The Most Dangerous Narratives Are Usually The Smartest

You’ve probably read a million market narratives that sound super smart. But have you ever read one that was so over-the-top smart that it just sounded like it had to be true? I consider myself to be a pretty smart market participant and in recent years I keep coming across narratives that sound so smart that I actually believe they might be true. Then I dig a little deeper and find that, like most market narratives, the explanation is just someone trying to explain a random price move in markets where most of the short-term movements are exactly that – random.

A common narrative of late is this crash narrative being blamed on automated strategies like Risk Parity.¹ Bloomberg had an article about this today and how some famous hedge fund manager (who doesn’t even implement the strategy) says the equity market is at unusually risky because of strategies like this. This is an effective narrative for three reasons:

It uses big confusing words like beta, gamma, etc that most people don’t understand so it’s easy for the average investor to believe simply because it sounds so smart that people defer to the idea that smart people know what they’re talking about.

It’s scary. Fear is always the best narrative.

It uses technology and the automation story to create a narrative of uncertainty because, you know, the actions of robots are so much less certain than those of humans (actually LOLing as I write this).

The problem is, some simple math debunks a narrative like this. I went to the experts on Risk Parity and spoke with Cliff Asness and Michael Mendelson at AQR who laid this out in simple terms for me.² For instance, if we wanted to attribute the relative price change of the market from a specific strategy we can assign the source as follows:

Equity Selling From Risk Parity = (AUM of risk parity) x (capital weight of equities in risk parity) x (responsiveness of equity weight to changes in market volatility)