Ray Dalio Is Probably Right About the End Of Supercycle. Could China Break His Risk Parity Model?

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The risk-parity model fund All Weather, managed by the billionaire Ray Dalio and having $80+ billion in assets was down 4.2% last month according to Reuters as reported by two people familiar with the fund’s performance. This means that the risk-parity fund is down about 3.7% in 2015 and as reported by Bloomberg the reason was forced reposition of assets as correlations and volatilities break down.

As Valuewalk reported: Ray Dalio believes the end of a long term debt cycle is here. The economy is approaching the end of a long term debt cycle that is little understood, Ray Dalio writes, as he says he has more faith in the Fed’s ability to tighten than ease – and this is part of the problem. If the economic environment changes, the Federal Reserve needs the ability to lower interest rates if necessary. With rates near zero in an expanding economy, the Fed doesn’t have much room to maneuver. This is particularly true as Ray Dalio says, at the end of a cycle, central banks are “pushing on a string” and their ability to stimulate the economy is more likely to fail than succeed.

The question now is, will Chinese selling of Treasuries break models betting on the normal correlation of stocks and bonds? If Dalio is right about the LT debt cycle, and China now in debt handover, same as the US was back in 2008-2009, won’t this suggest that there will be a seller almost as big as the FED was a buyer of treasuries? If so, treasuries will hardly rally this time during a turmoil and risk-parity funds will lose their ability to produce stable returns in any environment. Could All Weather’s last hope be that China is not as bad as claimed by the media?

Just as in the summer of 2013’s Taper Tantrum, the last 2 weeks have seen 4 to 5 sigma swings in daily returns and ‘generic’ risk-parity funds have suffered the biggest 3-month losses since the financial crisis.

As reported by Zerohedge

And here is the simple reason why these funds ‘broke’… China selling Treasuries to meet liquidity needs as global carry trades were unwound and smashed stocks lower ‘broke’ the historical relationship between stocks and bonds. Since the so-called “risk parity” strategy is supposed to make money for investors if bonds or stocks sell off, though not simultaneously.

 

And this did not help the multi-asset funds – the USD-Commodity correlation regime flipflopped…

 

Simply put, the historical relationships between asset classes (volatilities and correlations) that are used to construct optimal “risk-parity” funds in order that ‘risk’ is balanced and hedged across bonds and stocks (for example) broke down dramatically:

 First, realized volatilities exploded relative to historical (or even forecast volatilities) that are used to weight exposures; and

Second, the correlation regime entirely flipped for multiple asset classes – entirely breaking any ‘expected’ diversification or hedges.

And the result…based on Salient Risk’s Risk Parity fund index, the last 3 months have seen a 10.7% drop – the most since the financial crisis (and worse than the mid 2013 plunge). Some context for the recent moves may help:

  • Friday August 21st – 4 Sigma plunge
  • Monday August 24th – 5 Sigma crash
  • Thursday August 27th – 5 Sigma Spike
  • Tuesday September 1st – 4 Sigma collapse

Risk manage that!

 

Which explains why we also saw the big drop in mid 2013 (Taper Tantrum) when – just as this past 2 weeks – bonds sold off and stocks sold off…before a complete flip-flop right aftre the June FOMC meeting.

We asked in August 2013 – When Will Risk Parity Funds Blow Up Again? – it appears we have our answer.

 As UBS’ Stephane Deo noted then (and JPMorgan has confirmed now), that in a rising rate environment, so-called risk-parity portfolios were susceptible to draw-down as yields ‘gap’ higher.

As UBS noted at the time, which seems just as crucial now, it is not the actual rate increases (or decoupling) but the “speed limit” or velocity of the moves and with liquidity either ‘on’ of ‘off’ now, the gappiness of moves increased the potential threat from risk-parity funds.

And as JPMorgan’s head quant noted today, the management of this exposure (i.e. the selling) is only half-way through.

 Risk Parity strategies de-lever when asset volatility and correlation increase. In our report last week, we estimated that risk parity outflows from equities may total $50-100bn on account of the increase in market volatility and risky asset correlations. These rebalances have started, but, given their typically slower rebalance frequency (e.g. monthly), are largely incomplete. We believe the bulk of the risk parity flows are yet to come, and this may add selling pressure to equities over the next 1-3 weeks. To illustrate this point, one can look at a sample multi-asset Risk Parity strategy such as the Salient Risk Parity index. The beta of this index to the S&P 500 (shown in the figure above) reached highs of 60% in early August, and has dropped to about 45% currently (compared to a beta of 0% during some of the previous episodes of market volatility).

Charts: Bloomberg’

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