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Fri12152017

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Back You are here: Home Market Market Update Insight The cause of the recent market volatilities

The cause of the recent market volatilities

When markets fall fast and hard, investors look for something to blame. This time around, a lot of the ire is focused on a trading strategy known as risk parity,i.e. the risk parity strategies amplified a market downdraft.

What is risk parity?  According to Wikipedia, Risk parity is a conceptual approach to investing which attempts to provide a lower risk and lower fee alternative to the traditional portfolio allocation of 60% stocks and 40% bonds which carries 90% of its risk in the stock portion of the portfolio. The risk parity approach attempts to equalize risk by allocating funds to a wider range of categories such as stocks, government bonds, credit-related securities and inflation hedges (including real assets, commodities, real estate and inflation-protected bonds), while maximizing gains through financial leveraging.

It is an approach to investment portfolio management which focuses on allocation of risk, usually defined as volatility, rather than allocation of capital.  The risk parity approach asserts that when asset allocations are adjusted (leveraged or deleveraged) to the same risk level, the risk parity portfolio can achieve a higher Sharpe ratio and can be more resistant to market downturns than the traditional portfolio.

One of the most high-profile accusation was from Leon Cooperman, founder of Hedge Fund - Omega Advisors.  It's equity-focused funds dropped between 9% to 11% and are down between 6% and 11% for the year. According to Cooperman and his partner Steven Einhorn, fundamental factors, including turmoil in China and jitters over the Federal Reserve interest-rate outlook can't fully explain the magnitude and velocity of the stock market's drop in August.

Holding the same view is JP Morgan's Marko Kolanovic.  He warned that the rapid rebalancing by such funds could make chaos such as "price insensitive flows," determined by algorithms and risk limits, threaten to push the market away from fundamentals.  

Reference:

MarketWatch, William Watts, 2015-09-03, "As Volatility Soars, this Obscure Trading Strategy Draws Wall Street's Ire"