Risk Parity, CTA Flows ‘Pose Risk for Fundamental Investors,’ JPMorgan Says

Risk Parity, CTA Flows ‘Pose Risk for Fundamental Investors,’ JPMorgan Says

As my colleague Steve Sears noted in a post, the rapid rebalancing of so-called risk-control funds has been put forward as a possible reason for the extreme market volatility of late. 

JPMorgan’s Marko Kolanovic (JPM's head quant) weighs in:

Associated Press

Trend following strategies (CTAs),Risk Parity portfolios, and Volatility Managed strategies all invest in equities based on past price performance and volatility. For instance, in our June market commentary we showed that if the equity indices fall 10% (and don’t recover immediately), these trend followers may need to subsequently sell ~$100bn of equity exposure. These types of ‘price insensitive’ flows are starting to materialize, and our goal is to estimate their size and timing. These technical flows are determined by algorithms and risk limits, and can hence push the market away from fundamentals.

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 at the US market open on Monday. We attempt to estimate the amount of these flows from 3 groups of investors:  Trend following strategies (CTA), Risk Parity portfolios, and Volatility managed strategies. These investors follow different signals and have different rebalancing time frames. The timeframe is important as it may give us an estimate of how much longer we may see selling pressure, and when can we expect reversal….

[We] estimate that the combined selling of Volatility Target strategies, CTAs and Risk Parity portfolios could be $150-$300bn over the next several weeks (provided the market doesn’t recover very quickly). Rebalancing of these funds may appear as a persistent and fundamentally unjustified selling pressure as these funds execute their programs. In addition, there may be a positive feedback loop between all of these sellers – Gamma hedging of derivatives causes higher market volatility, which in turn leads to selling in Risk Parity portfolios, and the resulting downward price action invites further CTA shorting. All of these flows pose risk for fundamental investors eager to buy the market dip.

A good example of how price insensitive sellers can cause market a disruption/crash is the price action on the US Monday open. We believe that technical selling related to various hedging programs, in an environment of low (pre-market) liquidity indeed caused a ‘flash crash’ on Monday’s open. S&P 500 futures hit a 5% limit down pre-open, and then a 7% limit low at 9:31 and 9:33. The inability of hedgers to short futures spilled over into large cap stocks that were still trading and could be used as a proxy hedge. Had it not been for the futures limit down event, the selloff would likely have been worse as indicated by the price of the index implied by individual stocks.

If Kolanovic is correct, the volatility has only just begun.