Mechanical inflows to equity markets are an underestimated positive driver of stock prices, and this will add to market volatility throughout all asset classes in 2021.
These trends will take a bit of explaining.
The risk parity investment strategy was developed by hedge fund giants like Cliff Asness at Connecticut-based AQR Capital Management and Ray Dalio from Bridgewater Associates. Marketed as an “all weather” investment vehicle suitable for all market environments, risk parity funds have been extremely popular - estimates on assets invested range from US$150-billion to $400-billion.
The sophisticated asset allocation strategy involves multi-part risk analysis that overweights the asset class – whether fixed income, equities, or commodities – with the lowest risk. Leverage is often used in risk parity funds. For instance, a portfolio manager might use borrowed funds to add to bond holdings when risk is low in fixed income markets, increasing income for investors.
Citi analyst David Bieber noted that risk parity funds are extremely overweight bonds at this point, despite the rally in equities.
“[U.S. Treasury bonds] are leveraged close to the historical highs [at 98th percentile relative to history], equities are close to the long term average … while oil and gold are significantly underweight,” he wrote in a research report this month. “The current setup suggests rates downside and upside in equities.”
Mr. Bieber sees the potential for risk parity funds to re-allocate quickly, and all at once, from bonds into equities and commodities if markets rally and bond yields rise. This would drive bond prices lower and equity and commodity prices higher.
There are other potential sources of structural equity inflows. Money market fund assets remain high after investors parked money there in large numbers as COVID hit and have yet to shift to risk assets. Household savings rates on both sides of the border are also very inflated relative to history, increasing the likelihood of more retail Robinhood-style trading.
Risk parity funds highlight an asset allocation dilemma facing huge swathes of the finance industry. In an era of ultra-low interest rates and bond yields, pension funds and insurance companies – every large portfolio designed to pay out future liabilities – must find alternatives to bonds, which won’t generate sufficient reruns even with the magic of compound interest.
-- Scott Barlow, Globe and Mail market strategist
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Compiled by Globe Investor Staff