Bank of America Trashes Risk Parity Funds, Launches One a Month Later

Bank of America Merrill Lynch recently released a research note suggesting that Risk Parity investment strategies currently represent a substantial source of systematic risk in global markets. The note was picked up breathlessly by several media outlets and posted under sensationalist headlines employing eye-catching terms like “spectre,” and “mayhem.” The introduction to the actual report says:

Last week’s sharp sell-off in JGBs renewed concerns of forced selling by risk parity funds. While the drawdowns in US Treasuries, US equities, and ultimately risk parity portfolios were small and short-lived, the latent risk remains worth monitoring, as (i) leverage is still near max levels across a variety of risk parity parametrizations, (ii) bond allocations are historically elevated, and (iii) markets continue to be skeptical of a 2016 Fed hike.

The same day, Business Insider reported on the BAML note, adding:

Now, this isn’t as straightforward as watching volatility in one asset class, as risk parity funds focus on “the relative dynamics between component volatilities and correlation.” With that in mind, the note includes a scenario tool to help investors assess what moves in the S&P 500 and 10-year US Treasury futures could trigger “significant deleveraging by rules-based, vol-controlled risk parity funds.”

In plain English, they’re trying to help clients figure out what might trigger widespread forced selling.

The grey bar is the zone in which the risk parity funds aren’t forced to sell. So, for example, if there was a -2% drop in US Treasury futures and a 5% jump in the S&P 500, risk parity funds wouldn’t react.

The orange zone includes the events that would presage a dramatic deleveraging. Their model suggests that, for example, a -1% drop in US Treasury futures and a -4% drop in the S&P 500 would trigger forced selling.

Source: Bank of America Merrill Lynch

Unfortunately, this characterization of how Risk Parity works is misguided for a number of reasons. Let’s examine how Risk Parity actually works, and address the most important misapprehensions from the article in turn.