Averse Investment Strategies Deepened Decline: Risk Parity and ETFs on Trial
by the Curmudgeon
The second part of our series on Alternative Strategies Have Failed -- Liquid Alt Funds has been
delayed as we haven’t completed our research.
However, a quick check of Morningstar Category Returns reveals that over
90% of “multi-alternative” liquid alt funds have a negative total return this
year and only three or four are up over 4%.
We expect to complete this article within the next week.
Have you been surprised by the recent market volatility and
decline in all asset classes other than US Treasury bonds?
Today's NY Times print edition explains
why Investment strategies which promised to insulate investors from risk have
conversely contributed to the wild market swings in recent weeks. Experts warn that the $4+ trillion that have
flowed into so-called risk-parity funds
and ETFs over the last five years
have become so large that the end result has been a riskier, more volatile
market. Let's examine why in this
“The professional investment community is very worried about this,” said Julian Brigden of Macro Intelligence 2 Partners, an independent research firm based in Vail, CO that advises large money management firms on global investment themes. Mr. Brigden contends that this latest flurry of sophisticated investment vehicles produced by Wall Street has created a false impression of robust investment returns with minimal downside risks.
“It’s this constant striving by the Street to satiate investor demand. So you keep seeing these leveraged risk-parity funds and power ETFs.”
Mr. Brigden added: “We have had this long backdrop of suppressed volatility with equities doing well and an utter lack of bond risk,” he said. “With central banks no longer buying bonds, that virtuous circle is becoming vicious.”
Such sharp ups and downs in the market are expected to become more frequent as the time approaches for the Federal Reserve to push interest rates higher. The IMF and World Bank have recently warned the Fed NOT to raise rates anytime soon.
“People might as well get used to them,” said Nicolas Just, a portfolio manager at Natixis Asset Management, a French fund company that oversees $904 billion in assets. “These types of sudden market swings will become more and more frequent. So you have to be prepared for them at any time,” he added.
To survive such bouts of volatility, Mr. Just and his team of number-crunchers do not waste time trying to predict the growth rate of the Chinese economy or whether the Fed will go forward with its stated plan to raise rates sometime in the near future. Instead, they use a computer model that selects stocks from all over the world that do not shoot sharply up and down along with the broader stock market.
Deep Dive: Risk
Parity and ETFs:
1. Risk parity funds (the Curmudgeon owns one AQRNX) passively invest about $500bn in a range of assets such as stocks and bonds, using algorithms to periodically shift allocations in response to volatility. Those funds have used leverage to reduce the exposure that portfolios have to stocks by buying emerging-market and high-yield bonds. The idea is to give investors equity like returns without the volatility and concentration risk that comes from making a big bet on more volatile global equities. Last month, Ray Dalio’s All Weather hedge fund was down 4%, quite a sharp decrease for a fund that aims to insulate investors from precisely these types of sharp market movements. For the year, All Weather has lost 4.1%. Yet Mr. Dalio’s risk-parity strategy has had a long record of success. Its All Weather fund has returned 8 percent since its inception in 1996. Last year, the fund was up 7.5%.
Defenders of risk-parity investing say that these investment styles are not set in stone and that portfolios can be recalibrated on fairly short notice to make them less vulnerable.
“Some of the wrong conclusions are due to misunderstanding the strategy,” said Scott Wolle, chief investment officer of Invesco’s global asset allocation team, one of the biggest risk parity fund managers. “In some cases there are competitive reasons, in others there are the classic ‘the dog ate my homework’ excuses.” Invesco has about $20bn in risk parity strategies, which on average lost 4.34% in August, taking their loss this year to 2.43, according to Mr. Wolle.
Most risk parity funds use models and leverage to target a constant level of volatility, so when the turbulence of one or several asset classes climbs their models lower the exposure. Most agree that much of the sell-off was caused by fund managers spooked by China’s troubles and other, shorter-term volatility-targeting strategies that respond more swiftly to bursts of turbulence.
Bank of America has estimated that the volatility could trigger $30bn-$80bn of selling in equities and $50bn-$150bn in bonds by risk parity investors over time. JPMorgan said equity outflows alone could total $100bn over the next three weeks, mostly by RP funds. The industry itself strongly disputes these figures. AQR, a large hedge fund and one of the biggest risk parity managers, said it was “confident” the strategy played no role in recent ructions, and that the selling pressure estimated by some analysts was wildly exaggerated.
“The estimates in these reports overestimate the allocation to equities within risk parity strategies, overestimate the global investment in risk parity, and overestimate the amount of trading risk parity managers do in response to changes in observed volatility,” said AQR executive Michael Mendelson.
Roberto Croce of Salient Partners, another risk parity fund manager, sent a note to clients last week saying concerns over the strategy were based on a “fundamental misunderstanding” over how RP funds trade and how responsive its models are to bursts of volatility.
“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,” Mr. Croce wrote in the note to the Financial Times.
2. ETFs are baskets of securities, usually based on an index or sub-asset class. Unlike open end mutual funds, ETFs trade throughout the day with bid/ask spreads that should approximate their aggregate holdings. That is, big institutions are supposed to keep their prices in line with the value of the stocks they own. ETFs have grown rapidly, amassing more than $2 trillion in assets, half of which has accumulated in the past five years.
Ultra ETFs, which rely on leverage to boost investment returns, could in some instances be the “tail that wags the dog,” said Steven Schoenfeld, an early pioneer in ETF investing and founder of BlueStar Global Investors. The CURMUDGEON has said that or years, because the selling of ultra-long ETFs requires the market maker (i.e. authorized participants) to sell more than the constituent number of shares in the stocks that make up that ETF index or sub asset class.
Last weekend's Barron's attempted to explain
the ETF Debacle in late August.
“Aug. 24th highlighted the fragility of ETFs in a stressed market,” says James Angel, a professor at Georgetown University who specializes in the functioning of the stock market. “The characteristics of the products aren’t going to change, so we need to contain that fragility.”
A lack of transparency at the Aug. 24th opening bell prompted market makers to widen bid-ask spreads for both stocks and the ETFs that own them, according to fund company executives, traders, and academics who spoke with Barron’s. When orders to sell at market prices were then executed at unusually low bids, trading was paused, repeatedly, in hundreds of ETFs and stocks. That prevented specialized traders, known as authorized participants, from engaging in the arbitrage that keeps an ETF’s share price in line with its investments.
“The challenge was you had limited information in the marketplace,” says Jim Ross, global head of State Street Global Advisors’ ETF business.
Making matters worse, trading curbs for single stocks and ETFs kicked in en masse. Dubbed limit up/limit down, these rules aim to permit stocks and ETFs to trade only within specific price ranges before a time-out period in times of duress.
In practice, the large number of trading halts in both stocks and ETFs seem to have spawned even more trading halts, hindering the price recovery for many ETFs for about an hour. Fully 327 ETFs were hit with five-minute trading halts on the morning of Aug. 24. Eleven were halted 10 or more times, according to TD Ameritrade.
“ETFs are a function of the stocks they hold. If it’s unclear where the stocks open or if they go ‘limit down’ [if trading is paused], it makes it difficult to price the ETF wrapper,” said Luke Oliver, head of capital markets at Deutsche Asset & Wealth Management’s passive business in the Americas.
Joe Saluzzi, in a recent Welling On Wall Street (subscription required) piece titled “Liquidity Vacuum - ETF Market Dislocations & Market Maker Obligations” wrote: “These market makers are not the specialists of old and have no requirement to facilitate customer order flow so we understand why they might cut and run at the first sign of trouble. But let’s put an end to the charade that they add liquidity during times of market stress. Today’s market makers (or DMMs) are proprietary traders who look to scalp a profit for their own account and do so at their own discretion with very few obligations.”
Mr. Saluzzi goes on to say that the ETF market experienced a “flash crash” in many issues. Some large-cap, dividend ETFs like SDY and DVY dropped almost 50% only to recover much of those losses by 10:30am Eastern Time on Aug 24th. There were many ETFs which experienced multiple trading halts. Clearly, the ETF price discovery mechanism broke and some retail investors who had prudently placed stop-loss orders likely got terrible fills and lost more money than they should have the week of Aug 24th.
What remains unclear is how an investing community that has become accustomed to churning out safe and steady returns in a low interest rate, low volatility environment adapts to the new reality of wild market swings. Over 50 years of watching bull and bear market cycles have convinced me that this recent episode of big market swings will be with us for some time. The bias is definitely to the downside, with sharp one or two day rallies punctuating the downtrend. In several previous posts, Victor and I identified China as the potential catalyst for a severe correction/bear market. Therefore, we suggest watching China's market for a meaningful recovery before any sustained advance in global equities.
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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