The “60/40 risk parity” hedge fund strategy has been decimated in the market sell-off. The strategy was supposed to generate consistent returns while minimizing risk. So why not apply hedge fund leverage to the trade and enjoy multiples of “consistent returns” and “minimized risk?” The risk parity funds were among the most leveraged going into the market plunge, which began in earnest on February 19th, though the Dow started tipping over a week earlier.
We’ve seen this “excess returns/alpha” with “minimized risk” fail badly twice in the era of modern finance – i.e. the post Bretton Woods era of unfettered expansion of fiat money supply, highly questionable use of leverage and untested “quant” strategies.
Most of you reading this will not remember or even know about Fisher Black’s “portfolio insurance” quant strategy, which promised to remove downside risk from all-equity portfolios (if you trade options and don’t know who Fisher Black is, then you shouldn’t be trading options). But the “quantitative” magic embedded in the strategy failed miserably in the 1987 stock market crash.
In the 1990’s Long Term Capital Management branded a similar though more complex “all upside / no risk” strategy by assembling a “dream team” of quants which included Robert Merton and Myron Scholes, two Nobel laureates in economics. LTCM was using unheard of amounts of leverage because its mad scientists of quant finance had achieved the goal of removing risk from LTCM’s portfolio. Again, the strategies failed catastrophically when the high risk/return assets upon which LTCM was highly leveraged began to plummet, liquidity disappeared and the risk removal strategies proved worthless.
Amusingly, the purported “expert” in cross-asset strategies, Nomura’s Charles McElligot, apologizes for the failure of risk parity by explaining that “we now see the 18-day period of returns for [Nomura’s] model ‘World 60/40’ fund was 15.5% greater than an 8-sigma move and truly unprecedented dating back to the model’s start 1999 start date.” Interesting that this “model” does not include data going to back to the 1987 crash or the LTCM collapse. Everyone is the perfect armchair quarterback the day after. But it’s impossible to model the future. Nomura’s model didn’t even include the two most important multi-sigma downside events in the era of modern finance.
Funny thing about McElligot. He was in grade school during the 1987 crash and in college when LTCM blew up. These quantitative gimmicks are no different than the methodologies applied by boiler-room stock brokers pitching risky stock ideas doomed to eventual failure. They all work wonderfully and make everyone money – especially the purveyors of these fantasy ideas – when markets are rising and even better when the bulls are all-out stampeding into the market.
But all of these strategies have one thing in common. They fail to incorporate the ability to measure and manage the sudden vacuum of liquidity when markets go from functioning continuously with bids just as “deep” on the downside as were the “offers” on the upside. “Liquidity” is a risk variable that’s impossible to model or manage when everyone is running for the exits and bids disappear.
Just like Fisher Black’s “portfolio insurance” and LTCM’s Nobel Prize backed downside-risk removal models, the risk parity strategy turned out to provide all risk and no parity when the market had the rug pulled out from under it. And when this happens the biggest charlatans of modern money management start crying for the Fed and the Government to bail them out.