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the long view

Ian McGugan

The surging popularity of complex trading strategies designed to limit investors' risk is behind the stock market's recent swoon, according to some influential market participants.

Leon Cooperman, the billionaire founder of Omega Advisors, a large U.S. investment firm, told investors in a letter this week that slowing Chinese growth, weak commodity prices and concerns about a rate hike in the United States may have contributed to the losses in August but they weren't sufficient by themselves to explain the abrupt free fall in share prices.

The real culprits, Mr. Cooperman said, were "systemic/technical investors that are price-insensitive and largely indifferent to fundamentals." It's a theme that has been sounded by other market watchers in recent days.

Marko Kolanovic, a JPMorgan strategist, warned last week that a growing number of institutional investors are using heavily mathematical, computer-driven strategies to direct their trading. As these funds swell in size, they have the potential to feed off each other's selling and exacerbate market volatility, he wrote.

Ironically enough, it is the strategies designed to prevent losses that may be most responsible for worsening sell-offs. AllianceBernstein, the huge New York-based money manager, and GMO, the big Boston-based investment company, both wrote papers this summer that suggest popular approaches to reducing risk have a nasty way of amplifying market tremors.

Some of the critics' prime targets are so-called risk-parity strategies. Ray Dalio, a U.S. hedge fund manager, pioneered risk parity in the early 1990s as an alternative to the fixed-asset allocations that were then standard.

Back then, a typical portfolio would hold a blend of 60-per-cent stocks and 40-per-cent bonds. Mr. Dalio argued that this was inefficient, since most of the risk, as well as most of the reward, were to be found in the stock component.

He figured a superior strategy would adjust the holdings so each component would contribute an equal amount to the portfolio's overall risk and reward. Bonds are usually less risky than stocks, so in practice a risk-parity approach involves borrowing money to buy more bonds and bring their risk-adjusted return up to what stocks can be expected to provide.

Mr. Dalio theorized that a portfolio built on these principles should prosper in any economic climate. If stocks slumped, the large holdings of bonds would continue to churn out income. If stocks soared, the bond component, swollen with borrowed money, would do well enough to avoid being a big drag on returns.

Mr. Dalio's theory has worked out beautifully for his investors, at least so far. His company, Bridgewater Associates, has grown into the world's largest hedge fund in large part because of the strong performance of its All Weather risk-parity fund, which now has $80-billion (U.S.) under management.

All Weather's success has inspired a host of similar funds. Around the world, risk-parity funds have attracted about $400-billion from investors, according to AllianceBernstein.

Assuming those funds typically borrow an amount equal to about 3 1/2 times their assets, the Financial Times calculates the risk-parity industry now controls assets worth $1.4-trillion or more. Much of that money is invested in funds that constantly adjust their holdings based on esoteric calculations of each asset class's volatility and correlation with other assets.

The question is whether this ingenious and profitable approach has become so large that it is now a victim of its own success. Investing strategies that work in isolation can fail if everyone tries to employ them.

That's especially true of plans designed to limit your risk by getting you out of assets that are falling in value. It's like trying to escape from a burning theatre: If one person bolts for the door, he gets out. If everyone runs for the exit, there's carnage.

Risk-parity funds depend on "leverage" – large amounts of borrowed money – so relatively minor losses can force much larger sell-offs if funds are forced to meet margin calls. Any move by investors to pull their money out of the funds also triggers disproportionately large asset sales.

Here's the catch: If every risk-parity fund is dumping assets, and the selling is big enough, it increases the perceived volatility, or riskiness, of the assets. That, in turn, encourages even more selling as risk-parity funds try to bring their overall riskiness back into line.

"As the volatility of an asset falls, these strategies will tend to lever it up further, and as the volatility rises, they will sell," writes Ben Inker, investment director at GMO. "Given that low volatility tends to be associated with rising markets and high volatility with falling markets, this gives their buy and sell decisions a certain momentum flavour."

Mr. Cooperman of Omega is also unimpressed by the momentum-following propensities of risk-parity strategies. That may be because his funds have taken a licking in recent weeks. But he believes that U.S. stocks will still manage to finish the year higher than they are now.

Bear markets are typically preceded by rising inflation, tight monetary policy, investor exuberance and other signs of froth. None of those, he says, are visible right now. "If the U.S. equity bull market is over, it will be the oddest ending to a bull market in the postwar period."

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