By Luke Kawa
(Bloomberg) -- Look out below.
Risk parity funds, a popular strategy that was battered during the volatility shock that rocked financial markets in February, are still the most vulnerable around, said Paul Britton, founder of Capstone Investment Advisors LLC.
“That strategy has been so successful and deserves credit for providing the returns it’s provided, but it’s the weakest hand in the market," he said in an interview on the sidelines of Wednesday’s Global Volatility Summit in New York. "The strategy has gotten to a size -- whether it’s publicly available numbers or what’s embedded within institutions -- it’s so enormous that the market’s going to take a run at trying to stress that position."
There’s roughly $1 trillion in assets whose exposure is intrinsically tied to the price of volatility, he estimates, once risk parity funds, vol control strategies, and commodity trading advisers are tallied up. This pool hasn’t hasn’t changed its positioning dramatically since the market maelstrom, the 44-year-old hedge fund manager contends.
Risk Parity Party’s Over
Risk parity strategies attempt to spread volatility equally across different asset classes with the aim of producing smoother returns. In practical terms, this entails having higher exposure to fluctuations in bonds than a traditional 60/40 portfolio. Practitioners of this approach, which can be found in many different flavors, include the likes of Bridgewater Associates and AQR Capital Management.
A common theme among the fund managers and allocators presenting at Wednesday’s conference was a focus on a sustained flip in the presumptive negative correlation between stocks and bonds as a catalyst for enhanced volatility. Such a development could wreak havoc on strategies (like risk parity) that have benefited from a decades-long bull market in fixed income, effectively cushioning blows to the portfolio when equities sell off. Indeed, the 90-session correlation between stocks and bonds is at its most positive level in more than a year -- but for now, that dynamic is working in favor of those long both asset classes.
Britton, for his part, says he fields calls from clients at least once a week on how to hedge a persistent reversal in this correlation, underscoring broad investor angst over the potential for a market backdrop that could pose acute pain for risk-parity funds.
"I think the big, real, instrument to be watching is 10-year rates because of simple economics," he said. "If you can get paid 3 percent to hold U.S. government risk versus 5 percent for a short vol risk premia strategy -- well, that argument and those discussions are going on right now."
The Real Tail Event
February’s market chaos included a “tail wagging the dog” phenomenon as equity markets seemingly took their cues from massive swings in the price of implied volatility. But in Britton’s eyes, this episode proves the volatility complex’s influence over financial markets is more like a 200-pound Rottweiler on a leash with the power to drag its owner back and forth.
The Feb. 5 implosion of exchange-traded products that let investors bet on enduring market calm amounted to a loss of just over $3 billion in assets, according to Britton, who bet against the now-liquidated VelocityShares Daily Inverse VIX Short-Term exchange traded note the day it plummeted by more than 85 percent. That’s tiny, in the grand scheme of things. But the extent of the carnage that ensued in global stocks "is undeniable evidence that really the ecosystem is tethered, whether it likes it or not, to the price and gyrations of the volatility market," he said.
2017 -- not this past February -- was the "real tail event" for volatility markets, Britton said, and a new regime has dawned. From 1990 through 2017, the Cboe Volatility Index closed below 10 just 61 times -- and 52 of those occasions were in the last calendar year.
"That’s an extraordinary set of distributions that isn’t going to be repeated," he told the audience. "In fact, I’m taking it out of my risk process just like 2008 -- both are highly improbable events that aren’t likely to happen again, and if you don’t take 2017 out of the distribution then you’re underpricing risk."
Liquidity is at all-time lows, he said, pointing to the dwindling value-at-risk reported by the largest U.S. banks in aggregate, leaving the market "fragile and vulnerable."
--With assistance from Dani Burger. To contact the reporter on this story: Luke Kawa in New York at [email protected] To contact the editors responsible for this story: Jeremy Herron at [email protected] Joanna Ossinger, Dave Liedtka