Steamroller

bump in the night

The other dynamic with ‘risk allocation’ based on volatility modeling in this current environment is angle is that via CB policy, nearly all cross-asset vol has been crushed--so per the model, these fund types “get longer” the assets now too on trailing vols which have been at extreme lows—even “traditionally risky” assets like equities.

Vol targeting funds from an allocation basis (with many typically just covering the performance of say one index in one asset class) will use a similar trailing vol threshold to either ‘lever up’ or ‘de-lever’ to cash, and CTAs are extremely-reliant on VaR concepts to determining sizing / leveraging of their portfolios as well.  And frankly, anybody operating of a VaR model adds to this effect, as a lower vol environment will see “levering up” behavior…and of course if we see vol pop, more systematically-induced selling to get your value at risk down.  Net / net is all one big leveraged carry-trade….pennies pennies pennies pennies for 98% of days, then STEAMROLLER.

Size-wise, many quote the Alliance Bernstein report from 2015 placing the AUM at $400B for “pure play” risk-parity funds…but upon inclusion of the leverage inherent in the strategy (anywhere from 2 to 3.5 x’s) that number looks more like mid-point ~$1.1T from notional perspective.  And that’s not including the estimated $350B allocated to the CTA industry (thru 2Q16 per BarclayHedge) and potentially upwards of $400B AUM from vol control strategies (especially popular with the variable annuity / insurance community), most of which use similar systematic “risk management techniques” based-around short- and long-dated trailing volatility—PRE-LEVERAGE, as both of these strategies use leverage to “allocate risk” as well.  For the sake of argument, in light of the historically low vol environment recently experienced across assets, let’s safely (and HYPER-generically) assume that the $750B between these two strategies is operating at 2x’s leverage (CTAs typically much MUCH higher than that)—so approx. another “finger in the air” / “all things held constant” # of $1.5T notional with leverage.  Bottom line: when $1.5 trillion of strategies are forced to reallocate due to (again) again enormous “vol of vol” / “convexity in the market” swings, it moves markets--period, end of story.