Business

The cause of the mini crash

Some large papers blamed risk parity funds for driving the market mini crash
Peter McGahan

Mr Ferguson coined the phrase well with ‘noisy neighbours' referring to Man City - a phrase his current successor has not bothered with articulating.

Last week saw an example of that noise, and investors could easily have made a leap at the wrong time – in either way.

Observing from the fence, each time there is an upward or downward blip we see the commentators who were extolling the virtues of markets a fortnight before, now telling us the downturn was obvious.

Still, to this very day, these journalists use the Dow Jones as a thermometer for markets. It is like using wet toilet paper to measure tornado velocity.

In a flash downside, narrow press reports are often repeated ad verbatim (see note re Dow Jones) by the financial media and their pundits, along with politicians keen to make a name for themselves when called upon for a press quote. Most are simply regurgitated twaddle, but a benign answer to the press, keen to create a financial scoop won't be quoted – it just isn't sexy.

You may remember us correcting the “sharks sit off the Brixham coast driving oil prices up” article that appeared in the press, only for us to point out it was one of the few places where tanker to tanker transfers could take place. Which of the two sells papers?

Similarly, if a person in a pub spoke to you like a news reader dramatically speaks, you'd squint.

Whilst focusing on making the best investment decisions for our customers, we are always mindful watching this table tennis game of noise of who might have their hand in our pockets.

I can remember back over twenty-five years ago a headline that said “investors dash for safe haven of x,y,z”.

I've seen that repeated continuously over the following years but, like every financial adviser I've spoken to, we know nothing of who those investors are.

Few investors bolt for the hills or beach, so looking behind those headlines is key – nothing worse than jumping a queue in the bank only for the man in front to drag out a bag full of 3,000 coins to count.

So what happened last week?

Some large papers blasted about risk parity funds driving the market. In simplistic terms, risk parity funds might balance out risk by having 60/40, 70/30 in equities and bonds (for example, to balance out risk). The idea is they are in effect a see-saw with one foot on each of the above where a downturn in equities is met by an upturn in bonds as they are often seen as the opposite of each other (ie negatively correlated).

The theory in the press was that risk parity funds, which hold significant investments, cause huge volatility when rebalancing between equities and bonds. There's enough data to blast that out of the water with a bit of reading.

Firstly, they simply aren't big enough and don't hold enough money to move a market like that in its entirety. Their total holdings across the market is less than 10 per cent of just one day's global volume – one day's. Secondly, they don't trade that aggressively, or that often, to move a market.

In any event, the market as a whole took a battering, which doesn't make sense as a risk parity fund would have sold one asset and bought the other. The see-saw would have corrected, but not sunk in the middle.

We might think cynically, or accurately, that traders might be behind it. They are noted for running a market down and buying in on the downside especially if they know there are opportunities. Could that be the issue? It's more likely than risk parity funds.

Of course, risk parity funds might exaggerate a problem already created as they don't like, and sell out of volatility when it rises. But that's bolting the gate after the horse and markets have gone (see queue jumping above).

Yes markets are overvalued, but they don't need to pop. There is an abundance of good news so the market could catch up with that.

However, complacency is not an appropriate tactic as we move into world rate rises and the potential for quantitative uneasing.

:: Peter McGahan is the owner of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have a question on income producing investments please call Darren McKeever on 028 6863 2692, email dmckeever@wwfp.net or visit us on www.wwfp.net.

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