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What Risk-Parity Paring Could Mean for Equities

The stock market, the bond market, the commodities markets (to a lesser extent), FX markets – they are all experiencing a marked increase in volatility.

Some observers want to call this bearish for equities, mainly because they already are bearish. This is a very bad reason. While really bad equity returns almost always occur coincident with a rise in volatility – the old maxim is that stocks go ‘up on the staircase and down on the escalator’ – that does not mean that volatility causes bad returns. Or, put another way, there are also periods of increased volatility that do not precede and are not coincident with bad returns.

However, there actually is a reason that increased volatility might lead to poor short- to medium-term returns, that isn’t based on technical analysis or spurious correlations. Moreover, a relatively new phenomenon (the rise of so-called ‘risk-parity’ strategies) is starting to institutionalize what was already a somewhat natural response to volatility.

In ‘risk-parity’ strategies, the weight of an asset class (or a security within an asset class, sometimes) is inversely proportional to the risk it adds to the portfolio. Generally speaking, “risk” here is defined as variance, because it is easy to estimate and there are markets where symmetrical variance trades – i.e., options markets. But what this means is that when volatility (sometimes realized volatility, and sometimes option “implied” volatility) rises in stocks, then risk parity strategies tend to be shedding equities because they look riskier, and vice-versa. Right now, risk parity strategies are likely to be overweight equities because of the long period of low realized and implied volatility (even though the valuation measures imply quite high risk in the sense most of us mean it, in terms of the probability of return shortfall). Risk parity strategies are probably superior to ‘return-chasing’ methodologies, but by being ‘risk-chasing’ they end up doing something fairly similar when they are all operating together.

Note that while risk-parity strategies are comparatively new – well, not exactly because it is an oldish idea, but they have only recently become a big fad – this general phenomenon is not. The natural response to greater equity market volatility is to pare back exposure; when your broker statement starts to swing around wildly it makes you nervous and so you may start to take some profits. This is also true of other asset classes but it seems to me to be especially true in equities. Nobody who gets involved in commodities is surprised at volatility: the asset class suffers from a midguided belief that it is terribly volatile even though commodity indices are just about exactly as volatile as equity indices over time. But equity investors, contrariwise, seem perennially surprised at 2% moves.

So, while the recent volatility doesn’t mean that a move lower in equities is assured, it increases the probability of such because risk-parity strategies (and other investors reacting nervously to overweights in their equity exposure) will begin to scale back positions in the asset class in favor of positions in other asset classes, probably mostly bonds and commodities. At this point it would be good for me to point out that only the very short-term volatility measures have moved up dramatically; the VIX is well off its bottom but only up to 18.8 and it has been there numerous times in the last few years (see chart, source Bloomberg). But the longer the volatility continues like we have seen it for the last week or two, the bigger the chances that the asset-allocation boxes start to make important shifts (and the quant hedge fund boxes will probably move a bit before those asset allocation boxes do).


As an aside, the tendency for asset allocation shifts to follow volatility shifts is not the reason that the VIX displays a strong inverse directionality. Neither is the main reason for this inverse directionality because the VIX is a “fear gauge.” The main reason is that the VIX weights near-the-money options more heavily than out-of-the-money options. Because options skews almost always imply more downside volatility for stocks than upside volatility[1], when the market declines it tends to bring more “high volatility” strikes into play and so part of the VIX increase in a down market is simply mechanical.

I am not calling for a sharp decline in stocks, nor for an extended decline in stocks. My position and view is as it has long been, that the prospect for attractive real returns from equities over the next 5-10 years is quite small and beaten handily by commodities’ prospective returns at that end of the risk spectrum. I don’t think that most investors (me included!) should swing asset allocations around frequently in response to technical indicators or such things as “momentum”, but rather should focus on evaluating expected long-term returns (which are somewhat predictable) and invest for value. And I must admit I also think that “risk-parity” is a clever marketing gimmick but a pretty absurd way to assemble a portfolio for almost everyone. My point here is to highlight one little-considered aspect of herd behavior, and how that herd behavior may have become more institutionalized as late, and to consider the risks that herd behavior may create.

[1] This in turn is not due so much from the tendency of markets to have more downside volatility than upside volatility, but from the fact that buying protective puts and selling “covered” calls are both considered “conservative” options strategies. So, out-of-the-money puts tend to be too expensive and out-of-the-money calls too rich.

  1. October 9, 2014 at 5:37 pm

    Fascinating piece. By the way I think the expression is “staircase up, elevator down” for stocks (not “escalator down”) although the Fed may try sticking an “out of order” sign on the elevator.

    • October 9, 2014 at 5:39 pm

      I’ve always heard escalator, but does it REALLY matter? 🙂

      • October 9, 2014 at 5:41 pm

        Here you go, from “the world’s mot interesting man”, lol: http://thereformedbroker.com/2010/01/26/remember-guys-they-take-the-stairs-up-but-the-elevator-down/

      • October 9, 2014 at 5:43 pm

        What, so this guy is the expert? They were saying this before he was BORN!!!

      • October 9, 2014 at 5:45 pm

        i mean, he admits he was a BROKER! Why would you listen to him!? Rule 2 of investing is “ignore your broker.” 🙂

      • October 9, 2014 at 5:51 pm

        If you Google ‘stocks take the stairs up and the elevator down’ you’ll see a zillion links. If you do it with ‘escalator’ instead you only see a few. (Yes, I just wasted the time to check, lol.)

      • October 9, 2014 at 5:52 pm

        fine. But I’m going to keep saying it the same way I learned it. Can we at least agree that you buy the rumor sell the NEWS, not “sell the fact”?

      • October 9, 2014 at 5:56 pm

        Not only do I agree with that, but one of the things that tells you when the bubble is bursting is when story-stocks transform from “buy the rumor AND buy the news” into “sell on the news.” (Let’s see what happens tomorrow with TSLA.)

  2. eric
    October 10, 2014 at 8:05 am

    how much do you weight this mornings import prices report in the inflation picture? looking very soft.

    • October 10, 2014 at 8:12 am

      Basically zero. Import prices are essentially oil prices (or anyway all of the volatility comes from oil prices). So it doesn’t tell us much of anything. Inflation guys use it for marketing when it’s a good number, but that’s all. 🙂

    • October 10, 2014 at 8:13 am

      …and actually it was much LESS soft than expected, so if anything this would be bullish inflation.

  3. October 10, 2014 at 11:03 am

    This is a good perspective on building a portfolio as I have been reading on risk parity recently. That said, what makes you more bullish on commodities relative to equities and fixed income? [I’ve been thinking they would all be sub par over the next while].

    • October 11, 2014 at 8:28 pm

      You can look at some of my old articles, but the basic idea is that commodities relative to money or to other real assets have been in an awful downtrend for three years while almost every other asset class has gone up. That’s very weird – if you discover a huge supply of tin all of a sudden, the ratio of the price of tin to the price of (say) oil or real estate or anything else should decline sharply. Well, we have hit the motherlode on money (M2) which means the price of money should decline relative to real assets – that is, their price should rise over time at something like the GDP-adjusted rate of money growth. In fact, this ratio is near the worst levels ever (and it tends to be mean-reverting). Or look at commodities/stocks. Same story. So we see commodity indices ( not gold!) as having high risk-adjusted returns over the next 5-10 years especially relative to stocks.

  4. eric
    October 10, 2014 at 11:06 am

    Ok, good to know. Although at this point ignoring energy as “not core” might not be so wise, as its looking to be heading down in a way that might be more than just volatility. If Japan and Europe are both heading into recession (looks like a done deal for, e.g., germany) energy prices might remain very soft for the foreseeable future.

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