Risk Parity and Brexit: A Volatility Surprise!

Risk parity strategies hold the promise of smooth sailing through periods of market turbulence, offering consistent performance via risk diversification. However, during Brexit the losses they experienced were very high by historical standards as they came very close to exceeding, or exceeded, the 95% worst outcome as estimated by the historical VaR.

Risk parity strategies hold the promise of smooth sailing through periods of market turbulence, offering consistent performance via risk diversification. And prior to Brexit, risk parity funds had done quite well to reverse most of last year’s losses, displaying similar performance patterns despite the difference in strategy implementation or exposure and dynamics as reported by MPI in the recent past.

Performance

Chart 1. Recent risk parity fund performance

Although some polling data showed the two campaigns (Leave and Remain) as resonating equally in the minds of UK voters, the actual outcome caught many market participants by surprise – including risk parity funds

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Chart 2. June 24, 2016 Risk Parity Funds’ performance vs VaR

In the above chart we display the performance of risk parity funds on June 24 following Brexit. While risk parity products lost the least when compared to a 60-40, endowment and a 90-10 portfolio, we observe that the losses they experienced were very high by historical standards as they came very close to exceeding, or exceeded, the 95% worst outcome as estimated by the historical VaR up until that day.

What was the source of this drop? To try and understand what happened, we formed a multi-asset portfolio that mimics a naïve risk parity strategy, with four asset groups: Equity, Credit, Commodities and Fixed Income. The portfolio was constructed to invest on a daily basis in these asset classes proportionally to the inverse of volatility of each group, with the result being that the risk contribution of each group to the portfolio is equal (ignoring correlations). It was recently reported that over the last 2 months, low volatility and positive equity performance attracted Equity inflows into risk parity and other systematic strategies. Our research shows that the volatility prior to the vote in risky asset classes not only decreased, but decreased more than fixed income, a traditionally safe haven during periods of crisis. This in turn caused the more responsive risk parity strategies to move into those assets[1].  The chart below shows the asset class weights in our naive risk parity strategy in the week leading up to the referendum.

risk parity document new picsChart 3. Asset loadings within a risk parity portfolio headed towards Brexit

This suggests that any anticipation within the markets of the dramatic sell-off did not surface in shifts in volatility.  In fact, risk parity portfolios were being positioned for an appreciation of risk assets.

To put things in perspective, below are all periods over the past 20 years where the equity markets experienced large daily drops (over 2.5%), compared against the reduction or increase of market volatility between the day prior to the crisis and two months prior, for both fixed income and equities.

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Chart 4. Equity and fixed income changes in volatility the day prior to a large market drop

We observe that not only do equities dominate the change in volatility, but also that early 2010 was the last time we saw this phenomenon of an unusual and unfavorable market direction leading risk parity funds[2] to overload on equities without prior notice.

Reversing last year’s losses is not cause enough for investors to let their guard down, and they should be wary of the types of events to which risk parity funds are calibrated to adapt. What we just experienced could very well be the beginning of a new cycle of volatility surprises.

[1] Since the risk parity portfolio invests proportionally to the inverse of volatility contribution of each group, it will favor asset classes with lower volatilities than others.

[2] Risk parity managers in practice employ different techniques to calculate and predict risk. These range from taking market participant views into account, via equity and other option implied volatility, to using advanced econometric models that look at regimes and conditional predictions. This is just a simple illustration to highlight a plausible explanation of the observed market performance.

DISCLAIMER: MPI conducts returns-based analyses and, beyond any public information, does not claim to know or imply what the actual strategy, positions or holdings of the funds discussed are, nor are we commenting on the quality or merits of the actual investment strategies. This analysis is purely returns-based and does not reflect insights into actual holdings. Deviations between our analysis and the actual holdings and/or management decisions made by funds are expected and inherent in any quantitative risk factor analysis. MPI makes no warranties or guarantees as to the accuracy of this statistical analysis, nor does it take any responsibility for investment decisions made by any parties based on this analysis.   Rev. 5/16

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  • Christopher Tinker
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    Interesting analysis – which would tend to suggest that a naive risk parity strategy is aptly named. If one were to use such an approach, as market liquidity flows followed momentum into low vol strategies, the self reinforcing nature of the strategy would increase exposure to the asset class with declining volatility. However, because that reflects the prior expectation of no “Brexit” the decline in volatility did not reflect the risk of Brexit should it occur. As a result, there was no attempt to risk manage against the possibility of Brexit only the probability of remaining invested on the basis of no Brexit. This was reflected in the increase in risk appetite for risk assets.
    Bottom line is – naive risk parity does not provide a risk protection against event risk – only against portfolio volatility and the risk that that implies. If Risk parity funds wanted to hedge their exposure to Brexit occurring, then this needed to be done explicitly as their fund construction was/is not designed to provide such a hedge.

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