By Tyler Durden
Perhaps it was just a coincidence that one month ago, as we approached the anniversary of last year’s August 24 ETFlash Crash which showed just how broken ETfs can get in a coordinated market selloff during a liquidity vacuum, we previewed “What Would Prompt Another Blow Up Of Risk Parity Funds“, the same funds which suffered acute losses last August just after China devalued its currency and roiled global markets. One of the cataysts listed was a sharp spike in bond yields.
A few weeks later, with bullish positioning across the systematic investor universe (risk-parity, CTAs, etc) at all time, levered highs as JPM observed two weeks ago, that is precisely what happened, when none other than a central bank provided the spark to catalyze the latest episode of risk impairity, a technical term for a mass quant puke. Thanks to the relentless barrage of Bank of Japan trial balloons, which ultimately unleashed a dramatic steepening of the bond curve first in Japan and then everywhere else (as we first explained on September 8), the “risk-parity” rout indeed arrived.
This is what Goldman, which last week downgraded the S&P 500 and Stoxx 600 to a “sell” citing the spike in risk of systematic leverage as one of the reasons for its bearishness, said about the sharp hit to risk-parity.
The bond sell-off since last week illustrates this: equity/bond correlations have increased sharply (Exhibit 4). This likely led to a day of very poor returns for traditional balanced funds and risk parity portfolios: the latter have likely suffered more, as the significant decline in equity volatility over the summer has likely led to increased equity allocations. Exhibit 4, which shows daily returns of a simple risk parity portfolio (using 3-month volatility to scale weights), suggests that they would have had a similarly bad day recently to during the ‘taper tantrum’, ‘Bund tantrum’ and the two China/commodities drawdowns (August 2015, December 2015). Performance pressures in the event of a pick-up in volatility and correlations could drive more de-risking from risk parity investors and vol target funds.
Indeed, as the chart below shows, weeks, if not months, of risk-parity gains were lost across the three trading days starting with last Friday’s selloff which saw a surge in cross-asset correlations, which in turn resulted in a surge in volatility after 40-some days of comatose markes, in which the S&P failed to move more than 1% on any one day.
Goldman wasn’t the only one to warn about the ongoing risk-parity unwind, however. In a note by BofA’s Shyam Rajan released on Friday, the credit strategist explains why from being long US real rates, the bank switched to a real rate short last week; the primary reason: concern about risk parity exposure. Here is what he said:
One of the most talked about themes recently has been the impending unwind of levered risk parity portfolios. Our equity analysts estimate that the recent moves (bond and equity sell-off) could trigger as much as $50bn in bond selling from risk-parity type investors. While data on holdings is minimal, the influence of risk parity deleveraging on real rates is clear from Chart 4 and Chart 5.
While the deleveraging of risk-parity funds impacts far more than just real rates, most notably all risk assets, real and nominal, the following charts show BofA’s point that real rates are one of the numerous market variables impacted by the leveraging decisions of the increasingly more pervasive risk-parity community.
Rajan then points out that as the correlation between equities and nominal bond yields turn negative, the risk parity community delevers, resulting in a sustained underperformance of real yields. While one can assume that this is because risk parity performance mirrors nominal bond yields, as BofA shows in the next chart, there is a compelling case that this is purely a real rate phenomenon.
For what it’s worth, BofA believes that the best way to trade the current and future risk-parity episodes, is by going short real – not nominal – rates.
If anything, risk parity underperformance has historically meant higher real rates and lower breakevens, with the breakeven beta being about half the real rate beta. This relationship is the primary reason why we would rather be short real rates as opposed to nominal rates for an unwind of the risk parity theme. Further, anecdotal evidence in both the taper tantrum and the China reserve sales episodes also support this view- real rates increase, breakevens declined as average risk parity performance fell more than 5%.
While it is tempting to assume that the most recent “taper tantrum” episode is now over, neither Goldman nor BofA share that optimistic: indeed, once started a process of deleveraging can last weeks until a new stable equilibrium points is reached. As Rajan says, “to us, the focus on risk parity unwinds is here to stay even beyond the next couple of weeks. As the polls for the US elections narrow further, higher volatility and increasing likelihood of fiscal stimulus will keep this theme alive.”
If the two investment banks are right, and if Risk Parity is set to play a far greater role in market (in)stability in the coming weeks, then it would be prudent to re-read our article from a month ago, explaining the catalysts that could to lead one or more risk-flaring episodes among the RP universe, and especially this chart, which serves as a useful guide to just how extensive a systematic fund deleveraging one can expect, based simply on an intraday move in US Treasurys and stocks.
Last but not leasst, for the best indicator of just how [de]stressed risk-parity funds are, keep an eye on the performance of the world’s biggest hedge fund, Bridgewater, which suffered sharp losses during all previous instances when correlations across asset-classes soared, due to either VaR shocks or taper tantrums. Which brings us to the troubling question of the day: with nearly $200 billion in AUM, how soon until a sharp hit to Bridgewater’s risk-parity exposure “forces” Ray Dalio’s massive, and systematically important, fund to become the next “too big to fail” assured of a taxpayer bailout when “unthinkable” LTCM-type moment finally hits?