Recently, Jefferies chief market strategist David Zervos raised a scenario about what might happen when a popular hedge fund trade — called risk parity — stops working as rates plunge.
With the coronavirus pummeling stocks and pushing Treasury (^TNX) yields down to record lows, the veteran analyst said the strategy risked being put “in a coma.”
In the last paragraph of a client note on Sunday evening, Zervos wrote, "It won't die, of course, but we are approaching a dormant danger zone in risk parity strategies for sure."
For the last decade, Zervos acknowledged that he's ridden the "risk parity hobby horse" himself.
"I very much believe in the trade. It's a trade that's made a lot of very successful hedge fund managers even more successful over the years. And, I do think that trade structure has embedded itself in the marketplace," he told Yahoo Finance’s “On The Move” this week in an interview.
Here's how the trade works: Investors who own risk assets, instead of the traditional 60/40 mix of stocks and government bonds, use leverage to spread out some of that risk. It leaves them with enough volatility to match what’s in the stock portfolio.
"So you may have two or three times what you would normally have, on margin, on leverage in fixed income," Zervos told Yahoo Finance.
Traditionally, "That fixed income has acted as an insurance policy. When stocks go down, rates go down, the value of that portfolio goes up and you kind of live to fight another day."
However, when rates get to zero or close to zero, "the insurance policy doesn't work out so well,” Zervos added. "You need to have enough room for those rates to rally to protect your stocks."
The question now is what happens to the stocks owned on a risk parity basis, when the rate hedge is no longer effective?
According to Zervos, the question is “worth thinking about” in the context of market structure that’s worked for at least a decade.
"[I] don't think you have a lot of people that are, say, underwater, but there's a lot of people that are going to scratch their head and go, 'Well, wait a minute. What am I going to do here?” the analyst asked.
That would depend on whether investors really think the dramatic selloff in equities has reached its end — and the Federal Reserve’s next moves on monetary policy.
“Because the fixed income hedge is being taken away, if you will, by the perceived and likely central bank action that's coming,” Zervos said. And if risk parity trades got unwound, "it would not be pretty in the short term."
He added: "It would be an ugly scenario.”
Julia La Roche is a Correspondent at Yahoo Finance. Follow her on Twitter.
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