Eight years into a U.S. bull market, valuations are elevated and with them, the risk of U.S. stocks moving into bubble territory. In response, many investors have begun pouring assets into defensive approaches such as dynamic risk-based allocation strategies. However, could these defensive strategies actually be responsible for intensifying risk rather than mitigating it?
Investors got a taste of the potential for market disruption in August 2015, when the S&P 500 index tumbled 11% in little more than a week. The accompanying spike in volatility was by some measures among the largest in decades. It wasn't clear why the sell-off was so violent, but one possibility is that some strategies designed to help investors mitigate risk actually intensified it. These include volatility target strategies, some implementations of “risk parity” and portfolio insurance. The common characteristic of these approaches is that they're designed to reflexively and mechanically reduce the allocation to equities as the riskiness of the asset class or the overall portfolio increases.
It is important to recognize that these types of defensive approaches were originally conceived to regulate portfolio exposures in response to gradual, long-term changes in the market risk environment, not violent shifts. In some implementations, however, the equity allocation can be quite sensitive to a sudden surge in market volatility. As an example, the MSCI USA 10% Risk Control index determines equity exposure based on short-term trailing realized market volatility. In the August 2015 sell-off, which occurred against the backdrop of what had been a quiet market, such a mechanism likely would have triggered a sudden, severe reduction in equity exposure, perhaps in excess of 50% in a matter of days.
Moreover, these types of defensive strategies don't rebalance positions in a vacuum; as they delever, other defensive strategies might simultaneously generate programmatic selling. Portfolio hedging via options, for example, can result in such flows. Dealers that underwrite the protection assume long market exposure through their side of the trade. To keep it neutralized, they have to sell equities as stocks fall (and buy as stocks rise). As more investors secure protection against a future decline, the greater the potential selling pressure from the dealers if a sell-off actually does occur.
The severity of market swings during August 2015 triggered debate as to whether programmatic deleveraging from defensive strategies had grown large enough to influence market dynamics, exacerbating sell-offs and volatility. Some assessments ran into the hundreds of billions of dollars and were accompanied by eye-catching estimates of flows generated. While the jury is still out on the true magnitude of its impact, the August 2015 episode does highlight potential vulnerabilities investors should take note of when considering defensive strategies that hinge on mechanical, risk-based deleveraging.