These Formidable Funds Are Sending A Warning Signal

These Formidable Funds Are Sending A Warning Signal
Reda Farran, CFA

4 months ago2 mins

Risk-parity funds, also known as volatility-controlled or volatility-weighted funds, have a formidable presence in the market. They use rules-based strategies to allocate their portfolios according to risk, piling up on assets when they rally during periods of low volatility and offloading them when trading gets choppy – regardless of market direction. And lately, stock positioning among these funds has been hovering near a ten-year high, thanks to rising prices and falling volatility. And that recent popularity could trigger a huge wave of forced selling if volatility spikes.

According to investment bank Nomura, it could take just a 1% move in the S&P 500 – up or down – every day for a week to trigger a huge bout of selling among volatility-controlled funds, potentially halting the rally in US stocks. The last time the S&P 500 fluctuated by more than 1% a day for a whole week was at the start of February (shaded bars), which incidentally was the index’s only negative month so far this year.

What’s more, the asymmetry here (between potential selling versus further buying from these funds) would be huge, according to Nomura. A 1% daily fluctuation in the S&P 500 over a week, for example, could result in approximately $28.8 billion in stock sales. In contrast, a calm, sideways market would generate only about $2.3 billion in additional purchases.

A forced wave of selling that reverses the rally in US stocks could also trigger subsequent sales by another set of funds: commodity trading advisors (CTAs). These hedge funds buy and short futures to ride trends in different markets, and they’ve increased their exposure to stocks to the highest level since before the pandemic, according to Deutsche Bank. For these funds, both volatility and trend signals matter. So should volatility spike and US stocks start heading downward, they’ll also be forced to dump stocks, exacerbating the selloff.



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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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