As markets continue to remain skeptical of a 2016 rate hike, a Bank of America Merrill Lynch volatility research report notes that latent risk in risk parity strategies is “worth monitoring” across markets. Last week’s sharp sell-off in Japanese bonds stoked fears among investors that forced selling by risk parity funds might spread in an ever more globally interconnected world.

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BAML 8 11 Vol targeting 2

Certain risk parity funds are leveraged to the maximum level, which should be cause for monitoring

Ultimately last week risk parity funds ended up not deleveraging. While the Japanese interest rate market sold off, US Treasuries did not and thus major risk parity players remained playacted.

Separate analysis points to risk parity funds at a broad level working by deleveraging during periods of market stress and re-leveraging when volatility is reduced. As ValueWalk has pointed out in the past, this leaves certain risk parity strategies vulnerable to a market environment of mean reversion to various degrees.

Risk parity funds remain near that maximum leverage levels, the study from BAML’s Global Equity Derivatives Research team noted. It is for this reason “the latent risk in this corner of the quant fund space remains worth monitoring.”

In the wake of the Brexit vote, fixed income allocations inside risk parity funds “are historically elevated today.” This could be a problem, as risk parity funds could be surprised. This is particularly with the fed funds futures markets implying only a 25% probability of a December rate hike, “bond markets may be surprised by a 2016 Fed hike” and thus risk parity funds would once again be caught on the wrong side of a volatility trade.

BAML 8 11 Vol targeting 1

Risk parity funds did not sell on Japanese bond sell off because correlation trigger was not hit

When monitoring the current volatility schema, increasing volatility is correlated with selling. But what is less appreciated, the BAML report says, is the relative dynamics between component volatilities.

Through the close on the Monday post-Brexit (27-Jun-16), S&P 500 volatility rose from 9.6% two days prior to 17.9% (increase of 1.9x) while 10-Year US Treasury Futures return volatility rose 4.3% to 6.6% (increase of 1.5x). Despite these outsized vol moves, in a recent report we showed that owing to the diversification (increasingly negative correlation) between equities and bonds, unlevered risk parity portfolio volatility remained stable and hence, target vol overlays were less likely to be subject to model-driven selling.

In a low volatility market environment, elevated levels of leverage in risk parity products are an intuitive risk. “There are reasonable concerns on the potential market impact should these model-driven investments be forced to simultaneously deleverage.”

Considering various models for risk parity de-leveraging, BAML authors deliver a main takeaway is the primary performance risk driver of volatility controlled risk parity models comes when both volatility and correlation of the underlying components rise together.