Was David Woo Right; Was the Selloff Exacerbated by Risk Parity Strategies?
/Today after the close Bloomberg TV had David Woo, Managing Director and Head of Global Rates and Currencies Research at Bank of America/Merrill Lynch, on to provide some insight regarding recent market action. More specifically, he addressed how Chinese and American markets are linked.
He dropped a lot of gems during his segment but one point really struck a chord with me. He said that the recent selloff has likely been exacerbated by "Risk Parity Guys".
If you're unfamiliar with 'risk parity' here are some good working definitions:
“Risk parity (or risk premia parity) is an approach to investment portfolio management which focuses on allocation of risk, usually defined as volatility, rather than allocation of capital.”
“A portfolio allocation strategy based on targeting risk levels across the various components of an investment portfolio. The risk parity approach to asset allocation allows investors to target specific levels of risk and to divide that risk equally across the entire investment portfolio in order to achieve optimal portfolio diversification for each individual investor. ”
Essentially, this says that risk parity strategies approach portfolio allocation based on the underlying asset's risk/volatility as opposed to traditional portfolio allocation which allocates capital based on holding some specified amount of each asset class.
David Woo went on to elaborate that traditional asset class correlations began to break down during this selloff, implying that traditional methods of diversification were no longer viable and as a result any fund/fund manager which allocates capital on the basis of 'risk parity' or similar strategies would be forced to reduce risk across all asset classes.
I thought this was a brilliant insight and immediately wanted to see if I could find some evidence that would support his analysis.
To do this I used my Composite ETF model to plot rolling correlations of the 'Bonds' ETF composite vs the ETF composite of each asset class. The reason I use rolling correlation is because of the inherent link between asset correlations and volatility. Specifically, as correlations across assets/asset classes rise diversification decreases and volatility/tail risk increases. I've selected some of the more interesting plots that lend credence to his statement.
bonds vs asia-pac equity
bonds vs consumer discretionary
bonds vs consumer staples
bonds vs europe equity
bonds vs financials
bonds vs global equity
bonds vs industrials
bonds vs large cap
bonds vs materials
bonds vs mid cap
bonds vs precious metals
bonds vs real estate
bonds vs small cap
bonds vs telecom
After reviewing some of the evidence I would say David Woo is on to something. To be fair however, rising correlations among this many asset classes over a short time period is likely to cause multiple types of fund strategies to reduce risk exposures quickly.
If you haven't seen his segment I'd recommend trying to find it. Either way I'll be on the lookout for his analysis going forward.
