Measuring the Risk in Risk Parity

Risk-Parity investment strategies focus on greater allocation to less risky investment to achieve a given return goal.  Leverage is used to “supercharge” the investment in the least risky asset class.  Conceptually, a great plan.

In practice, most risk-parity strategies use a long bond strategy.  Levering up long bonds via the use of futures and derivatives.  During the 10-year bond bull market and over the past 5-years with easy money, this has been a great tactic and led to excess returns.

The question for risk-parity investors is does this strategy hold going forward?  One school of thought says that coordinated Central Bank cheap money has inflated prices to artificial levels for both bonds and stocks.  Others say that while the bond market has peaked, the equity and commodity markets still have legs to climb higher.  No one really knows.  However, there are some factors that should lead risk parity investors to delve further into exposure analysis.  The main factor is that risk parity strategies have never been tested in a bear market for bonds.

To this end, I would recommend a r-Dex analysis of any risk-parity strategy.  Never heard of r-Dex?  r-Dex or Risk Downside Exposure is similar to Value@Risk in that it measures downside risk to the expected value of a portfolio.  r-Dex measures this risk by stress-testing the “left tail” of portfolio returns.  The value of r-Dex is that it allows you to test for highly-correlated negative movements across all asset classes (dependent testing) or simulate a “break” in a single asset class (independent testing).


Tail testing with r-Dex


From a risk-parity standpoint,  r-Dex would allow you to simulate risk of a simultaneous break in both equity, bond, and commodity markets.  Given that almost everyone agrees that the bond market has minimal upside potential, at a minimum, a r-Dex Independent test could be run only on fixed income assets.

Either way, using r-Dex would allow you to evaluate the Risk in Risk Parity.

Excel and The Power of Fat-Fingering

The news that Reinhart and Rogoff’s study of Austerity Economics has flawed conclusions due to basic Excel errors has perked the interest of mainstream media.  One article states that up to 80% of spreadsheets have some form of error.  

My answer is…..So What?  Excel is a tool and it can be used well or poorly.  I can use my hammer correctly or hit my thumb instead of the nail.  As a financial analyst, I also make mistakes in Excel as I parse data, change columns, add data, etc…  However, I have learned through the years to cross-calculate my work as well as stress and back-test important findings.  I have also run simulations to look at best case, worst case, likely case scenarios.  Any “out-of-balance” findings are reviewed for accuracy.  Furthermore, when presenting findings, I always prefer to have a “peer review” of my calculations and methodologies.

The real issue of excel errors is not fat-fingering errors but what I will term “fat-heading” or the failure to test one’s conclusions.  Reinhart and Rogoff had a pre-disposed vision.  When the data validated their initial hypothesis, their rush to judgment (and to publish) became a higher priority than validation.  Back to the tool example here,  measure twice cut once, should have been the go-forward metaphor.  However, I am sure I have made my share of fat-headed mistakes as I rushed to deliver findings as well.

So, here is a list of ways to minimize fat-headed mistakes and keep excel humming along as a calculation engine (Listed in increasingly complexity and time commitment):

1.  Use Ctrl + ‘ keys to show formulas in all cells

2.  If you are creating a shared workbook, use the Track Changes functionality in Excel (

3.  Cross-calculate summary cells 

4.  Create a validation worksheet that re-calculates and compares key formulas

5.  Use a validation tool such as XLTest to validate calculations

6.  Use a Monte Carlo simulation tool to test worst case, best case scenarios

7.  For time-series investment and trading related calculations, back-test results with real-world data

8.  Peer review of spreadsheets.

OTC Centralizing Clearing – The Great Deleverage?

Approximately $626 trillion in notional credit and currency derivatives are outstanding,  a majority likely traded OTC.  Last week (March 11) all OTC IRS and CDS swaps had to be centrally cleared via approved centralized clearing mechanisms (ICElink, CMEclear, etc..).  Centrally clearing these products now involves posting margin (initial average calculations at 150 bps) of notional value in addition to collateral posted to CCPs.  

This money on the sidelines will deleverage a number of non-equity players in the Private Fund industry as well as hit performance.  It will be interesting to see the “true” incremental margin rates as OTC clearing it still in a flux as the June 10 deadline for Private Fund central clearing of OTC IRS and CDS swaps approaches.

SEC Presence Exam & Fund Expenses

As this WSJ articles states, the SEC new presence exams can dig deep into a Private Fund’s operations.  The potential exists for the SEC to review a fund’s Ledger and request receipts across a variety of fund expenses.

A key point is that funds have a “fiduciary” duty to act in the best interest of clients, including policies and procedures to allocate expenses fairly to the client.  Given these Presence Exam policies, firms need to:

1) Develop expense allocation policies and procedures (including thresholds for travel, entertainment, and other non-operating expense categories)

2) Disclose to existing investors (by updating and circulating as part of the annual policy/procedure update or distribution of the fund audit

3) Disclose to potential investors (as part of DDQ and/or separate policy/procedure room in due diligence review)


Increasing cost structure impacting private fund management

Increasing operational costs and compliance requirements are impacting the cost of running a fund.  For established funds, this increase has created the need to add support office functions (back-office, reporting, and compliance resources).  For new funds, the high cost, creates a barrier to entry (at a maximum) and a higher start-up baseline investment in support functions (at a minimum).

Let’s look at a few of the cost drivers:

1) Need for increased transparency –  Clearly, a positive benefit for anyone running and/or investing in a fund.  However, this benefit comes at a cost.  Funds have invested in risk, performance management, and reporting systems.

2) Regulatory requirements –  Form PF, FATCA, and registration with governing agencies have underlying operational and reporting costs.

3) OTC Swap Clearing – Additional capital/collateral requirements to clear a swap transaction via a CCP require additional borrowing and/or capital to be held in a “minimally productive” account.

Higher costs and Barriers To Entry create incumbency.  In a complex world that requires continual evolution,  incumbency can lead to lower macro returns and less choice for investors.

Cyprus crosses the Red Line

Today’s announcement of a deposit levy in Cyprus crosses a Red Line in liquidity assistance for the banking sector.  The first question:  Is it legal?  Can a government seize private assets to pay for mistakes of the custodial bank?  Unfortunately, that is a theoretical question which is most likely going to be swept under the rug as time is the real driver here.  In other words, now that the Cyprus government has started the bank run, there is no turning back.  Bank customers will either have to accept the 7 – 10% penalty as opposed to a full-scale banking collapse.

The longer term issues are more pertinent.  Depositor and Investors will not forget the Red Line being crossed here.  For smaller emerging market central banks, this likely makes future bank runs more likely as investors will be wary now that the red line is crossed  In addition, investors will require higher yield and more stringent capitalization requirements.

Again, the lessons from overall financial collapse:

1.  Don’t be first….Don’t be last.

2.  Be Too Big To Fail

3.  If you are small, have big friends  (Would Cyprus be allowed to seize assets if large banks and/or US had a large presence in Cyprus)?