Everybody wants to know why the market just did what it did, and what is its next likely move. Chinese equities don’t seem that important to us, but the U.S. sell-off in August coincided with the Chinese one so maybe there’s a stronger connection than we thought. It’s important because investors would love to alter their risk profile profitably — taking more risk when markets are rising and less risk when they’re falling. There is of course an easy way to do this, which is through buying call options. Through their command of Greek, an option’s Delta (your exposure) moves in synchronicity with the market in a thoroughly satisfying way (if you’re long), and the more Gamma you have the more co-operatively your Delta recalibrates your risk appropriately. The snag with this most Utopian of investment postures is that buying options costs money. The happy state in which options deposit their holders cannot be had for free.
Nonetheless, the search for free, optimized risk is never-ending. Investors want more risk when it’s low and less when it’s high. Put another way, they want less risk but not yet, as St. Augustine (“Give me chastity…but not yet”) might say if he was alive today and glued to CNBC. Older readers will recall Portfolio Insurance, which was blamed for the 1987 crash. Its adherents were required to sell when prices were falling and buy when they’re rising, mimicking the exposure shifts created by being long options but without having to fork over the option premium. It must have worked for a while, but most good ideas in investing eventually die of popularity, and too many portfolio insurers ultimately ran out of less-informed market participants against whom to trade. For the iron rule of hedging is that it requires the availability of a counterparty who isn’t hedging.
Today’s Risk Parity (RP) strategies are more sophisticated, as you might expect given the quantum increase in desktop computing power over the last 28 years. Practitioners target a specified amount of risk (typically defined as volatility) for each chosen asset class, and vary the amount of assets invested as needed. Higher expected volatility tomorrow, which is usually the result of higher actual market volatility today, requires reduced holdings in that asset class so as to maintain constant risk exposure. At its most basic, RP reduces down to changing your risk profile as your forecast of market volatility changes. Equity markets rise slowly and fall sharply, so looking back at a rising market makes you want more of it, and less of one that’s falling. These are pro-cyclical strategies, and they’ve evidently been very successful because their followers are growing in number. RP and other momentum strategies are now blamed by some for the performance of stocks in August. Leon Cooperman of Omega Advisors, a big hedge fund, blamed risk parity strategies for both his fund’s and the S&P500’s poor results. How ironic that one overcapitalized sector (hedge funds) is complaining about another over-capitalized one (RP). For more on hedge funds, see Direct or Indirect, the hedge fund industry can’t deliver.
Before you discount Leon Cooperman as offering a self-serving defense, you should know that JPMorgan’s Marko Kolanovic published a recent research note in which he sought to quantify the volume of selling that such strategies might execute in different market scenarios. By calculating the amount of RP and momentum-based capital and adding informed judgments on how it reacts, he came up with numbers, and he concluded that selling in the hundreds of billion of dollars is possible. Moreover, because such portfolio adjustments take place over many different time periods, the type of dislocation that we saw on, say, Monday August 24th will, in his opinion, be repeated.
Much of this risk on/risk off activity measures risk as volatility, which is not the best measure for most investors unless you use leverage. Investing with borrowed money means you not only care about whether an investment travels from 10 to 20, but also the path it takes on its way there. Stopping at 5 first represents merely an inconvenient detour for the cash investor but a potentially capital-destroying one for the leveraged one as a margin call forces untimely liquidation. Cash investors who worry excessively about the market are emotionally leveraged if not economically so; their best move is to reduce their positions to the point at which they are more concerned with their golf swing. For a cash investor, the risk of a permanent loss is the risk they care about. If you own companies with strong balance sheets and earnings power, the path prices follow needn’t concern you. Just focus on the health of your companies’ businesses.
The nice thing about Leon Cooperman’s complaints is that our inability to link Chinese equity volatility with the U.S. looks slightly more forgivable. In fact, it renders most short term market judgments invalid unless they accommodate the emotionless algorithmic activity of RP. Explaining market moves in the context of fundamental developments may be less important than interpreting them through the eyes of systemic traders. This is our Brave New World. Investors should conduct their affairs accordingly.