Equity Bull Bias in Volatility Targeting

Frustrating. A sharp break in the market for stocks, diversifying assets (hedge funds, risk premia, risk parity, trend following, equity l/s) all down. What gives? In a word- Vol. In the hedge fund space, or more specifically the quant hedge fund space (which is responsible for bulk of trading flow today), trading in the short run is being dominated by reactions to changing vol. Whether you are risk parity, risk premia, trend following, equity l/s, momentum, value, carry, etc., the common theme is sizing positions based on vol. When vol is low, take bigger positions, when vol is high take smaller positions. So, what happens when equity markets break and vol spikes? Hedge funds “de-risk”, “de-lever”, “gross-down”, “vol-adjust”, “risk manage”- lots of names, all mean the same thing.

Think about it.  You invested in all those factors, methods, markets, using all manner of sophisticated quantitative methods, but they all get unwound at the same time. Irony is, it is the manager’s risk management that is creating systemic risk in your balanced portfolio. Continue reading