Was David Woo Right; Was the Selloff Exacerbated by Risk Parity Strategies?

Today after the close Bloomberg TV had David Woo, Managing Director and Head of Global Rates and Currencies Research at Bank of America/Merrill Lynch, on to provide some insight regarding recent market action. More specifically, he addressed how Chinese and American markets are linked.

He dropped a lot of gems during his segment but one point really struck a chord with me. He said that the recent selloff has likely been exacerbated by "Risk Parity Guys".

If you're unfamiliar with 'risk parity' here are some good working definitions:

Essentially, this says that risk parity strategies approach portfolio allocation based on the underlying asset's risk/volatility as opposed to traditional portfolio allocation which allocates capital based on holding some specified amount of each asset class.

David Woo went on to elaborate that traditional asset class correlations began to break down during this selloff, implying that traditional methods of diversification were no longer viable and as a result any fund/fund manager which allocates capital on the basis of 'risk parity' or similar strategies would be forced to reduce risk across all asset classes.

I thought this was a brilliant insight and immediately wanted to see if I could find some evidence that would support his analysis.

To do this I used my Composite ETF model to plot rolling correlations of the 'Bonds' ETF composite vs the ETF composite of each asset class. The reason I use rolling correlation is because of the inherent link between asset correlations and volatility. Specifically, as correlations across assets/asset classes rise diversification decreases and volatility/tail risk increases.  I've selected some of the more interesting plots that lend credence to his statement.

bonds vs asia-pac equity

Data Source: Yahoo Finance

bonds vs consumer discretionary

Data Source: Yahoo Finance

bonds vs consumer staples

Data Source: Yahoo Finance

bonds vs europe equity

Data Source: Yahoo Finance

bonds vs financials

Data Source: Yahoo Finance

bonds vs global equity

Data Source: Yahoo Finance

bonds vs industrials

Data Source: Yahoo Finance

bonds vs large cap

Data Source: Yahoo Finance

bonds vs materials

Data Source: Yahoo Finance

bonds vs mid cap

Data Source: Yahoo Finance

bonds vs precious metals

Data Source: Yahoo Finance

bonds vs real estate

Data Source: Yahoo Finance

bonds vs small cap

Data Source: Yahoo Finance

bonds vs telecom

Data Source: Yahoo Finance

After reviewing some of the evidence I would say David Woo is on to something.  To be fair however, rising correlations among this many asset classes over a short time period is likely to cause multiple types of fund strategies to reduce risk exposures quickly.

If you haven't seen his segment I'd recommend trying to find it. Either way I'll be on the lookout for his analysis going forward.

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