|| Peter Hecht, Evanston Capital Management|
It seems as though just about everyone in the investment community has pontificated on the role that risk parity strategies play in market sell-offs like the one in August. Unfortunately, many of the views are coming from possibly uninformed or biased parties, creating confusion and the need for clarification. I’d like to move the debate forward by focusing on the key risk parity portfolio construction technique possibly contributing to market sell-offs: volatility targeting. To understand the recent debate in the media, you need to understand volatility targeting and how it is used by risk parity managers.
Let’s get this important topic out of the way upfront: Why listen to me? Besides being a Eugene Fama–trained University of Chicago finance Ph.D. and ex–Harvard finance professor, I have a lot of practical experience with risk parity products through my prior work, which included managing large, complex institutional investment portfolios. More importantly, neither I nor my employer has anything to gain or lose by promoting or criticizing risk parity. In other words, while we all have personal biases, at least it’s hard to argue that I’m talking my own book.
So what role does volatility targeting play in risk parity? In general, risk parity tries to set portfolio weights that (1) equalize the risk contribution across the various asset classes and (2) achieve some total portfolio risk (volatility) level. For example, in the simple case of a 10 percent volatility product where only stocks and bonds are available, the portfolio weights are chosen such that the stock and bond risk contributions are equalized (e.g., 20 percent stocks and 80 percent bonds equates to a 50-50 risk allocation) and add up to a total portfolio risk of 10 percent (e.g., the stock-bond allocation has to be levered 2-to-1 in order to achieve a 10 percent total volatility, leaving you with 40 percent stocks and 160 percent bonds).
All else equal, if stock volatility is higher, a risk parity manager will hold fewer stocks for both reasons 1 and 2 outlined above. To equalize risk, fewer stocks will be held relative to bonds (reason 1). Additionally, less leverage will be needed to achieve the 10 percent total volatility target (reason 2).
So far I’ve left out a critical piece of information: Is the manager using short-term volatility or long-term volatility when implementing reasons 1 and 2? Understanding this is critical to clearing up the confusion around all of the recent risk parity chatter.
What if a manager uses short-term volatility? If short-term stock volatility increases, as it did in August, a risk parity manager will need to sell stocks to maintain the equal risk allocation and total portfolio volatility, as explained above. Whether there are enough risk parity managers using short-term volatility to move the markets is a different question — and one I’ll leave others to answer — but at least there’s a rationale for short-term, volatility-focused risk parity managers to sell stocks in a month like August.
What if a manager uses long-term volatility? There was nothing special about August. Period. By definition, long-term volatility numbers are not affected by one particular month. Whether in a low or high short-term volatility environment, a long-term, volatility-focused risk parity manager is trying to maintain the same portfolio weights — the set of weights that (1) equalize the long-term risk contribution across the various asset classes and (2) achieve some long-term total portfolio risk (volatility) level. So what happens in a month like August, when stocks drop in value relative to bonds? The long-term, volatility-focused risk parity manager needs to buy stocks to bring the portfolio weights back in line with objectives 1 and 2. In other words, in a month like August, long-term, volatility-focused risk parity managers were providing stability to the equity markets. Does this make the long-term approach better? Not necessarily. It’s just different.
The bottom line is that risk parity managers come in different flavors when it comes to their use of volatility. Some use short-term volatility. Some use long-term volatility. Short-term volatility users were likely selling stocks in August, while long-term volatility users were doing the opposite. Was the entire risk parity market net buyers or sellers of stocks in August, and is this net effect big enough to move markets? I’m not sure, but my gut says risk parity managers were probably net sellers in August, and that net amount is minuscule relative to the markets they trade. But this last statement is all speculation. Let’s focus on the facts: Not all risk parity managers were selling stocks in August. In fact, a material amount of the risk parity market were buyers of stocks.
Take the time to understand the risk parity manager’s portfolio construction process. Is he allocating based on short- or long-term volatility? It’s not only critical to understanding the strategy, it’s critical to navigating through what the talking heads say about risk parity anytime markets experience volatility.
Peter Hecht, Ph.D., is managing director and senior investment strategist at Evanston Capital Management. The information contained herein does not constitute an offer to sell or a solicitation of an offer to purchase any securities and is not intended to provide investment advice. Before investing in any investment product you should consult with your financial, tax and/or legal advisers.
|| Jeffrey Saret, Two Sigma|
Many investors hold a long position on China, whether they know it or not. Developed-market equities have exposure to Chinese consumers, Chinese growth fuels commodity markets, and China holds approximately 20 percent of U.S. Treasuries.
In light of this, the 30 percent-plus decline in China’s equity market from June to early July, and the nearly 9 percent decline during the last week of July, raise concerns but should not inspire panic. As of mid-August, Chinese equity prices remained some 70 percent higher than a year ago. However, the Chinese government’s response — lending money to brokerages to buy stocks, forbidding large shareholders from selling, allowing companies to suspend trading of their shares and devaluing the yuan — is more worrying. Investors have experience managing the fallout from equity bubble pops, but rarely do governments directly intervene in stock markets.
Three historical case studies — Hong Kong in August 1998, Japan in August 1992 and Japan in October 1987 — outline a range of potential outcomes from China’s unconventional intervention.
In 1997–’98, Hong Kong’s equity market abruptly turned from bullish to bearish during a foreign currency crisis. Thailand’s baht devaluation triggered a yearlong, 50 percent decline in the Hang Sang Index. To reverse the slide, the Hong Kong government purchased HK$118 billion ($15 billion) of domestic equities. Some empirical evidence suggests the intervention lifted share prices in the short term. In the longer term the Hang Sang reached a new high in 2001, and the Hong Kong economy returned to growth.
The similarities between today’s China and 1990s Japan run deeper. During those respective periods both countries enjoyed two decades of fast economic growth that relied on manufacturing exports. Their demographics shifted as their populations urbanized and aged. Real estate and equity prices rapidly increased.
When it became apparent in the early 1990s that Japan’s growth trend had stalled, the government responded to the plummeting Nikkei index by adopting the Price Keeping Operation in August 1992. The goal was to sustain the index above the psychologically important level of 17,000. The government restricted some stock sales, purchased equities and limited the release of state-owned shares. By most measures, the intervention proved unsuccessful. Equity prices stabilized, but Japan’s economy still has not recovered — annual per capita real GDP is lower today than in 1994.
Further back, Japan offers another case study of government intervention. Between January 1982 and October 1987, Japanese stocks gained nearly 350 percent while the country enjoyed 4 percent real annual GDP growth. The good times threatened to end in the week of October 14, 1987, when the Nikkei fell 18 percent. To avert panic, Japan’s Ministry of Finance “advised” brokers and fund managers to avoid selling. The Bank of Japan promised sufficient funds to satisfy liquidity needs. The Nikkei recovered within five months, and economic growth continued at more than 4 percent annually for the rest of the decade.
Significant differences exist between today’s China and the first two case studies. Unlike the laissez-faire reputation Hong Kong enjoyed, China struggles to shed its dirigiste image. The government’s intervention threatens to undermine investors’ confidence that market forces will play a decisive role going forward.
Unlike Japan in the 1990s, where per capita real GDP exceeded U.S. levels, China can still enjoy strong growth as it converges with more-developed markets. China’s strategy may rest on the belief that medium-term growth will justify current equity valuations and that all China need do to avoid a more significant drawdown is buy time and maintain political stability.
Japan in 1987 offers the most apt comparison. China’s intervention may seem unorthodox, but its debt and inflation remain manageable. However, Japan’s intervention in October 1987 likely contributed to the bubble in the country’s real estate and equity markets by inflating overly exuberant expectations. China can only hope that its current intervention similarly maintains steady economic growth and wealth accumulation — preferably without inflating a bubble.
Unfortunately, asset allocators do not enjoy the option of waiting for the outcome of the Chinese government’s intervention to manifest. If China’s intervention ends poorly, few investors will find their multi-asset-class portfolios well hedged to the Chinese economy.
Jeffrey Saret is head of thematic research at New York–based hedge fund firm Two Sigma. Opinions are the author’s only. TS may have views and market positions that differ.