Concerns that two investment strategies – risk parity and short volatility – can compound market crashes are overblown, according to new research from AQR Capital Management.
Researchers from the quantitative investment firm tested claims that the two strategies are correlated, which could result in market destabilization if too many investors use them. The concerns particularly center on how the two strategies would perform in an equity market crash, as it is believed that both would sell significantly, according to the paper, which was published August 15.
“Occasionally, a stronger assertion is made: that these strategies may actually create a ‘vicious cycle’ by selling, exacerbating crashes, selling further as a result, and so on,” the paper stated.
However, simulations run by AQR researchers Benjamin Hood, John Huss, Roni Israelov, and Matthew Klein showed that the two strategies are “not as strongly linked as they may first appear and that the ‘vicious cycle’ fears are grossly overstated.”
The goal of a risk parity strategy is to balance risk levels across asset classes, according to the paper. The strategy typically involves holding larger positions in less risky assets like bonds, and smaller positions in riskier assets like equities, compared to a traditional portfolio made up of 60 percent equities and 40 percent bonds, according to the research. Then, the investment manager usually incorporates more leverage into the portfolio, which increases the risk to levels normally seen in traditional portfolios.
A short volatility strategy, meanwhile, uses options that are valued based on their underlying asset’s volatility.
“Risk parity takes long positions in equity markets; short volatility takes short positions in options markets,” the paper stated. “These are materially different things, even while they both interact with common equity markets.”
[II Deep Dive: AQR’s Cliff Asness Told You Bad Times Were Coming]
The researchers created historical simulations using daily data from between January 1996 and April 2018 from databases including OptionMetrics IVY, Bloomberg, and Commodity Systems Inc. After running those tests, the researchers concluded that the two strategies were uncorrelated.
However, they’re not unrelated. According to the paper, the direction of a risk parity trade is related to the magnitude of a short volatility trade.
In other words, if the short volatility strategy has a large buy or sell trade, risk parity traders will likely sell because the short volatility trade indicates that there was a large move in the equity market, thus increasing volatility.
“We reject the idea that risk parity (or a volatility-targeted strategy in general) is taking a bet on falling volatility,” the paper said. “We also reject the idea that the trading behavior of these two strategies is so connected as to constitute a systemic risk to the financial system.”