Mark Hodgson explains how model-driven, volatility-linked trading strategies such as risk parity can fail should risk spike or predicted correlations between equities and bonds break down.
- At its simplest level, model-driven, volatility-linked trading strategies such as risk parity, assume past volatilities and correlations will hold and allocate across equities and bonds with the aim of achieving stable returns
- However, by definition, volatility is erratic and can abruptly wrong-foot investors who believe they can correctly predict it
- As such, if prolonged, the recent uptick in volatility could spell serious trouble for such strategies
Like alchemists in the Middle Ages, some of the greatest minds of today frequently try to solve the age-old conundrum of how to make easy money in the financial world. The prospect of an easy buck forever attracts investors; one only has to look at the recent bitcoin craze to realise how swiftly some investors will put their faith into unknown strategies without understanding the risks attached.
History is, however, littered with financial models that found and successfully exploited a niche - until they imploded. In the 1990s, Long-Term Capital Management (LTCM), a US hedge fund, based its entire investment strategy on the notion that markets could be modelled and profit made from temporary anomalies in foreign currency and bond markets. The fund thrived, boasting annual returns of 42.8% in 1995 and 40.8% in 1996. However, its premise that historical market data could forecast future market behaviour ultimately proved catastrophic. By underestimating the fickleness and unpredictability of markets, LTCM proved a valuable example of how algorithms only work until they don't, verifying John Maynard Keynes's supposed-quip that, "markets can remain irrational longer than you can remain solvent."
Nevertheless, this has not stopped the rise of model-driven, volatility-linked trading strategies. Risk parity, one of the most popular of such strategies, allocates between asset classes based on modelled levels of correlation and volatility, using historical data. In its simplest form, it assumes past volatilities and correlations will hold and allocates across equities and bonds with the aim of achieving stable returns.
Over the last few years of subdued market volatility, risk parity funds have been using leverage to increase their exposure. This, combined with a global bull-run in equities and bonds, has resulted in lucrative gains - the Salient Risk Parity Index posted an annual return of 10.15% in 2017. The result is that the size of the risk parity industry has ballooned to $600bn (£432bn). Undoubtedly the strategy has proven successful and has been especially popular with institutional investors on the perennial search of stable risk-adjusted returns, such as pension funds.
However, by definition, volatility is erratic and can abruptly wrong-foot investors who believe they can correctly predict it. Risk parity's use of historical data means that if risk does suddenly spike or predicted correlations between equities and bonds break down, the strategy suddenly begins to fail.
The events of the past weeks show that this may be a sharp wake-up call for risk parity strategies. On 5 February, global stocks plunged - the Dow Jones Industrial Average dropped more than 1,000 points and the S&P 500 declined more than 4%, erasing the gains it had made in January. After a brief respite, the Dow dropped a further 1,000 points on 8 February. Dangerously for risk parity funds, the CBOE Volatility Index (VIX) rose 115.6% on 5 February to 37.32, its highest ever one-day climb, eclipsing the previous record of 64.2% set on 27 February 2007. The index soared to over 50 on 6 February, its highest level since August 2015. Furthermore, the yield on US 10-Year Treasuries rose by 20 basis points in the week preceding the sell-off.
Altogether, if prolonged, this could spell serious trouble for risk parity funds. Even if the sell-off turns out to be a blip rather than a full-blown market correction, such market events highlight the hazards associated with investing based on a model. Once again, investors are in danger of having faith in the alchemists.
Mark Hodgson is managing director at Gatemore Capital Management
 The Salient Risk Parity Index is a quantitatively driven global asset allocation index that seeks to weight risk equally across four asset classes — equities, rates, commodities and credit. The index is calculated daily, rebalanced monthly, and targets a 10% volatility level.
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