Is Risk Parity an Overcrowded Trade?

We just recently discussed what has caused the increase in volatility lately. A plausible explanation is that hedging and short interests have caused a dramatic increase in volatility. Another cause for concern is the popularity of the risk parity strategy.

But what is the risk parity strategy?  According to Peter Tchir:

At its most basic level – it is buying stocks AND buying bonds under the assumption (hope) that when one goes down, the other goes up, dampening volatility while generating positive returns over time.

How can it affect the volatility?

…more investors are allocating money, directly or indirectly into Risk Parity strategies.

• Investors wouldn’t need to sell stocks out of fear as they would be hedged – check
• Investors wouldn’t be buying options so the price of volatility, or VIX, would be low – check
• Investors would be buying bonds, particularly ‘safe’ bonds – check

If I am correct, the risk in the  market is not to increasing volatility but something that changes the relationship to stocks and bonds that causes them to both drop. 

The strategy has had long periods of success – not surprisingly up until the financial crisis as bond yields were high and reasonably stable while equities rallied.  In the Quantitative Easing Period when Central Banks helped inflate the price of all assets – which was rudely interrupted by the Taper Tantrum and again in the post Brexit era of more central bank support.

It is far from clear how well this strategy will do going forward, especially if central banks are scaling back their support and it is becoming a crowded trade in a world where liquidity often seems fickle.
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But we note that if the risk parity strategy does not involve volatility products, then it will affect the realized volatility rather than implied volatility.

ByMarketNews