The Most Dangerous Narratives are Usually the Smartest

You’ve probably read a million market narratives that sound super smart. But have you ever read one that was so over-the-top smart that it just sounded like it had to be true?  I consider myself to be a pretty smart market participant (this conclusion is under considerable debate in most circles) and in recent years I keep coming across narratives that sound so smart that I actually believe they might be true. Then I dig a little deeper and find that, like most market narratives, the explanation is just someone trying to explain a random price move in markets where most of the short-term movements are exactly that – random.

A common narrative of late is this crash narrative being blamed on automated strategies like Risk Parity.¹ Bloomberg had an article about this today and how some famous hedge fund manager (who doesn’t even implement the strategy) says the equity market is unusually risky because of strategies like this. This is an effective narrative for three reasons:

1. It uses big confusing words like beta, gamma, etc that most people don’t understand so it’s easy for the average investor to believe simply because it sounds so smart that people defer to the idea that smart people know what they’re talking about, which, when it comes to markets, isn’t always true (looks in mirror).
2. It’s scary. Fear is always the best narrative.
3. It uses technology and the automation story to create a narrative of uncertainty because, you know, the actions of robots are so much less certain than those of humans (actually LOLing as I write this).

The problem is, some simple math debunks a narrative like this. I went to the experts on Risk Parity and spoke with Cliff Asness and Michael Mendelson at AQR who laid this out in simple terms.² For instance, if we wanted to attribute the relative price change of the market from a specific strategy we can assign the source as follows:

Equity Selling From Risk Parity = (AUM of risk parity) x (capital weight of equities in risk parity) x (responsiveness of equity weight to changes in market volatility)

Importantly, the responsiveness of rebalancing is unlikely to be all that pro-cyclical because not all risk parity managers manage to constant volatility. Cliff says they don’t even rebalance all the frequently and we know the turnover isn’t that high so it’s not like this is some sort of strategy that involves the reshuffling of billions of dollars every minute. So, when you consider risk parity AUM of $150B and capital weight of 30% the numbers and the frequency of rebalancing get too small to move the markets.³ It just doesn’t add up that $45B of assets being rebalanced infrequently in trillion dollar markets is somehow creating crash risk.⁴

This is a good example of how reading too much about the financial markets can create behavioral risk. The more you learn the deeper in the rabbit hole you can get and the more you risk getting sucked in by scary sounding narratives. Sadly, it’s often the smartest sounding narratives that turn out to be the most dangerous because they’re the most difficult to debunk.

¹ – Risk Parity catches a lot of unfair flak in my opinion when the reality is that it’s just a very sensible way to balance risk in a portfolio. I am admittedly biased here because my Countercyclical Indexing strategy is somewhat similar, but again, these strategies are not wizardry. And if anything, they’re actually reducing equity market risk as they’re fairly passive, relatively countercyclical and generally underweight equities.  

² – I have no relationship with AQR other than the fact that I think it’s a great shop run by super smart people. I also recommend their products on occasion because, well, I think a lot of them are genuinely good.  But I have zero business or financial conflict with them.  

³ – Read more detailed analysis from AQR here and here.  Importantly, what I’ve done here is clever. I’ve created my own myth busting story that sounds just smart enough that now you don’t know who the hell to believe.  

⁴ – One narrative that doesn’t die here is the myth that Risk Parity funds were to blame for the summer of 2015 crash in markets. But anyone who was actually trading that market remembers that China was the catalyst. It wasn’t just some random automated crash. There were very real fears that China was the next Financial Crisis. Further, risk parity funds were only down 3.3% during that week so while they likely did some rebalancing during that week it’s hard to imagine that the entire trillion dollar scope of equities was shifted significantly by these strategies. And in fact, this global downturn in equities can’t be explained by Risk Parity funds which are mostly allocated in US stocks.
So, if anything, this 2015 narrative makes no sense in the scope of the global market.