Wall Street is getting sucked into the blame game.
Now that the market seems back on more solid footing, and the reasons for the recent selloff are somewhat fading from view, more and more people on Wall Street are looking for someone to point the finger at for last month’s quick drop. And a surprising number of people are zeroing in on an obscure hedge fund strategy, with a name that suggests that it seeks to decrease risk, not increase it, as the source of all the trouble: so-called risk-parity funds.
Risk-parity funds have been around for a while, and they seek to do something that sounds pretty benign: diversify the risk in your portfolio between stocks, bonds, and other assets. Ray Dalio’s Bridgewater Associates is one of the pioneers of the strategy, marketing it as a better long-term approach to investment for pension funds around the country. He calls his The All-Weather Fund.
Nevertheless, a growing number of people are implicating Dalio’s fund and others like it for last month’s market storm. Top strategies at both Bank of America and JPMorgan Chase have published reports that pointed to the funds as at least a partial source of the trouble. Last week, hedge fund billionaire Leon Cooperman said that risk-parity “shares the blame” for August’s market turmoil. And on Wednesday, the New York Times piled on, reporting that a Wall Street cure for risk is proving to be worse than the disease. Clever.
Risk-parity funds were not supposed to completely protect people from risk, though. They do tend to be less risky, but that is just a by-product. The main goal of the strategy is to even out risk. And they tend to do that by bringing increasing the risk of owning safer assets, rather than the other way around. The funds typically do this by borrowing against a debt portfolio to amplify the gains, and losses, of holding bonds, which, when unlevered, are generally less risky than holding stocks. And risk parity funds will typically hold significantly more bonds than stocks to borrow enough to get their bond market risk to equal what they are risking in the stock market.
The issue is that many risk parity funds do, along with lots of other traders, tend to measure risk by looking at volatility. And stock market volatility spiked on August 24, when the market opened with the Dow Jones Industrial Average down 1,000 points. The theory is that a spike in volatility caused risk parity funds to automatically sell stocks, which all of sudden looked more risky, in order to keep their portfolios in balance.
The problem with that logic is that risk parity funds, even all put together, didn’t have that much to sell, at least when it came to stocks. In a report, JPMorgan’s chief quantitative strategist Marko Kolanovic said that there are $500 billion dollars in assets invested in risk parity funds. Bank of America says as much as $80 billion in stock sales may have come from risk parity funds. And JPMorgan’s analysis said the funds may have to sell an additional $100 billion worth of stocks to get back to their preferred risk-neutral stance. You may already see the problem with that math.
Even in normal times, the average risk parity fund only has about a third of its portfolio in stocks, again to be risk-neutral. That means, as a group, they only hold around $150 billion worth of stocks. They would have to sell all of the stock they own and then some in order to satisfy Bank of America and JPMorgan’s numbers. And risk parity funds didn’t sell all of their stocks, just some of them. And that’s if JPMorgan’s asset numbers are correct.
And they probably aren’t. Bridgewater’s All-Weather fund has just $75 billion in assets, and it is by far the largest of the risk parity funds. Michael Mendelson at AQR, another hedge fund that runs a large risk parity portfolio, says the amount of assets in risk parity funds is smaller than people think. He says the funds don’t even collectively own $100 billion in equities, let alone have $100 billion to sell. And to put that in perspective, at the end of last year, there was over $8 trillion dollars in equity mutual funds. Risk parity funds, even if they sold all of their stocks, which they didn’t, still would only be a drop in the bucket.
A separate report from JPMorgan found that the stock market exposure of funds in general fell more than that of risk parity funds.
What is true is that there are more fund managers that look at volatility. And all of that volatility watching has probably made the market more volatile, in short spurts. The VIX, which is the most common measure of volatility, has been around for over a decade and for most of that time volatility has been pretty low, until very recently.
But the fact that selling leads to more selling is not a new thing on Wall Street. People panic. And computers aren’t new. The stock market crash of 1987 was blamed on computers programed to sell when the market was down. And when we stop panicking, we have a tendency to look around and blame someone else. There were a lot of reasonable reasons to sell stocks last month, including China, oil, and the fact that stocks have gone up a lot, perhaps more than the weak economic recovery deserves.
In fact, the real danger with risk parity funds doesn’t have to do with stocks. It has to do with bonds, which is the levered part of their portfolio. And with the Federal Reserve nearing its first rate hike in a long time, we could see a significant spike in bond market volatility. That could cause the risk parity funds to generate some volatility in the market, but we haven’t seen that yet.