At the risk of giving specious arguments more attention than they deserve, my team and I would like to respond to several written reports speculating that risk parity strategies are systemically risky and amplify downside market volatility. In our opinion, these reports are based on a fundamental misunderstanding of how a risk parity strategy is implemented. In our experience, systematic risk parity managers traded less during the elevated volatility of the last full week of August than many of their discretionary counterparts. Rather than being a major contributor to market turmoil, we believe that risk parity and other volatility-controlled strategies are potentially effective ways to help navigate volatile markets.
We think the genesis of this speculation may be the false assumption that risk parity managers trade their entire book in real time in response to changes in intraday volatility. This assumption leads to analyses where an intraday tripling of equity volatility potentially leads the risk-targeting manager to cut equity exposure by two-thirds in real time, potentially exacerbating downward pressure on the market. But remember: market volatility can change a lot from one day to the next. If a manager trades a portfolio to reflect exactly the observed volatility in the market today, it is very likely the manager will have to trade it a lot again tomorrow because volatility is likely to change a lot between now and then. A strategy that requires this much trading would be prohibitively expensive to implement even if it made sense, and it doesn’t in our view. Professional money managers take market impact seriously because it is one of the relatively few factors affecting performance that they can directly control, and risk parity managers are no exception.
In our experience, even a very adaptive risk parity strategy updates its measure of risk by at most 1% per day, leaving 99% of the risk estimate exactly as it was the prior day. This means that a one-day tripling of volatility will increase a manager’s perception of market risk by about 0.5% on day one. If market risk remains elevated, the manager’s risk estimate will continue rising gradually. We think that a middle of the road risk parity manager that targets a 10% level of volatility may have reduced equity exposure by about 5.5% during the period of August 21 through August 28.
Several recent articles estimate total risk parity assets at $500 billion, much of which is likely managed on a more conservative basis than the very adaptive example proposed above. Even if all $500 billion were managed as in the example, last week’s deleveraging would amount to sales of roughly $28 billion in equities over the course of the week, or about $5.5 billion per day. Assuming all this exposure was shed in the S&P 500 E-mini market (in reality it likely would have been spread out across global equity futures markets), it comes out to roughly 2% of average daily volume (on August month-to-date average daily volume of $217 billion through August 28). The hypothesis that this activity poses a systemic risk seems unlikely in our opinion.
We will not speculate on the factors contributing to very high levels of market volatility on August 31. But we think it is an excellent reminder that equity markets can be very risky. In our opinion, this is a powerful argument in favor of diversifying away from a single-factor portfolio and toward a diversified allocation like risk parity.
Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.
This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.
Diversification does not assure profit or protect against risk.
One cannot invest directly in an index.