Many investment ideas are promising so long as few do them. Yes, there is an opportunity, but it is limited. “Shh, don’t tell everyone about it.”
Thus, the concept of “risk parity.” Lever every asset class up until it has the same volatility as common stocks. Under theoretical conditions, one could make extra money doing this, and with less risk than just a common stock portfolio.
That makes sense when few are doing it, but not when many are doing it. When I worked for Hovde Capital Advisors, I highlighted to the group how hedge funds were forcing every asset class to the same level of riskiness. A Grants Interest Rate Observer article on Leveraged Non-prime Commercial Paper is etched on my mind as emblematic of that era.
Risk parity can work so long as the total riskiness of the system does not get too high, as it did in 2007-8. But if it does get too high, the assets that are levered face disadvantages versus volatile unlevered assets. Failures of leverage feed on themselves, and lead to a real washout. Failures of growth stocks don’t do that to the economy.
Risk parity turns managers into bankers, or worse yet, asset managers that specialize in non-AAA investment grade portions of structured securities deals. Most asset managers are not used to thinking like bankers, largely because they think in terms of total return, and because they don’t have a balance sheet. Their capital can run at will, unlike banks that have deposit stickiness, savings accounts, CDs, ability to borrow from the FHLBs, etc. The banks can hold the assets to maturity, they have a buffer against losses in their capital, and don’t have to mark to market in an assiduous manner (though they *should* have to do so).
Think of the mortgage REITs in the most recent crisis — the ones that did the best were the least levered and had the longest terms for their repo lines. In the short run, that costs more than the vain idea that one can roll over their repo lines every night, and that repo haircuts won’t rise. Crises lead to a failure of both ideas, together with a set of forced sellers driving down the price of assets being repo-ed, which sometimes leads to a cascade where repo terms get progressively tighter, and only those that were the most conservative at the start of the crisis survive.
There is a Wall Street aphorism, “The fool does at the end of a bull market what the wise man does at its beginning.” Risk parity falls into that bucket. Early adopters of new asset classes and liability structures typically do well, but when they become mainstream, the dynamics can be ugly, as we learned in 2007-present.
So ignore the idea of risk parity. Risk managers are not bankers, they don’t have the capacity to play leveraged spread games to maturity. Risk parity if practiced on a large scale will produce wipeouts akin to the recent crisis.