Cliff Asness Quick Hits: Smart Beta and Risk Parity

Cliff Asness gave a talk at The Bloomberg Markets Most Influential Summit a few weeks ago, and offered up some discussion of recent market developments, including a discussion of the Shiller P/E and expected equity and bond returns, which are approximately the lowest ever by this measure. You can watch the video for details, but you might want to take an antacid first.

Separately, Cliff offered some insights on Smart Beta and Risk Parity. We include a transcript below of these remarks.

On Smart Beta:

A term I imagine many of you have heard, in the last 6 months, 12 months, 2 years, “smart beta.” I will tell you I fought this term for a while, and I’ve caved. I fought the law and the law won. I fought smart beta and I’m caving to it, because, you know, what is language? If everyone starts using a term, it’s a term. You can fight it all you want.

A few things about it. For those of you who’ve not followed it, it’s a different weighting scheme, usually amongst equities. Some have applied it to bonds. Usually amongst equities. A different way to own stocks. Instead of market cap weighted like an index fund typically would be, you might weight it by book value. You might weight it by low volatility…There’s evidence these outperform over time, but one thing to know (I love smart beta):

It’s not anything new.

You’ve been hearing geeks like me talk about risk factors, return factors, things like value investing. Low risk investing. Momentum investing. Regularities. Things that seem to outperform, not all the time – they’re not money machines – but on average. Smart beta has rediscovered them and relabeled them. If you want to be a real cynic, they are quantitative investing, circa 1992. Now again, I’m in a weird position. I like quantitative investing circa 1992. But it’s important to keep perspective on what’s new, and what’s not. You’re buying something that’s been around a long time, with a good history. You’re not buying something revolutionary.

We agree with Cliff: there is nothing revolutionary about smart beta. But we would take it a step further. We would also characterize smart beta as a redundant and and overpriced way to exploit investment factors. A lot of smart beta is simply overpriced closet-index products. In our post, Why Smart Beta is More Expensive Than You Think, we explain how you can financially engineer smart beta exposures by combining concentrated active exposures with cheap, passive Vanguard funds. Why pay extra for what you can get for free?

On Risk Parity

Let me talk about just the last thing…This one has been pretty controversial lately. I’m assuming many people in the room have, if they hadn’t until the last few weeks, have recently heard the term “risk parity.” Remember that volatility…in October…Risk parity…is a strategy…that has been blamed a lot for that volatility. And even as a proponent for risk parity, and quantitative methods, I’ll tell you it’s not impossible.

One thing many, not all, risk parity strategies do is try to keep risk level through time. And if the world gets riskier, if volatility is your measure of risk (that’s a whole separate discussion whether that’s a good measure of risk. Let’s pretend it is). If volatility is your measure of risk, and the world gets more volatile, you need to invest fewer dollars to stay at a constant level of risk. If the world gets calmer you need to invest more dollars. Many risk parity strategies do that. That’s a form, a sneaky, subtle form, of trend following. When the world falls, it tends to get more volatile, and risk parity tends to sell.

I don’t know why…people jump to blame risk parity. We have many investors in this market that are much more direct trend followers than risk parity. We have managed futures market[s]. We have momentum stock pickers. Markets have always been kind of this crazy combination of people who like to buy more when price is going up and people who like to buy less when price going up. Or sell when price is going up. We all want the price to go up after we buy. I think we can agree on that. But there have been what are called positive feedback strategies, strategies that buy more, that are momentum, that are trend following. And negative feedback strategies – contrarian, value strategies. It’s always been a mix of those two. Now risk parity, we don’t think…I know simple facts are kind of boring. It’s very hard to defuse a story with a fact. That sounds crazy. Risk parity, we don’t think, is nearly large enough to have caused the chaos in markets that we saw in October…if you look at the sizes in markets, I think it’s an excuse. I think markets went crazy, a little bit crazy…in October because of real economic worries. They may turn out to be overblown. They may turn out to be the beginning of something worse. But I don’t think it was any one strategy.

Second of all, trend following strategies, strategies that buy when things are going up and sell when things are going down, almost definitely do what the critics say: exacerbate near-term volatility, make things move more. That doesn’t mean that they’re crazy. That doesn’t mean that they move the price in the wrong direction…I’m an old University of Chicago guy so this is a major admission for me. We do not live in a world of perfect capital markets. Price is not always exactly equal to value. If price is below value, and it starts to trend back towards value, a trend follower will buy it. They will make it move more herky-jerky. They will make it move faster. They’ll also make it move towards, not away from true value. So when you hear people talk about trend following, sometimes it can make things crazy, but sometimes it can also be helping restore prices. It’s not always making prices more crazy.

So just how big is risk parity, anyway?

Last month, Alliance Bernstein published a research piece entitled “Playing with Fire: the Bond Liquidity Crunch and What to Do About It” that addressed some of the issues Cliff references. The piece estimates that “risk-aware” products have grown to $1.3-$2.5 trillion AUM, with risk parity accounting for $0.6-$1.8 trillion of that.

The Alliance Bernstein piece also points out that in “correlated” sell-offs, when risk assets and safe assets both sell off, risk parity managers have to sell both. There is also the effect of leverage, and risk parity funds can be leveraged from 200%-350%. Thus, a bond sell-off might also trigger a sell-off in equities as risky parity gets margin called.
The debate rages on.