Risk Parity — Is It Game Over?
Unprecedented, unprecedented … Yes, it happened again. Unprecedented. At least in certain ways.
I lost count of how many times I said this word since I started investing. And unsurprisingly, it was usually accompanied by a period of extraordinary pain to my pocket.
In this first quarter of 2020, we witnessed the power of Mother Nature coinciding with Human Nature. disrupted our daily lives and brought extreme fear and chaos to the financial markets. What is most astounding in this episode is the speed at which the stock market turned and plunged into the bear territory.
It took only 19 trading days for SPY to plunge 29% from its highs. To put things into perspective, compare this with the previous bear markets. The Great Financial Crisis (GFC) in 2008–2009, which we thought was fast, took about 250 trading days. And the Dot Com Crash in 2000–2002 took around 360 days. Previous moves of such magnitudes happened only well into the bear market and not at the start. So what just happened made the past 2 crisis looked like gentle babies. There is hardly any time to react unless you are already positioned for it.
Risk Parity Chronicle 2020
I ran multiple strategies in my own portfolio. Most headed south rapidly during this period because they are running a net long bias. My best performer for the year is a volatility hedge that I put on prior to this event. I had closed the position to lock in the profits. That helped to cushion the losses coming from my other positions. But for your information, I didn’t know this is coming. It is just part of my longer term hedging strategy in case such a tail event occurs. Aside from the hedge, only a few other strategies were spared the magnitude of this fallout. And the Risk Parity strategy (it runs on 1.7x leverage) I wrote about in a previous post is one of them.
It was not entirely a joy ride though. Let’s take a look at how Risk Parity did during this period.
The Invincible Ride Up : 1 January 2020–21 Feb 2020
Risk Parity started the year on a solid footing. While COVID-19 is starting to stir up a storm, the different asset classes are still performing in line with expectations. Even when the first wave of sell off in the equity markets began on the 19 Feb 2020, it was still holding up. Safe haven assets such as bonds and gold were on a roll when the turmoil worsened, more than offsetting losses from the stock markets. As at 21 Feb 2020, the Risk Parity portfolio was still sitting on a YTD gain of about 8%. SPY ETF representing S&P 500 was also in the green as well, being up more than 3%.
Panic Descends : 22 Feb 2020–6 Mar 2020
Things took a dive from 22 Feb — 28 Feb as the global COVID-19 situations deteriorate. SPY took a steep fall of more than 12% from its high, dropping every single day continuously for 7 days. Risk Parity followed south this time, albeit to a lesser degree, as safe havens showed a more muted response against the larger drops coming from risky assets.
The start of March then provided some respite. Many asset classes rallied and Risk Parity actually regained its footing and hit a new high on the 6 March. The credit goes to the strong performance from longer duration bonds as risk aversion rose and investors piled in. SPY, on the other hand, resumed its descent 2 days ago and was back near its prior low. At this point in time, Risk Parity was up more than 8% for the year while SPY has rapidly deteriorated and nursing a loss of -8%.
Liquidity Dries Up and Correlation Breaks Down : 22 Feb 2020–18 Mar 2020
As most people stayed fixated on the stock markets, a worse threat is growing in the bond markets. The sell off have sparked a level of volatility not seen giving rise to strains in liquidity within the Treasury markets. This leads to numerous issues including widening basis between off-the-run Treasuries and on-the-run Treasuries with similar features. For a long time, funds had put on highly leveraged relative value bets on the narrowing of these basis. In theory, this should work most of the time. But this is not your typical time. Mounting losses leads to further unwind in an already unfavorable and illiquid market.
The traditional bastion of safety, US Treasuries, buckled and gave way. Gold was not spared as well. We witnessed massive outflows from all asset classes as institutions started deleveraging, taking profits or selling whatever they have to meet coming obligations. The only thing in demand is CASH.
US Federal Reserve stepped in on the 15 Mar slashing Fed Funds Rate to 0% and announcing a $700 billion program to restore the proper functioning of the Treasury markets. That didn’t seem to impress the market amidst concerns on funding and progress of a much larger fiscal stimulus in the pipeline. Risk Parity continues to plummet to a loss of -11% on 18 Mar 2020. SPY was far worse at -25%.
The Federal Reserve Show Hand : 19 Mar 2020–31 Mar 2020
In just a week, US Federal Reserve upped its stakes to the max. It introduced officially UNLIMITED Quantitative Easing. As far as monetary stimulus is concerned, this is practically the end of the road. It can’t put money directly into the hands of the people, force people to lend or spend, but it can at the very least stabilize the market volatility somewhat. And in the process, they bailed the big guys out again. Yes, it is not fair. But I guess the policy makers are not in an enviable position either. Let everything crumble, go through a hard reset, walk into a totally unchartered terrain to forge a new order or kick the can down the road and keep the music playing?
Anyway, the monetary bazooka was a welcomed relief while waiting for the fiscal measures. Almost all asset classes staged a rally after that. Stocks, in particular, put on a compelling performance that rivals the ferocity of its drop. And at the end of March, Risk Parity recovered and edged up with a slight gain of less than 1% gain for the year
Are We Near The End?
Even though Risk Parity weathered through this quarter, it triggered questions regarding its sustainability. With Fed Fund rates at zero and monetary tools drying up, does this mark the demise of Risk Parity type strategies which relies on traditional safe haven assets such as bonds to deliver?
Theoretically speaking, bonds prices will rise as long as the rates goes lower, even if it is below zero. There are real examples around e.g. Japan and Germany. Moreover, while US is close, it is not there yet. Unlike Japan, as at this moment, the yields of longer term Treasuries are still above zero. And as we have seen, Fed Fund rates are not the only tools at the central bank’s disposal. And since 2008, central banks worldwide have become more ready to innovate and deploy whatever is necessary to keep things running.
In fact, what I worry more goes beyond the upside of bonds being capped, but rather where this leads to for the broader market. In a way, the loose monetary policies helped set the stage for what happened today. It was spectacularly successful in fueling a dramatic stock market rise and widening the rich-poor gap and social divide. But it was way less effective in generating wealth and demand among the larger population which is the real engine for growth.
It is difficult to know where this will take us. And I believe no one have the answer. If the top brains with all the resources at their fingertips fails to see what is to come again and again (or rather they knew what is to come, but just did not know when, or thought they could managed whatever came their way), then what could mere mortals like us do? But in a highly undesirable scenario, if we do follow Japan down the bottomless pit of deflationary and economic woes, then the stock market is in for a rough ride. Japan lost more than 3 decades of time and is still in this pit.
Performance Assessment
As a rule of thumb, I lean towards using historical performance to guide my decisions when treading on uncharted waters. Because that is the only reliable thing at my disposal. I have seen enough so called “sensible” discretion that fails. Timing and execution is of paramount importance even if you get your call right. For example, there are people shouting bears as early as 2014. Yes, they finally got that right but only 6 years later in 2020.
So for me, a more objective way is to look at how Risk Parity fared today against what is has been through.
Is this the first time that Risk Parity encounter situations where all assets tumble together?
NO. There are numerous occasions throughout history where correlation between the assets goes up over a period of time. They happened for various reasons. For example, a rate tightening regime which the market is not prepared for can trigger a sell off across both stocks and bonds. The taper tantrum in 2013 is one such incident. And in this current case, Mother Nature triggered a liquidity crisis. But if you looked back further, the same thing happened in Oct 2008 after Lehman Collapse. And the impact was worse. The Risk Parity portfolio lost more than 12% in that month alone.
The table below shows the historical months between 2005 and 2019 where all major assets fall in line with one another.
Is this the worst the Risk Parity experienced so far?
NO. For sure, it is bad but not the worst yet. But of course, this episode may not be over yet.
* 2020 is not over yet.
The worst historical loss (using daily returns) happened during 2008 after Lehman Brother collapsed. During 2008, the Risk Parity strategy took on a cumulative loss of -23.5%. The episode was fairly similar with what happened today. Both are mired in liquidity emergencies. In this current one, Risk Parity lost as 17.7% at the worst point. There were several other episodes since 2005 which sees Risk Parity losing more than 15%. One happened in 2009 where the world is just emerging out from the GFC. Another occurs during 2013 or the year where market throws the QE taper tantrum.
How does the overall performance looked to date (as of 31 March 2020)?
The chart and table shows the back-tested performance of the strategy since 2005 till end 31 Mar 2020.
As of 31 Mar 2020, Risk Parity (1.7x leverage) is still up, but only mildly at less than 1% for the year while the global stock markets are still deep in the red. So at this juncture, there is nothing conclusive that suggest the strategy is behaving out of its norms. I wouldn’t say we are out of the woods yet. The situation remains fluid. Lasting damage has been done and more may be uncovered as we go. Meanwhile, keep watch.
Originally published at https://investmentcache.com on April 1, 2020.
