Investment advisors everywhere are bemoaning the shenanigans of high frequency traders, offshore hedge funds, and the Chinese for the recent volatility of the market that has been scaring the living daylights out of their clients.

But they have a new enemy that few outside the trading community are aware of: “Risk Parity” managers.

Risk parity is now being blamed for the steady rise of volatility from 12 to 27 in a matter of weeks, culminating in the dramatic June 24 flash crash.

The industry is thought to have $400-$600 billion in assets under management now, with hedge funds Bridgewater and AQR in the lead. Potentially, they could unload as much as $100 billion worth of stocks in coming weeks.

What’s more, the fun and games isn’t confined to just equities. Risk parity strategies have spread like a pandemic virus to bonds (TLT), foreign exchange, commodities, and even precious metals.

Risk Parity is an esoteric new investment strategy that targets a specific volatility level, rather than a return relative to a convention benchmark, like Treasury bonds or the S&P 500.

When volatility is low, they add risk, hoping to beat the returns of competitors. When volatility is high, they cut back positions, hoping they miss the losses of others. The goal is to come out on top of the money manager league tables, sucking in tons of new assets and countless riches in management fees.

You can see right now where this is going.

In rising markets they increase buying, and in falling ones they greatly step up selling.

I’m sure there was a day several years ago when this approach made money hand over fist. That was probably back when only its inventor was implementing it alone in a back room and an undisclosed hedge fund with a tiny amount of capital.

The problem with risk parity and all other strategies of its ilk is that they become victims of their own success. New capital pours in, returns fall, until they inevitably dive into negative numbers.

I have seen this occur time and again, from the portfolio insurance of the 1980’s (think October 1987 when the Dow plunged 20% in a single day), to Japanese warrant arbitrage, to high frequency trading and the flash crashes.

The proof is in the pudding.

An index of 17 risk parity funds tracked by JPMorgan has fallen by 8.2% since the beginning of May. More losses are to come. It sounds like the great unwind of risk parity assets has already started.

Like all investment fads that promise great risk free returns, this one will come and go.

In the meantime, fasten your seatbelt.
 

Did You Say “BUY” or “SELL”