Risk-Parity Funds and The Selloff

Feb 08, 2018

Risk-Parity Funds and The Selloff

Global equity markets have sold off significantly over the past several trading sessions. This is not breaking news! What may interest investors, however, is the recent debate around the acceleration in the stock market sell-off.

More traditional investors have become wary and critical of firms utilizing what is known as a risk-parity investment strategies. The objective of this approach is to reduce total portfolio risk of a multi-asset portfolio. Risk-parity funds use leverage and purchase more treasuries (and other high-grade bonds) in an attempt to lower total portfolio risk (through the use of leverage). However, is portfolio risk “actually” lowered? Recent increases in implied and realized volatility have led risk-parity portfolios to sell risky assets (like equities) and buy more high-grade debt (like Treasuries). This creates a negative feedback loop as selling equities causes volatility to increase which triggers further selling of equities. This phenomenon, in part, explains the rapid rise of the VIX index and the acceleration of the sell-off over the past few trading days.

In spite of the negative feedback loop, risk-parity funds have managed to outperform the broader market. A recent Wall Street Journal piece titled "Is This Obscure Wall Street Invention Responsible for the Market Selloff?" looked at AQR's Risk Parity Fund as a way to measure the effectiveness of the strategy. When the market saw an average decline of 4% on Monday, the firm experienced a loss of only 1.9%. While there exists a negative sentiment towards funds using this approach, are these funds having the last laugh?

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