AlphaTrAI Quant Says Risk-Parity Old Guards Are About to Suffer

(Bloomberg) — In the era of rising rates, there’s no shortage of people on Wall Street sounding the alarm on the systematic trade known as risk parity.

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But not everyone has actual day-to-day experience running the balanced-portfolio strategy popularized by Ray Dalio.

Max Gokhman at AlphaTrAI Inc. does — and he’s now exhorting his quant peers to diversify their bets as stocks and bonds come under pressure in the new hawkish era of Federal Reserve policy.

Gokhman, the chief investment officer of the San Diego-based firm, joined the “What Goes Up” podcast to discuss all that and more, including his takeaways from the Fed meeting and looming geopolitical risks.

Below are the condensed and lightly edited highlights of the conversation. Click here to listen to the full show and subscribe on Apple Podcasts, Spotify or wherever you listen.

Q: Is it possible we see simultaneous weakness in both the bond and the stock markets, and how do you play that?

A: The answer is yes. I think that’s likely — that’s actually my base case, that we will see weakness in stocks for at least some part of this year. I do think we’ll eventually be a little bit higher than where we started ‘22, but, we will likely see a bull correction and we’ll also see rates go up.

I do think we are going to see this secular rising-rate environment come back and that really poses a challenge, not only for 60/40, but the thing that supplanted 60/40 for a lot of institutional portfolios, which is risk parity. And while risk-parity folks will tell you that it’s very sophisticated, having run risk-parity strategies before, I can tell you that generally speaking, it still relies on the crucial concept of bonds go up when stocks go down, and rate and duration risk diversifies equity risk. If that’s no longer is the case, you need to create something different.

It’s going to be really important to be more dynamic in terms of asset classes. So the concept of a balanced portfolio is really important. If we break it down to its building blocks, it’s a risk asset that can go up and produce capital gains and then a diversifying asset that maybe produces a little bit of income and steady returns, but primarily is there to hedge the risky asset. So what those two components are, I think that’s going to be more dynamic going forward.

And the new all-weather strategies are going to be playing with those concepts. They may hold equities and bonds like current strategies do. They may also hold some amount of commodities, like some risk-parity strategies do. But they may at various points hold totally different things. They may actually hold some amount of crypto and some amount of loans and some amount of stocks. And those asset classes will have to keep varying. It’s going to be a bit of a musical-chairs strategy.

And I know it sounds a lot more complex than it is, but the unfortunate byproduct of our reality is things do get more complex over time. And if you stick to your traditional approaches, I think you’re more liable to actually suffer long-term and not achieve your objectives as an institutional investor.

Q: Can you briefly go over your takeaways from the Fed meeting, and do you think the market is correctly interpreting Powell?

A: Just look at the action we experienced right after the meeting — we had the really big drop, then overnight we started dropping further, then came back up. I don’t think Powell said anything really dramatically new. To me it seemed like just the hope is gone — that was the initial reaction. Like, OK, the Powell put is out of the money, it may be completely off the table.

If you think of the training wheels example — it almost seemed like you take your kids, you send them down the hill and they start really wobbly and they think they’re going to fall, they then eventually start pedaling and they’re like, ‘Oh, look at me, I’m going.’ But at no point did Powell say anything, to me, that was different, that was unexpected. They’ve done a really good job of telegraphing what they were going to do. It shouldn’t have been a surprise that the Fed said, ‘Yep, we’re going to hike in March, end QE, and we’re going to look at tightening.’ That’s pretty much what I think everyone should have expected.

Q: What are some geopolitical risks you’re thinking about?

A: One thing that we know about Russia is they tend to be the most aggressive in winter times because they control the heating power for Europe. This is one area where it’s nice to have been born and raised in the country because I can actually listen to Putin in Russian, and he uses very colorful language — let me just put it that way. He does talk about how he can basically freeze all of the people in Europe, and there’s some truth to that. And that’s why you never see very meaningful sanctions come out. Now, the biggest concern for Putin of course is that Ukraine somehow becomes a part of NATO. So that’s the gamble and the risk. I do think that a conflict there is likely, unfortunately, in terms of a kinetic conflict, because you just have this powder keg on both sides. And even though it’s cold, it’s very dry in the sense that anything could spark it off.

I think for the markets, that’s not going to be as big of a risk as what’s going on further out east. There, I’m really thinking about China and Taiwan. I do think Taiwan has perhaps the best defense forces of any small nation and that defense force is called TSMC. So Taiwan Semiconductor is probably the best deterrent because it is so vital to all other nations around the world that no one can actually afford to risk China taking over TSMC.

This was just the highlights. Click here to listen to the full podcast.