Risk parity funds, automated investment vehicles pioneered by the hedge fund manager Ray Dalio and designed to do well in almost any market environment, were among the big casualties of financial markets’ wild week, suffering their worst performance since the depths of the credit crisis and the second-worst on record.
The sharp losses came because one of the central ideas that underpins these funds broke this week: the prices of equities and low-risk US government bonds both went down, instead of going in opposite directions. When investors are selling risky assets such as stocks they are usually buying low-risk ones.
The most widely followed S&P 500 risk parity index tumbled 9.6 per cent over the five days, its steepest loss since 2008. The index goes back to 2004.
“It’s been a painful structure over the past few days,” said Scott DiMaggio, co-head of fixed income at AllianceBernstein, pointing out that a surge in volatility across financial markets triggered selling across all asset classes in risk parity funds, from government and corporate debt to stocks and commodities. “This cocktail is very bad.”
Pioneered by Mr Dalio’s Bridgewater Associates, risk party funds and trading strategies have exploded in popularity over the past decade.
Like many funds, risk parity vehicles invest in a broad array of assets but they get their name because they try to keep the relative volatility of each component equal and constant. Bonds are less volatile than stocks or commodities, so risky parity funds typically use leverage to increase their exposure to safer fixed income, which should act as a counterweight if equities are rocky.
As markets churned this week, leveraged players faced margin calls, forcing them to sell even safer assets, fuelling the decline in Treasuries.
Among the biggest losers was the Wealthfront Risk Parity fund, which shed 23.2 per cent of its value from the start of the week. Others to suffer losses include the AQR Risk Parity II HV fund, which dropped 12.7 per cent, and the Putnam PanAgora Risk Parity fund, which shed 8.5 per cent.
Defenders of risk parity point to the staggering bull run in the Treasury market in recent months, as investors around the globe have sought the safety of US government debt at a time of uncertainty over coronavirus. Until this week, rising Treasury prices had inflated returns for risk parity funds and offset the early losses in equities.
“Bonds already did the diversification we are counting on them for,” said Roberto Croce, a portfolio manager for Mellon, where he runs risk parity funds. “The losses in fixed income are exceptionally muted after the gain they have made over the past month.”