’s All Weather Fund itself is said to have lost 4.2% in August. A JPMorgan analyst has been very vocal about the selling pressures caused by such quantitative funds, said Thursday that heightened volatility means that Risk Parity players will likely have to exit about another $100-B in stocks in the next 1 to 3 weeks.
To JPMorgan’s flows-and-liquidity team matters are not quite as clear-cut.
Friday, analysts said that discretionary money managers, or mutual fund and hedge fund managers, appear to have sold stocks to a far greater degree in recent weeks than quantitative-driven players such as Risk Parity managers.
Below is what they said, as follows:
… This dismal performance by risk parity funds during August does not necessarily make them the main culprits of the recent market correction. First, the equity beta change during the August correction shown in is rather small compared to its historical variation. Second, risk parity funds do not typically apply high leverage to their equity investments. They instead apply high leverage to their bond investments in order to diversify their equity holdings, since bonds have roughly a 3rd of the volatility of equities.This framework makes Risk Parity funds more vulnerable to rises in bond volatility and in correlation between bonds and equities, rather than rises in equity volatility. And this probably explains the rather muted re-balancing in risk parity fund positions. During August, neither bond volatility nor the correlation between bonds and equities saw any material increase to induce Risk Parity funds to change their exposures in a more pronounced way.”
Meaning, had Risk Parity Funds been significantly selling stocks during last month’s turmoil, one might have expected that equity beta figure to fall much more. By contrast, the JPMorgan analysts point out, the stock beta of those discretionary money managers declined a far greater degree.
The data studied show rapid de-risking with the equity betas of both -0.4, Discretionary Macro hedge funds and Balanced Mutual Funds declining abruptly in August.
In fact, the equity beta declines seen in August by both Discretionary Macro hedge funds and Balanced Mutual Funds were a 1.5X and 2.0X historical standard deviation compared with just 0.6X for Risk Parity funds, respectively.