I've recently been highlighting a shift by investors of all shapes and sizes into versions of what I call a "Homebrew Risk Parity" or "Risk Parity Lite" strategy. That's the use of long-dated sovereign debt as a "universal" hedge.
Investors tired of frittering away money on options premiums or facing seemingly endless losses on VIX-based products have adopted this simple strategy, which involves buying long-dated bonds to pair with their equity holdings. In a nutshell, investors use long-dated U.S. Treasuries to hedge equities -- and it's worked out well so far.
This is an extremely simplified version of a strategy made famous by hedge fund Bridgewater Associates decades ago. The idea's popularity only grew after it performed extremely well after last year's British Brexit vote, and again after the 2016 U.S. presidential election.
You can see evidence of the strategy in a variety of forms, ranging from Treasury futures Commitment of Traders to ETF flows (the iShares 20+ Year Treasury Bond ETF (TLT) vs. the iShares Barclays 7-10 Year Treasury Bond Fund (IEF) ). You also witness it in the launch of risk-parity funds by leading fund companies, as well as in mutual-fund flows. (The Columbia Adaptive Risk Allocation Fund (CRAZX) and the AQR Risk Parity Fund (AQRIX) are two funds whose flows I personally track.)
This strategy's popularity explains the market's current behavior better than almost any other scenario that Wall Street pundits have been bandying about. For example, it provides an explanation for:
- How low yields are compatible with higher stock prices.
- The market's current lower volumes and volatility, as this strategy requires less rebalancing.
- The decreased options volumes and lower VIX that we've recently seen. Fewer investors are buying options, which causes premiums to decline (and reduces implied volatility/VIX).
Why This Strategy Might Ultimately Fail
However, this leads me to conclude that the greatest risk facing the market is a shift in correlation between U.S. Treasuries and equities, where one no longer "zigs" when the other "zags."
In my worst-case scenario. we'd see a vicious cycle where:
- Higher yields would drag down high-flying equities.
- The combination of higher yields and lower stock prices would cause even more selling as risk-parity hedges stopped working.
- Investors would return to buying traditional hedges, driving the VIX higher in a market where selling options had become too popular.
- "Faux" liquidity, where algorithms vie for fractions of a cent at any given price point but disappear quickly when real flow comes through, would suddenly create greater "gap risk" as the market's depth (particularly to the downside) became accentuated.
- All of this would drag down equities even more, starting the above cycle all over again.
It's unclear when we might see this cycle occur, but it's already seemed to happen on a small scale multiple times, continuing into overnight trading.
The bottom line -- I think my Homebrew Risk Parity strategy does the best job of explaining what's been happening in markets recently. But if I'm right, the worse-case scenario above is far more likely to occur than most investors are prepared for.
