GMO: Risk Parity Could Pose Systemic Risk

Investors that buy assets with little concern for price could seriously disrupt the market once they start selling, according to GMO’s Ben Inker.

Asset owners that tend to invest without much regard to price—passive players like risk parity investors, for example—could easily cause asset prices to nose-dive should they start selling—or even quit buying, according to GMO.

Ben Inker, the manager’s co-head of asset allocation, has argued that these price-insensitive purchasers—who already have trillions of dollars invested in the market—could quickly become “price-insensitive sellers.”

“With hundreds of billions
of dollars under management in risk parity strategies… it is easy to imagine their selling in unsettling markets under certain circumstances, such as a repeat of 2013’s taper tantrum.”
Once this happens, Inker warned asset prices could plummet below historical norms, bringing on more downside volatility than most investors have bargained for.

“Anyone conditioned to think that these investors provide a permanent support for the markets should be aware that the support may at some point be taken away,” he wrote in the firm’s latest quarterly investment letter. 

Risk parity investors, for example, buy and sell depending on an asset’s volatility and risk profile, Inker argued. They tend to buy—and lever—more when volatility falls and sell when it rises.

This quality also “gives their buy and sell decisions a certain momentum flavor,” he continued.

In addition, rising volatility in bond markets could push investors to de-lever across their risk parity portfolios, Inker said, causing them to sell non-fixed income assets to keep their volatility balanced.

“With hundreds of billions of dollars under management in risk parity strategies and large holdings in some of the less deeply liquid areas of the financial markets such as inflation-linked bonds and commodity futures, it is easy to imagine their selling in unsettling markets under certain circumstances, such as a repeat of 2013’s taper tantrum,” Inker wrote.

Other “price-insensitive buyers” cited include emerging-market monetary authorities and developed-market central banks. According to the letter. each group has purchased $5 trillion worth of assets to hold down currencies and boost real economies.

Central Bank Balance Sheets Source: GMO, US Federal Reserve, ECB, Bank of Japan, Bank of England

Defined benefit plans have also buckled under regulatory pressure to buy and sell without regard to price and low interest rates, Inker added.

Index funds, which are “at the mercy of client flows,” have also been pushed to transact whether pricing is favorable or not, he continued, even venturing into increasingly illiquid assets such as credit.

Inker described himself as an “instrument-agnostic, price-obsessed value investor.” He warned that he and his peer asset managers could be at the mercy of these price-insensitive asset owners if the latter start selling.

“Our paltry few billions of firepower pales in comparison to the trillions of dollars that have pushed markets up, and might, just possibly, push them back down.” 

In an effort to prepare for a potential drop in valuations, he said GMO is making sure to limit its exposures across asset classes.

It also holds a significant amount of cash as dry powder, Inker added, for “prudent flexibility in a world where the pressures on markets might well reverse in a way few are banking on.”

Read Ben Inker’s full article in GMO’s quarterly letter: “Price-Insensitive Sellers.”

Related: Pricey Stocks—Not PE Bubble—Causing Record Dry Powder, Rubenstein Says; Managers Stockpile Cash as Tail Risk Fears Grow; Risk Parity’s Annus Horribilis; Risk Parity’s Hunger Games