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Earlier this month, famed hedge fund guru Leon Cooperman made news when he blamed the summer’s market sell off on “risk parity” money managers. From the FT:

Lee Cooperman, the founder of Omega Advisors, has joined the growing chorus of investors blaming last week’s stock market sell-off — and his own poor performance in August — on esoteric but increasingly influential trading strategies pioneered by hedge funds like Bridgewater.

In a letter to investors on September 1, Mr Cooperman and his partner Steven Einhorn said fundamental factors such as China’s ructions and uncertainty over the US interest rate outlook “cannot fully explain the magnitude and velocity of the decline in equity markets last month”.

Omega’s equity-focused investment funds dropped by between 9 per cent and 11 per cent in August and are down between 6 per cent and 11 per cent for the year, according to the letter.

Mr Cooperman’s complaint came at it emerged Bridgewater’s $80bn All-Weather risk parity fund was down 4.02 per cent in August. The loss wiped out all the fund’s gains for the year to date, according to people familiar with the numbers, and it underscores the difficult market environment for such funds.

The FT actually got it wrong. Bridgewater’s All-Weather risk fund was down 6.9% last month. You might be saying to yourself, who cares? Lots of funds had a tough August. But Bridgewater is the world’s largest hedge fund, and their flagship fund is supposed to be a low volatility portfolio that produces steady returns. This isn’t some Crispin Odey “up and down 20% in each month” kind of fund (May 08/15 – Don’t be afraid to fade the hedgies). Being down almost 7% in one month is a big deal.

But what is this “risk parity” strategy? The FT article has this simple description of the portfolio management technique:

Risk parity is the strategy that has aroused the most attention recently, and now boasts as much as $600bn of assets under management, excluding leverage that multiplies its influence. These funds seek to create a blended but dynamically adjusted portfolio of stocks, bonds and commodities balanced by the respective volatility of the asset classes, rather than traditional capital allocations.

The strategy was pioneered by Bridgewater, the largest hedge fund in the world, and its mostly superlative performance has helped it spread to pension funds and insurers across the world and spurred imitators at other asset managers.

Given the accusations that Cooperman and other market pundits are flinging around, a more in depth analysis of the strategy is probably in order.

Luckily for us, Dalio and the crew at Bridgewater have written a thorough piece documenting the evolution of their All-Weather strategy. It can be found on their web site: The All Weather Story. It is a great piece and I recommend you take the time to read about the rise of the world’s most successful hedge fund.

Far be it from me to criticize Dalio and his team, as I have always had the utmost respect and admiration for Bridgewater, but I have long held one uneasy feeling about their strategy. If you examine the core of their beliefs, the concept of using leverage to equally weight the risk of various asset classes comes up time and time again. From their piece “The All Weather Story”:

Bridgewater’s response documented two key ideas that would later reappear in All Weather – environmental bias and risk balancing assets. Ray, Bob and others knew that holding equities made an investor vulnerable to an economic contraction, particularly a deflationary one. The Great Depression was the classic example of this. Stocks were decimated. It was also true as Rusty suspected that nominal government bonds provided excellent protection in these environments. The goal was an asset allocation that didn’t rely on predicting when the deflationary shift would occur but would provide balance nonetheless.

The 1990 memo to Rusty put it this way, “Bonds will perform best during times of disinflationary recession, stocks will perform best during periods of … growth, and cash will be the most attractive when money is tight.” Translation: all asset classes have environmental biases. They do well in certain environments and poorly in others. As a result, owning the traditional, equity heavy portfolio is akin to taking a huge bet on stocks and, at a more fundamental level, that growth will be above expectations.

The second key idea stemmed from their work helpingcorporations hedge unwanted balance sheet exposures. Ray, Bob, Dan and others always thought first about risk. If the risks didn’t offset, the client would be exposed. Due to his equity holdings Rusty was exposed to the risk that growth in the economy would be less than discounted by the market. To ‘hedge’ this risk, the equities needed to be paired with another asset class that also had a positive expected return (i.e. a beta) but would rise when equities fell and do so in a roughly similar magnitude to the decline in the stocks. The Bridgewater memo agreed that Rusty should hedge this risk with long duration bonds that would have roughly the same risk as his stocks. Quoting from the study: “lowrisk/low-return assets can be converted into high-risk/high-return assets.” Translation: when viewed in terms of return per unit of risk, all assets are more or less the same. Investing in bonds, when risk-adjusted to stock-like risk, didn’t require an investor to sacrifice return in the service of diversification. This made sense. Investors should basically be compensated in proportion to the risk they take on: the more risk, the higher the reward. As a result of this work, Ray wrote Rusty, “I think your approach to managing the overall portfolio makes sense. In fact, I would go so far as to say that I think it makes more sense than any strategy I have seen employed by any other plan sponsor.” The long duration bonds, or futures equivalents, would make the portfolio roughly balanced to surprises in economic growth while not giving up return.

Bridgewater’s big breakthrough was the idea that certain asset classes like equities and bonds perform differently in the various economic environments. Yet their sensitivities to these different economic conditions are dramatically varied. For example during an economic contraction stocks might decline 40% but bonds would rise only 20%. Therefore Bridgewater constructed a portfolio whose asset allocations were more equal on a risk basis. In the above example they would leverage their bond position to twice the notional value of their equity portion to make them equal on a “risk parity” basis.

I am grossly oversimplifying the concept of “risk parity,” but sometimes this is the best way to understand what is really happening.

The Bridgwater team did more than just examine economic contractions and expansions. They also examined periods of rising and declining inflation. Again they found asset classes that out performed in each environment and then risk adjusted the weights.

Herein lies my concern about the soundness of the “risk parity” strategy. Bonds are inherently less volatile than equities. This means that Bridgewater and other “risk parity” followers use leverage to amplify their fixed income returns. They need to make the risk from bonds equal equities.

Over the last 35 years bond yields have been headed only one way – down.

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This monster bull move in bonds has been a massive tailwind to investors. The incessant decline in the risk free rate has lifted all asset classes.

Bridgewater’s All-Weather fund has been perfectly positioned to take advantage of this phenomenon. Due to the lower volatility of fixed income, Bridgewater has been overweight bonds relative to most of their peers for this whole period. Not only that, but for the most part, all the other financial asset classes have been bid up as investors have been left with no alternative but to search for bargains elsewhere. This means that the other assets that Bridgwater held have also performed admirably during this period.

Bridgwater is not hedging by being short other asset classes. They are hedging by being long different assets in varying weights according to their risk models. Some of these asset classes appear to have negative short term correlations thus lowering the portfolio’s risk.  Bridgewater believes their portfolio to be hedged, but my concern is that it is all just a fancy way to run a leveraged long book of financial assets. They have worked hard on creating a portfolio that will have the least amount of volatility. And I have no doubt they believe their “inflation” hedges will save them in a bond bear market.

Yet if we enter into a financial asset bear market, I doubt they will have enough non-correlated assets to save them.

How much of Bridgwater’s success has been from creating a truly “All-Weather” fund and how much is from finding the best way to lever up this great financial asset bull market?

Like most things in life, I doubt the answer is black or white. Yet the one thing I know is that when Wall Street falls in love with something, they always over do it. Given the monster success Bridgewater has experienced over the last decade, it would not be surprising, if they are due for a big accident. When a strategy becomes too popular, it always eventually blows up.

I have long argued that the next accident will not be anything anyone is expecting. If the market was prepared for it, then it wouldn’t be an accident. When all the hedgies and market pundits are busy forecasting the next disaster, you know it won’t happen.

This Leon Cooperman comment about the market’s summer swoon being the result of “risk parity” investors is not a typical doomsday forecast, but rather, a complaint. Cooperman got tagged from the volatility, and he is looking for someone to blame. He is not positioned to deal with the problems from these “risk parity” strategies. Nor, do I suspect, is anyone else.

Although I am sure the “risk parity” investors were not wholly to blame for the summer’s decline, I assume Cooperman is plugged in enough to know the big selling came from these funds. Let’s face it, the world’s largest hedge fund is going to leave tracks when it trades.

In 1987 there was another strategy that was all the rage…

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During the mid 1980s, dynamic portfolio insurance gained so much popularity that when the market turned in October of 1987, there were so many investors that were forced to sell at the same time the market crashed.

The current popularity of “risk parity” funds has enabled investors to take advantage of this unbelievable bull market in financial assets. The question is whether they are truly hedged, or have fooled themselves into believing they are adequately diversified to weather a downturn in the markets. It would not surprise me one bit if the Cooperman’s complaints about “risk parity” investors exacerbating the problems is spot on correct, and that it will get a lot worse before it gets better. It would be exactly the sort of out of the blue problem no one is expecting…

Thanks for reading,

Kevin Muir

the MacroTourist