Risk Parity Risks

I recently came across a great article about the rise of “risk parity” and “passive” investing. It’s no secret that passive investing is taking over the markets and that active managers have collectively underperformed in a way that has no historical precedent. I feel the author tends to conflate and confuse the two phenomena. Nevertheless, he makes some excellent points about some possible risks that lie ahead.

Hari Krishnan makes similar warnings about risk parity in his excellent book, “The Second Leg Down”. He argues that risk parity notions are similar to the portfolio insurance systems in place leading up to the 1987 crash. Krishnan believes that algorithms could liquidate equities all at once and at the same time in response to a rise in volatility, which could cause a major crash.

I guess the essential question is whether the risks are genuine and, if so, when we are likely to witness such a sell off. I’m certainly no Cassandra. I think most doom-sayers are in it for the attention they get, and most are wrong far more often and for far longer than they are right. In addition, markets rarely if ever crash twice within ten years. So we should be safe till at least 2018 (I hope). Nevertheless, I agree there is cause for concern in the years that follow. Given that timing these things is impossible, the best we can do is to keep the risks at the front of our mind and to be on watch for conditions that may lead to further deterioration.

While timing these things may be hard, it’s quite easy to imagine a mechanism for the kind of cascade selling we saw in 1987 and 2008:

  1. Firstly, passive investors and risk parity strategies increasingly dominate the market until discretionary stock pickers and other active managers constitute a small minority of market participants (already happening, but likely to get much worse within a couple years).
  2. A rise in volatility causes risk parity funds to liquidate equities at the same time in an effort to keep volatility constant. This causes a significant sell-off.
  3. The general public becomes alarmed and, although they are invested in passive index funds, they pull their money out of the market all at once, forcing their index funds to sell in order to pay out investors.
  4. ETF liquidity dries up as everyone rushes for the exits at the same time.
  5. There are no buyers of last resort because all the fundamental investors and other discretionary traders are gone.
  6. Politicians the world over (being such noble and knowledgeable creatures) impose short selling bans in an effort to stem the tide, causing more panic selling as the few remaining long/short funds withdraw from the markets (we saw this in 2008).

The more I think on this, the more concerned I become that this type of event could play out within the next decade. Although technology has progressed, human behaviour has not. We are still governed by fear and greed. For this reason, I think active managers whose techniques rely on exploiting investor irrationality will make a huge comeback at some point.

In my next post I will discuss how I intend to protect the fund from the kind of scenario outlined above.

21 thoughts on “Risk Parity Risks”

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