Hedge Funds

‘Risk parity’ shares blame for market ructions, says Omega

Henny Sender and Robin Wigglesworth

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".

Leon Cooperman
Rick Wilking | Reuters

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.

The "systemic/technical investors" blamed by Mr Cooperman include so-called risk parity funds and momentum investors known as CTAs. Initially commodity-focused, these commodity trading advisers' funds now invest across futures markets and are typically computer driven.

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These investors, along with "smart beta" passive equity strategies that have become increasingly popular, adjust their exposures according to algorithms in response to market moves, and spikes in volatility can trigger a rash of automated selling.

"These technical factors can push the market away from fundamentals," Marko Kolanovic, a senior JPMorgan strategist, noted in a widely circulated report last week. "The obvious risk is if these technical flows outsize fundamental buyers.

"In the current environment of low liquidity, they may cause a market crash such as the one we saw on [August 24]. These investors are selling equities and will negatively impact the market over coming days and weeks."

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.

However, risk parity funds first came unstuck in 2013, when bond markets were severely rattled by the Federal Reserve's plans to unwind its quantitative easing programme, and are now suffering another bad summer. A JPMorgan index of 17 RP funds lost more than 8 per cent between the beginning of May and the end of last month, compared with the S&P 500's 6.5 per cent drop over that time.

Some analysts and investors fear a self-reinforcing cycle of selling, as RP funds and other volatility-sensitive trading strategies respond to the recent bout of turmoil. Mr Kolanovic estimates that the selling pressure could reach $300bn over the next three weeks, and some big traditional investors are perturbed at the consequences.

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"Risk parity has definitely contributed to the volatility," said Eddie Perkin, chief equity investment officer at Eaton Vance. "There's not enough liquidity when all the elephants are trying to squeeze through the door."

Tod Nasser, the investment head of Pacific Life Insurance Company, stresses that the markets have tumbled mainly due to fundamental concerns, but also argues that risk parity has aggravated the recent turbulence. "We've seen some extreme moves over very short periods that have been triggered by some very large flows," he said.

Mr Cooperman, meanwhile, maintains his faith that US stocks will end the year higher. "If the US equity bull market is over, it will be the oddest ending to a bull market in the postwar period," his letter added. "We believe that the bulk of US equity market damage has been done."