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Crunches the Numbers on Summer's Quant Storm

Risk parity is all the rage right now, though not in the way you might think. In fact,
the strategy may have just exacerbated one of the largest selloffs ever
Traders Magazine Online News, September 1, 2015

Tracy Alloway
(Bloomberg Business) -- After decades of study Ray, Bob, Greg Jensen, Dan Bernstein and others at Bridgewater
created an investment strategy structured to be indifferent to shifts in discounted economic conditions. Launched in
1996, All Weather was originally created for Rays trust assets. It is predicated on the notion that asset classes react
in understandable ways based on the relationship of their cash flows to the economic environment. By balancing
assets based on these structural characteristics the impact of economic surprises can be minimized.

Risk parity is all the rage right now, though not in the way you might think. In fact, the strategy may have just
exacerbated one of the largest selloffs ever as asset managers reduced leverage and rebalanced portfolios during
recent swings in the markets, according to Bank of America Merrill Lynch.
But first some background.
Risk parity strategies, pioneered by the Bridgewater Associates hedge fund in the 1990s, seek to create "all-weather"
diversified portfolios of assets including bonds, stocks and currencies -- often adding leverage to fixed-income
investments to boost their returns to stock-like levels.
While the assets in risk parity-related funds have proliferated in recent years, causing some to question their safety
and performance, it's worth noting here that the danger is not necessarily in the strategies themselves but in the
particular way they target, forecast and handle both volatility and leverage.
It's a point brought home on Tuesday by Bank of America Merrill Lynch equity derivatives strategists, led by Chintan
Kotecha, who write that "Risk parity is not the risk, vol[atility] control is." As they note, it's worth differentiating
between risk parity investors with a fixed amount of leverage, and those who tie the amount of leverage applied to
their portfolios to market volatility. The latter begin life with a target portfolio volatility level and then apply a certain
amount of leverage to their portfolio based on their forecast of future portfolio volatility. An easy example used by
BofAML is two times leverage applied to a portfolio with a target volatility of 10 percent and expected to have a
volatility of 5 percent. Conversely, a portfolio with forecast volatility of 20 percent could achieve a target volatility of 10
percent by deleveraging its portfolio to 0.5 times levered.
The assumptions are key here, and unfortunately the world of quantitative finance has a somewhat spotted history
when it comes to forecasting things like correlation and volatility. We know already that low levels of volatility and high

correlations across asset classes over the past six years have encouraged many investors to load up on risk -- both
in terms of duration, leverage and credit.
With volatility exploding from historically suppressed levels last week, it's almost certain that some risk parity funds
were forced to rebalance their portfolios, but the degree will depend on their particular volatility strategy.
Here's BofAML:
If the leverage applied to risk parity is via target volatility, then the change in component allocations due to
dynamically adjusting the portfolios leverage could potentially lead to a collective significant deleveraging of assets
tracking risk parity. The amount of deleveraging will be a function of the funds target volatility and maximum leverage
allowed. But more significantly, the deleveraging will also be a function of the prevailing volatility prior to the volatility
spike and the magnitude of the daily moves within the volatility spike. There are a variety of different target volatility
levels and leverage caps that are often applied by risk parity funds. Typically, they tend to target a volatility level
between 6 percent to 10 percent with maximum leverage ranging from 1.5x to 3.0x.

Regardless of the target volatility and max leverage limits within a risk parity fund, however, the recent and unusually
violent spike in equity volatility from depressed levels ... alongside a relatively muted diversification benefit from fixed
income ... led to a significant spike in the volatility of, and likely a subsequent deleveraging from, some risk parity
strategies.

In Charts 7 through 9, we aim to show the sensitivity of the deleveraging of target volatility funds as a function of (a)
the funds target volatility, (b) the maximum leverage allowed, (c) the prevailing level of the funds unlevered volatility
prior to a spike in vol, and (d) the drawdown in the unlevered fund. Each chart assumes a different level of the funds
unlevered prevailing volatility prior to a vol spike and we use 8%, 6%, and 4% respectively.

By BofAML's estimates, based on a sample risk parity fund with 10 percent target volatility and maximum leverage of
two times, last week's market events could have been massively and historically painful.
In this hypothetical example the current deleveraging would be the 7th largest (Table 3) but could be the most
impactful on markets given the growth in assets tracking risk parity in recent years.

But there are several assumptions that underpin that claim, not least the funds' own assumptions and expectations of
market volatility. On the plus side, it's not at all clear that all risk parity funds are using target volatility to create
leverage. On the downside, there are non-risk parity funds that may have been using similar volatility overlay
strategies.

Overall, BofAML estimates that last week could have seen $30 billion to $80 billion of stock selling from risk parity
funds plus $25 billion to $50 billion from non-risk parity vol players who had to retool their portfolios thanks to market
swings.
Still, the BofAML analysts -- unlike some of their compatriots at other banks-- remain pretty optimistic, that the
summer storm for all-weather funds is over.
The critical assumption embedded in all of these estimates is that the funds in question operate mechanically and are
forced to deleverage relatively rapidly, almost agnostic to market impact. While this is certainly true of some funds,
and while vol target funds as a whole may rebalance more frequently than risk parity funds, many managers can and
do exercise discretion to smooth out their rebalancing. While some have advised remaining on high alert over the
coming weeks for the impact of further programmatic deleveraging flows, we believe the risks are in fact much
reduced. Funds that operate mechanically with quick triggers have likely already delevered meaningfully, and coupled
with now-elevated volatility levels, a secondary shock would necessitate materially less model-driven selling.
Fingers crossed.

To contact the author of this story: Tracy Alloway in New York at talloway@bloomberg.net To contact the editor
responsible for this story: Timothy Coulter at tcoulter@bloomberg.net