As the market turbulence continues, so does the quest to place both cause and reason. The past month had moments where market technicals have flabbergasted the fundamental narrative—adding to uncertainty and the desperate yearning for an answer.
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Increasingly, the financial media “powers to be” are dishing out dense terminology including “alternative beta”, “risk premia,” and “alpha” while suggesting that “CTAs” (Commodity Trading Advisors) and “risk-parity funds” have exacerbated the sell-off as these “alternative funds” have programmatic black boxes to “sell short” into a falling market or “sell closing” to simply get out of the way.
Conceptually, the accusation makes sense and although I believe these funds have played a role in driving volatility higher, I’m starting to think the brushwood to this market debacle is simply a reflection of where we are – that forward looking economic growth estimates have been too high for too long. This new management of expectations by prerogative will lower 2016 earnings estimates and thus stock valuations.
Up until very recently, the market felt like a re-run of the 2014 fall “swoon & snapback” – I’m now facing the reality that this market is thundering its way to a new reset level similar to the 2013 “taper tantrum”.
Generally speaking, CTA funds employ futures markets to express opinion. The beauty of a futures contract is one can express market conviction with equal ease. Unlike equities, if you are bearish on an asset class, you can sell a future short without borrowing or other related complications.
There are many different styles and time horizons within the CTA style, the takeaway is to understand that CTAs sell closing or sell short in order to close out a long position or to express a bearish bias. Whether CTA futures selling begets outlandish variance in stocks, bonds, FX, or commodities is fair to suggest, yet markets are efficient and markets thrown temporarily out of kilter have a way of snapping back with a vengeance.
Risk-parity and/or volatility target funds use various products – including options and futures – to systematically stabilize volatility risk exposure to stocks, bonds, FX, and commodities. In theory, a risk-parity fund balances its risk/reward profile through the lens of the underlying asset’s volatility and not necessarily their opinion on that asset.
One of these funds may buy an asset class with low volatility while simultaneously selling another asset class with high volatility – all in the name of maintaining an equal volatility contribution between their holdings. As of late, equity volatility has been stunningly high both on a relative and comparative basis. This imbalance would undoubtedly cause many risk-parity fund managers to sell equities as they seek to control their risk in response to the elevated levels of volatility.
There are significant differences among CTAs and Risk-Parity investments including scope of asset classes traded, levels of risk, and trading style. What ties them together is their approach to risk and its allocation.
Over the long haul, using history as a guide, traditional 60% stock and 40% bond investment portfolio has been a very consistent source of return, but it has the potential to deeply disappoint in the short-term – particularly relative to its risk, which is much greater than most acknowledge. For all its Main Street appeal and simplicity, we know that stocks have and do expose investors to quick and deep losses.
To offset the risk of the traditional portfolio, many have added liquid alternatives including CTA and risk-parity funds. History has shown these strategies to lower portfolio volatility while enhancing returns as they are not necessarily depending on the pathway of a group of stocks rather, they are exposing the investor to assets, strategies, and styles that could potentially weather any economic environment.
Are They Now Broken?
It’s both complicated and frustrating. It is generally true that most (not all) of these alternative strategies did outperform the typical equity laden investment portfolio, however, most of these strategies were STILL negative in August – just not as negative. It’s frustrating as investors either think or are sold on the idea that these funds are the panacea for a wayward market. And, to that end, it’s hard not to have this perspective when you view these strategies returns during 2008, 2001, and 1987.
So, is it different this time? No. Are these strategies broken? No. Has the market changed rendering these strategies obsolete? No. As frustrated as I am, none of these questions are true as these strategies have shown this propensity before and most likely will again when – at least currently – markets either temporarily don’t follow their own fundamentals or one or two asset classes move too far, too violently compared to the others. Once these anomalies settle, these strategies will begin to work as hoped.
From my perspective, there are not many higher callings more critical than managing the hard-earned dollars of others. This past month has been gut-wrenching yet I’m steadfast in my commitment to coach investors into focusing more carefully on the drivers of risk in their portfolios. To worry less about whether portfolios go up or down in a given month and more about will that up and down cause you to do something foolish.