The $80 billion Bridgewater All Weather Fund, a risk-parity model managed by hedge fund titan Ray Dalio, was down 4.2% in August, according to Reuters citing two people familiar with the fund's performance. This leaves the fund down 3.76% for 2015 as the frameworks for these funds are forced mechanically to reposition as correlations and volatilities across asset classes break down. Just as we saw in the summer of 2013's Taper Tantrum, the last 2 weeks have seen 4 to 5 sigma swings in daily returns and 'generic' risk-parity funds have suffered the biggest 3-month losses since the financial crisis.
And here is the simple reason why these funds 'broke'... China selling Treasuries to meet liquidity needs as global carry trades were unwound and smashed stocks lower 'broke' the historical relationship between stocks and bonds. Since the so-called "risk parity" strategy is supposed to make money for investors if bonds or stocks sell off, though not simultaneously.
And this did not help the multi-asset funds - the USD-Commodity correlation regime flipflopped...
Simply put, the historical relationships between asset classes (volatilities and correlations) that are used to construct optimal "risk-parity" funds in order that 'risk' is balanced and hedged across bonds and stocks (for example) broke down dramatically:
First, realized volatilities exploded relative to historical (or even forecast volatilities) that are used to weight exposures; and
Second, the correlation regime entirely flipped for multiple asset classes - entirely breaking any 'expected' diversification or hedges.
And the result...based on Salient Risk's Risk Parity fund index, the last 3 months have seen a 10.7% drop - the most since the financial crisis (and worse than the mid 2013 plunge). Some context for the recent moves may help:
- Friday August 21st - 4 Sigma plunge
- Monday August 24th - 5 Sigma crash
- Thursday August 27th - 5 Sigma Spike
- Tuesday September 1st - 4 Sigma collapse
Risk manage that!
Which explains why we also saw the big drop in mid 2013 (Taper Tantrum) when - just as this past 2 weeks - bonds sold off and stocks sold off...before a complete flip-flop right aftre the June FOMC meeting.
We asked in August 2013 - When Will Risk Parity Funds Blow Up Again? - it appears we have our answer.
As UBS' Stephane Deo noted then (and JPMorgan has confirmed now), that in a rising rate environment, so-called risk-parity portfolios were susceptible to draw-down as yields 'gap' higher.
As UBS noted at the time, which seems just as crucial now, it is not the actual rate increases (or decoupling) but the "speed limit" or velocity of the moves and with liquidity either 'on' of 'off' now, the gappiness of moves increased the potential threat from risk-parity funds.
Risk Parity strategies de-lever when asset volatility and correlation increase. In our report last week, we estimated that risk parity outflows from equities may total $50-100bn on account of the increase in market volatility and risky asset correlations. These rebalances have started, but, given their typically slower rebalance frequency (e.g. monthly), are largely incomplete. We believe the bulk of the risk parity flows are yet to come, and this may add selling pressure to equities over the next 1-3 weeks. To illustrate this point, one can look at a sample multi-asset Risk Parity strategy such as the Salient Risk Parity index. The beta of this index to the S&P 500 (shown in the figure above) reached highs of 60% in early August, and has dropped to about 45% currently (compared to a beta of 0% during some of the previous episodes of market volatility).