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Was Dalio Risk Parity Strategy Responsible For Recent Turmoil?

Within minutes after the opening bell on Black Monday, August 24, the Dow plummeted 1,089 points, surpassing even the flash crash of 2010. Dramatic declines caused stocks and exchange-traded funds to be automatically halted by stock exchanges more than 1,200 times. The market remained volatile in next weeks also, pulling down both the Dow and the S&P 500 indices down by more than 6 percent in August. The risk parity strategy, pioneered by Ray Dalio, the founder of world’s largest hedge fund, came under fire for this market volatility. The risk parity investment strategy was developed and first adopted as All Weather Fund in Bridgewater Associates in 1996 and has become increasingly popular in the industry. This has been one of most successful investment strategies since last two decades. But its recent performance has been poor. Of late some analysts and fund managers such as Lee Cooperman of Omega Advisors have started blaming the risk parity strategy for the market turmoil seen in recent weeks. This pushed Dalio to a defensive position, prompting his firm to come out with a report for its clients defending his risk parity approach. The Bridgewater report tries to dispel many of the concerns surrounding risk parity and the All Weather fund. Let us see what this risk parity strategy is, how it works, what blames are and what Dalio wants to say. What is All Weather risk-parity strategy and how does it work? The risk- parity strategy is Bridgewater’s flagship strategy, known as All Weather strategy. It is one of the two investing strategies consistently followed since last two decades by Bridgewater Associates, the world’s largest hedge fund with $170bn in assets under management. While the Bridgewater’s other strategy, known as Pure Alpha, is a traditional hedge fund strategy, All Weather is a risk-parity and leveraged beta strategy. It is based on the philosophy that there are four basic economic scenarios: rising or falling growth, rising or falling inflation. And different class of assets behave differently in each of these economic scenarios. The risk-parity’s objective is to reduce the volatility of investing in assets that normally move in the opposite direction in different economic environment. The All Weather strategy allocates 25% of a portfolio’s risk to each of these scenarios. It is allocation of risk and is different from allocation of assets. The portfolio makes money in any economic environment and is considered as a solid strategy in both good and bad markets. All Weather has given 8.95 percent average annual return since its inception in 1996. Its long-term success has helped the industry expand. But this August, $80bn “All-Weather” risk parity fund lost 4.2 per cent and is down nearly 5% YTD. The famous all weather strategy is facing rough weather from critics. What are blames on the risk parity strategy? First, the risk parity strategy allocates assets based on volatility. The ‘smart beta’ passive equity strategies adjust their exposures according to algorithms in response to market moves. The risk parity funds and momentum investors known as CTAs are typically computer driven. Any in volatility can trigger a rash of automated selling. Second, the risk parity strategy involves use of leverage, derivatives and borrowed money, to amplify their bets tied to the performance of bonds, stocks and commodities. Fund Managers often shift their allocations of assets to maintain an equal distribution of risk. They invest passively in a range of financial assets according to their mathematical volatility. In August as volatility increased, these funds are accused to have begun selling with increased intensity. The selling created more selling. This effect then cascaded through markets, and asset correlations increased. As a result assets like stocks and bonds, which often trade in opposite directions, began to fall at the same time. Market collapsed. The risk parity strategy too underperformed. What does Ray Dalio say in defense of risk parity strategy? The inventor of risk parity strategy, Ray Dalio, strongly defends his strategy and Bridgewater’s approach amid criticism. While the strategy might occasionally underperform other investment techniques, but it was still the best long-term strategy. Unlike other funds, Bridgewater does not tend to sell assets when prices fall and buy them when prices rise. It does the opposite to rebalance to achieve a constant strategic asset allocation mix. All Weather portfolio is well diversified so as not to be exposed to any particular economic environment. It has no such systematic bias to do better when interest rates are falling compared to that when they are rising. So it is not vulnerable to a bond sell-off. Dalio says Bridgewater is not responsible for the stock market increased volatility seen last month. Relative to the size of global asset markets, the risk parity strategy funds is too small to move market. It is like a drop in the bucket. Allocations are not adjusted due to swings in volatility, and therefore could not have created the market impact. “All Weather is a strategic asset allocation mix, not an active strategy. As such, All Weather tends to rebalance that mix which leads us to tend to buy those assets that go down in relation to those that went up so that we keep the allocations to them constant. This behavior would tend to smooth market movements rather than to exacerbate them,” fires back Dalio in the Bridgewater Report .

A Volatile, Illiquid Paradise

Summary Two characteristics of today’s market – volatility and illiquidity – are in focus for many investors. What many small investors fail to realize is that straightforward Graham-style investing isn’t the only way to profit from volatility. This market is paradise for the small, self-directed value investor with a willingness to take on insurance liabilities. There is a lot of confusion about volatility . Some people think that volatility is the square root of the variance in a price series. They would be correct, except when they’re not. Others think that volatility is whatever the CBOE’s VIX metric says. This is also true, but limiting. Similarly, still others would argue that volatility is whatever the derivatives market implies that volatility is. Most will agree, however, that volatility is bad . We say “most,” but Seeking Alpha really isn’t “most” people. Any investor with even a cursory understanding of Graham-style investing knows the metaphor of Mr. Market, the moody, irrational purveyor of market prices. If we are patient with him, we can take advantage of his irrationality, which is what we ought to do as investors. In this understanding, volatility is simply noise , and it certainly isn’t a bad thing. As value-driven investors, we encourage this latter mentality, but we wonder if “volatility-as-noise” cuts the conversation too short. We see more opportunity here than the traditional Graham paradigm suggests. Taking advantage of more When we take advantage of what we estimate to be mispriced securities, we are directly using the volatility of the market to our advantage. The idea is that our counterparties (sellers or buyers) are simply lacking in time, cash, or information (or perhaps they are limited by fiduciary obligations), and when we trade shares, their loss is our gain. What if we take this one step further? If we are comfortable taking advantage of others’ value miscalculations by buying or selling a stock at a certain price, why would we not also be comfortable taking advantage of our counterparties’ miscalculations (or irrational obsession) with volatility itself? Return to the popular impressions of volatility. Each has profound limitations. When we take the square root of a variance , we are more often than not simply using a security’s end-of-day closing prices. This ignores daily ranges, which can be quite significant. When we refer only to the VIX , we correlate volatility almost exclusively with indices’ downside and thereby mistake “volatility” for “fear” (thank the financial media for this). When we rely on the implied volatility of derivatives, we assume a standard deviation of returns in a stock, largely ignoring the possibility of gapping and skewed returns. Assessing risk with any one of these volatility measures is a fool’s errand — and there are plenty of fools in the market. The illiquidity trap When we view volatility as baseless noise rather than risk , a whole world of opportunity presents itself. I.e., if we think that Mr. Market’s irrationality presents us with opportunity, then others’ “risk” can be our reward. If you were afraid of volatility (here meaning simply variation in a price series), as many portfolio managers are (think pensions), you would be eager to hedge against it. This has always been the case, though as we gaze into the maw of a potential bear market, survival instinct makes portfolio insurance more appealing than ever. As a corollary, selling insurance (puts) in periods of (VIX-style) volatility can be quite profitable. August 24th demonstrated, however, that this is not “normal” volatility. In the last few years, the Wild West of HFT penny-spread market-making turned the average transaction size into a tiny fraction of what it used to be, and largely pushed other market-makers out of the game. When the exchanges then gradually disincentivized even HFT market-making (thank you Michael Lewis ), no one was left to provide liquidity — especially in times of uncertainty (see 2010 Flash Crash ). What this means for the aforementioned portfolio managers is that the exchanges are not friendly places to do business in volume. For large orders, crossing networks and dark pools are preferred. The problem with these venues is that your counterparty is typically as well-informed as you are (i.e., they won’t be buyers when things are hairy). With nobody to sell to, paying a premium for a put option (and guaranteeing yourself a customer at a pre-determined price) becomes even more appealing. Selling insurance Value investors have beliefs about the intrinsic value of companies . Whether by virtue of cash-flow growth, “real options,” management savvy, or relative undervaluation, we can determine a range of prices at which we would be happy to own any publicly traded stock. Sometimes those ranges are small and confident; sometimes they are wide and uncertain; sometimes they converge at $0.00. Regardless, we have a basis for investment and a preferred entry point. The upshot to this assumption is that by selling insurance to portfolio managers in the form of put options, we can have our cake and eat it too. By selling a put at a strike price within our target range, we can not only provide ourselves the opportunity to buy into a stock at a favorable price, but also collect premium for our trouble (regardless). Furthermore, since brokers tend to be generous in their risk calculations for put-sellers (thank the Black-Scholes-Merton equation for conventional risk-assessment), we can get our fingers into all sorts of opportunities at relatively low cost, spread risk across multiple sectors, and collect premium while we wait. To most speculators, “risk of assignment” in the case of a decline in price would be detrimental. To a value investor, “risk of assignment” at a favorable price doesn’t sound much like risk at all. This is the strength of being a value-oriented investor. Ignoring a high-volatility, high-premium market environment is a missed opportunity. To some readers, this will already seem mind-numbingly obvious. Indeed, some contributors on Seeking Alpha are already practitioners of this philosophy (though they are not usually the most visible). Others, however, may not have seen an opportunity for this approach in the frothier, low-implied-volatility markets of the past few years, and may have discarded the idea out of hand. Now – in a high-volatility, high-uncertainty, and low-liquidity market – is the time to reconsider.

The New Silk Road Is A Great Opportunity For The BRIC And Asia Ex-Japan Shares

Summary BRIC and Asia countries want to develop the New Silk Road. The New Silk Road will boost international trade. BRIC and Asia companies will benefit from the existence of the New Silk Road. Every BRIC and Asia shares price reduction should be treated as an opportunity for accumulation. When 500 years ago the economy of many countries began to integrate, Eurasia became the world trade center. But in the following centuries the USA became a hegemon. Now Eurasia has a chance to change the situation significantly. The construction of the New Silk Road can help. There is a powerful force in Eurasia . This region has 75% of the global population. On its territory there are more than 70% of all energy resources and about 65% of global wealth. An alternative for controlling an entire continent is to dominate the world’s oceans. Controlling the sea trade routes allows control of international trade and movement of strategic raw materials, so Eurasia can be indirectly controlled. This was a British Empire strategy in the 19th century – whoever control the sea routes, controlled Eurasia also. In the 20th century, control of the oceans has passed into the hands of the United States. Just as the British, the Americans control Eurasia with the help of numerous military bases . Americans have more military bases than all other countries put together. Where in the world is the U.S. Military? (August 2015) (click to enlarge) Lily pads – small security locations Source: Politico China and Russia show the largest disapproval against the US hegemony. Unable to resist the sea power of the United States, these countries are trying to neutralize it. Russia and China are trying to transform Eurasia in such way, which allows them to control trade routes but also allows to diminish the importance of the sea trade routes. (click to enlarge) Source: World Shipping Council Reducing the role of the sea trade is of great importance in terms of geopolitics. The transformation with which we now have to deal with on the Eurasia continent is one of the major changes on the international scene since the end of World War II. Reintegration of Asia and Europe – known most recently as the “New Silk Road” – is what the United States fear most. Silk Road existed in the past. It was a trade route which connected China with Europe . It was more than 6,500 km length. The Old Silk Road Source: Perceptions The New Silk Road is supposed to be a network of high-speed railways, modern highways, airports, seaports, energy networks and infrastructure. If everything will go according to the plan, the train from London will reach Beijing in just two days in 2025 ! The New Silk Road (click to enlarge) Source: Xinhua New Silk Road is the largest infrastructure investment in history. The combination of Europe and Asia overland trade routes will give Eurasia the independence from the United States. Reactivation of the Silk Road was announced in 2013 by the Chinese president Xi Jinping. Officially, the project was not, of course, a counterweight to the US sea hegemony. The project was presented as the axis of cooperation between the countries of Europe and Asia. The Chinese are incredibly effective and consistent, they have access to appropriate technology and they have huge financial resources and political will to implement such an ambitious project. The New Silk Road project is officially in the initial stage. Implementation of the first stage has already begun. The train run from Yiwu (China) to Madrid (Spain) took four months at the turn of 2014 and 2015. An ambitious project of the New Silk Road is just one of the elements that integrate the economy of Eurasia. In the past three years we saw the establishment of the Asian Infrastructure Investment Bank (AIIB), New Development Bank (NDB), Eurasian Economic Union (EEU). There are also ongoing works at SWIFT-alternative payment system . Summary China, Russia and other BRIC and Asia countries know that they must act together in order to counter the military and economic power of the United States. The development of the New Silk Road will create new conditions for trade. The projects are incredibly ambitious, but the Chinese are very effective in the implementation of the economic assumptions. In just three years, their local currency was made the fifth most commonly used trading currency in the world. The Chinese established juan-denominated crude derivatives contract just few weeks ago. However, it is not certain that the New Silk Road will emerge. Chinese projects will encounter the powerful resistance from the US administration and its allies. The United States – as a real hegemon – will do everything it can to maintain a dominant position. In addition, the creation of a New Silk Road may be hampered by the imperial Russian impulse under the leadership of W. Putin. For example, the extension of the conflict in the east of Ukraine on the whole CEE region will certainly hamper the implementation of the New Silk Road project. How to invest in the development of a New Silk Road Assuming, however, that all will go well, and the new Silk Road will be built in 10-20 years, you can ask the question: how should I invest to achieve gains from the emergence of this incredible infrastructure project? Of course, the creation of the New Silk Road will benefit – first and foremost – Russia, China and all countries which find themselves on the trail. The companies from countries which are now in 3rd league of world economy can grow significantly. So it seems that every panic sale of Asian, Russian and BRIC’ shares should be used by investors to accumulate. Of course, the easiest and cheapest way to do it is investing through appropriate ETFs. Below there are lists of the cheapest and the best performing ETF funds. 5 Best Broad Asia ETFs – 3 Years Return Source: ETFdb 5 Cheapest Broad Asia ETFs Source: ETFdb BRIC ETFs 5 Year Returns Source: ETFdb BRIC ETFs Expense Ratio Source: ETFdb