Volatility in the US Treasury market at the end of 2014 could be a taste of the next financial panic.
And risk parity, a hedge fund strategy that made hay through leveraged exposure to bonds over the last 20 years, may be part of the problem rather than the solution.
Risk parity strategies create specific risk levels across an investment portfolio in contrast to traditional allocation models that are based on holding a certain percentage of investment class, such as 60% equities and 40% bonds, within a portfolio.
Action in US government bond markets on 15 October – when yields moved 40 basis points in a day – stunned commentators. The seven-to-eight standard deviation swing is statistically a one in three billion year event, wrote JP Morgan chairman and CEO Jamie Dimon in April, in an annual letter to shareholders.
“The good news is that almost no one was significantly hurt by this, which does show good resilience in the system,” he adds.
“But this happened in what we still would consider a fairly benign environment. If it were to happen in a stressed environment, it could have far worse consequences.”
Risk parity does not receive specific mention from Dimon; other commentators have gone further. Volatility in markets as crucial as US government securities can cause problems for these hedge funds, argues joint-chief investment manager Chad Slater at Morphic Asset Management in Sydney, Australia.
“The issue we’d raise is that these models encourage the selling of assets as risk goes up, rather than the buying that the old model suggested,” Slater writes on the Morphic Asset Blog.
Traditional long-only 60:40 equity/bond mutual funds ordinarily buy equities or bonds as allocations fall below desired weights, creating a counter-cyclical element of demand for asset classes as they fall.
Pitched for a risk parity product by an investment bank in Sydney, Slater argues a number of factors – including the popularity of risk parity as well as standardised risk management models – are converging to create a perfect storm in financial markets.
“To us, October was a warning shot across the bow of how a number of new factors – new in the sense they didn’t play a role in the 2008 crisis – could come into play in the next crisis,” he adds.
Illiquidity in the bond market, Slater shows, caused fund managers to sell equity futures as a proxy for overweight bond positions that could not be offloaded because of a lack of liquidity. This led to a 7.5% decline in the Standard & Poor’s 500 index across five trading days.
Slater’s research findings are reminiscent of criticisms of “portfolio insurance” strategies employed widely in the 1980s, and blamed for the 1987 Wall Street crash. Ironically that sell-off occurred on October 19.
In 1987, portfolio insurance providers sold equity index futures contracts to cover losses if stock markets declined. Heavy selling on the Chicago futures exchange pushed contract prices lower than those implied by the stock market indices in New York. Selling of stocks in New York set in motion a downward spiral, which saw the Dow Jones Industrial Average fall 23% in a day.
Markets stabilised this time around as they found a floor and margin calls appear not to have kicked in, continues Slater.
“If we are right, the risk of this occurring in the future is higher than most participants believe. We think we will see more of these factors come to the fore again,” says Slater.
“Or, as Warren Buffett famously put it: It’s not until the tide goes out that you see who was swimming naked.”