In addition to Paul Tudor Jones making headlines overnight with his comments during a closed-door GSAM session, in which he warned that Yellen “should be terrified” by some of the market’s key valuation metrics, he went so far as to predict what trading strategist would blow up the market and cause the next crash when volatility returns.
“Risk parity,” Jones told the Goldman audience, “will be the hammer on the downside.”
PTJ is not the first one to blame risk-parity funds of crashing the market: Both Omega’s Leon Cooperman and especially JPM’s Marco Kolanovic famously repeated on several occasions that the greatest “crash catalyst” facing the market is, you guessed it, risk-parity.
The two have good reasons to be skeptical: as we first reported in September of 2015, it was a risk-parity meltdown in mid-August that catalyzed the ETFlash crash of August 24, 2015, sending the VIX so high, the CME admitted the calculation had malfunctioned and the VIX was offline for nearly an hour. This is what Bank of America reported at the time:
The volatile sell-off in global equities from Thursday August 20th through Tuesday August 24th, alongside a relatively muted diversification benefit from fixed income, led many risk parity funds to suffer a sudden and sharp drawdown over the four-day period (Chart 1). The performance drawdown and subsequent spike in the volatility of risk parity funds likely triggered a significant deleveraging in their assets.
We have written much more on the topic of risk parity over the past 3 years, but suffice it to say, PTJ is right. Which explains why one day later, the quants that make up the risk-parity community went up in arms against Jones, starting with Cliff Asness’ AQR Capital Management, perhaps the largest player in the the risk parity field, who responded that “concerns are overblown”, with any selling forced by the strategy having an “utterly trivial” impact on the $23 trillion U.S. equity market. Cliff of course assumes that everyone has forgotten the events of August 2015. Luckily, we are there to remind them.
Others were just as defensive: “There are scenarios in which risk parity funds sell equities, but the possible magnitude of that is very small,” said Michael Mendelson, a risk-parity portfolio manager at AQR, quoted by Bloomberg. “Some reports have grossly exaggerated the potential impact.”
“Even on a sharp move in the stock market, the positioning changes would be utterly trivial and would have about zero impact,” Mendelson said.
True, a 1000 point Dow drop is rather “trivial” these days, especially once the BTFD algos kick in, another byproduct of an “efficient” market.
While the blame game is sure to continue at least until the next risk-parity caused crash, Bloomberg make an interesting observation, namely that risk parity funds hav seen capital flight in seven of the past nine quarters, for net outflows of more than $16 billion among funds tracked by eVestment.
What that means is that over the past two years, risk parity funds have become even more unstable, suffering equity outflows, and perhaps leading to even greater internal fund leverage, in turn magnifying potential local volatility shocks.
In any case, the “doth protesting too much” continued.
According to Edward Qian, another risk-parity advocate, “they’re always focused on the equity portion of risk parity, saying that equities might have a terrible time and other scary fear mongering things. Even if someone has a stop loss or equity reduction program, it can’t be a significant player in those time periods.”
To be sure, Qian did hit Jones where it hurts: right in his performance, or lack thereof. “First you had Leon Cooperman and now it’s a hedge fund guy,” said Qian. “Any time performance isn’t doing well, they just blame risk parity.”
That however, does not change the fact that both Kolanovic and Jones are right (for more details see “One Year Later, This Is What Would Prompt Another “Risk-Parity” Blow Up“). And since volatility now appears to be rising, and sharp moves in both equities and bonds are likely on the immediate horizon, we present one of our favorite charts: the risk parity deleveraging sensitivity analysis. As BofA showed last summer, the most risk of deleveraging from vol controlled risk parity funds comes when both volatility and correlation of the underlying components rise together (i.e. quadrants 2 and 3 in the chart below).
In other words, a day which sees a -4% SPX drop and +1% bond rally (good diversification) would generate no selling pressure, “underscoring the critical role played by bond-equity correlation in governing the severity of risk parity unwinds.” However, a troubling scenario is one where even a relatively benign 2% selloff of the S&P coupled with just a 1% selloff of the 10Y could result in up to 50% deleveraging, which in turn would accelerate further liquidations by other comparable funds, and lead to a self-fulfilling crash across asset classes.
We look forward to those two market conditions being met and watching the market’s response as only that “experiment” will finally resolve the debate over whether risk-parity is the market’s most pressing, imminent time bomb.