The Impact of Risk Parity Strategies on Market Moves

Deutsche Bank recently published their list of market risks for 2019. Top of that list is “Algo-driven, risk parity-driven fire sale in equities and credit continues”. In a previous article (The Impact of Algorithmic Trading on Market Moves) I discussed the impacts of algorithmic trading but this article is focused specifically on risk parity strategies. 

Ray Dalio and his colleagues at Bridgewater are credited with the foundation for the risk parity approach. They developed the All Weather concept as they sought to answer the question “What kind of investment portfolio would you hold that would perform well across all environments, be it a devaluation or something completely different?” Instead of targeting optimal risk and return in the traditional portfolio optimization setting, All Weather and risk parity strategies strive to achieve balanced risk contributions from all asset classes. 

Risk parity strategies seek to perform well across all trading environments but they will under-perform traditional equal allocation portfolios in a rising market and as such are often leveraged to boost performance. A traditional portfolio that is equally weighted to equities and bonds has a higher risk profile than a risk parity portfolio because equities exhibit higher volatility (and therefore risk) but produce higher returns. Though risk parity strategies cannot guarantee out-performance over traditional strategies over the short term, research indicates that they produce better risk-adjusted returns over a longer period. 

The goal of risk parity is to build a diversified portfolio in which each group of assets contributes an equal amount of risk so that the return is not primarily determined by equities. The formula is based on historical research on how each asset performs and relates to the other groups over time. In a simple example, if equities exhibit three units of risk compared to one unit of risk for bonds, a risk parity portfolio would consist of 25% equities and 75% bonds. This would balance the risk between the assets. A slightly more sophisticated approach utilizes the historical volatility of assets. If equity volatility over a specified period was 25% and bond volatility was 10%, the asset allocation for equities would be 1 – equity risk / (sum of all risks) = 1 – 25% (25% + 10%) = 29%. Bond allocation would then be 71%. In practice risk parity strategies include multiple asset classes, not just equities and bonds but the principles are the same. 

Volatility tends to rise as prices fall. So, in a falling equity market, equity volatility would be rising and risk parity portfolios would be reducing allocation to equities to balance the added risk. Estimates vary but with large players such as Bridgewater and AQR executing risk parity strategies, the assets under management are likely to be in the hundreds of billions of dollars. When considering all trading strategies that react to changes in volatility, the assets under management could add up to trillions of dollars. As with any “crowded” trade, reallocation of assets within the portfolio can have a significant impact on market moves. Forbes published an article in February 2018 titled “How Trillions In Risk-Parity/Volatility Trades Could Sink The Market”. 

The risk parity trade also relies on the historical fact that price movements of equities and bonds have not been highly correlated. As long as that low correlation remains, the strategy reduces the overall risk for the investor. If the price movements in equities and bonds become highly correlated, the risk parity trade will under-perform, possibly significantly. If bond investors are concerned about rising interest rates, rising federal expenditure and falling revenues, they will reduce their exposure. At the same time, if equity investors are concerned about rising interest rates and potentially inflated valuations they will also reduce their exposure. This scenario will hurt risk parity portfolios and possibly result in some liquidation. But, because the time horizon for these strategies is typically longer term and designed to produce better risk-adjusted returns through the cycle, I wouldn’t expect sudden mass liquidation. There is always a risk of liquidation of risk parity portfolios but how significant is it for the markets as a whole ? 

The Deutsche Bank list was not in any order of significance but I don’t think that I would have penned “Algo-driven, risk parity-driven fire sale in equities and credit continues” at the top of the list in an environment where interest rates are rising, global growth is slowing and there is significant uncertainty around the impact of tariffs and Brexit. When we experience the next financial crisis, I don’t believe that the primary cause will be risk parity-driven liquidation, even if these strategies may have some effect on the scale of the market moves.