Black swan observations...

There are two particular observations of "black swan" events that tend to repeat themselves over and over again.
The first has to do with the fact that they occur more frequently than we think they do. Our cognitive brain has a way of erasing or minimizing unpleasant experiences, so we almost tend to forget that they ever occurred, unless something of that "unpleasant" experience persists. That probably explains why we tend to repeat the same mistakes or when the tide runs down, so to speak, a lot of people are caught swimming naked.
The second has to do with clustering or the fact that a negative event almost instantly tends to attract other negative events like a magnet, which means that the original event is subject to a snowball effect. Take the last two months as an example. It began with an uprising in Tunisia, rapidly spread to Egypt, and now Libya and other countries in the region. As if that was not enough, commodity prices have been surging (adding more fuel to the fire) and now we have the totally unanticipated quake/tsunami disaster in Japan and a growing risk of leaks from nuclear reactors in the region. Impressive and worrying series of events that have the potential of dragging the rest of the world into another slump.
So if there are certain "predictable" patterns built into black swans, can we do something about them? This is the topic of much debate, and there seems to be growing consensus that strategies can be built around them. I guess the first place to start would be to accept these observations as a given and to "strategize" accordingly.

Risks on various fronts...

From inflation fears triggered by a surge in commodity prices to growing tensions in the middle east to more downgrades in peripheral Euro zone sovereign debt, it is challenging to figure out where or in what form one can find shelter from the damaging effect of a sudden "fat tail" event. This challenge stems from the fact that the last couple of years have shown us that what used to be considered "safe" may no longer be. If you cannot differentiate between high risk and low risk, you are in trouble.
The Euro zone debt debacle is a case in point with the onetime almost "risk free" sovereign debt of a number of member states suddenly finding themselves in "junk bond status" territory. Another example would be the infamous money market funds that at one time was considered as safe as cash but in fact carried an disproportionate amount of risk as managers, under pressure to enhance returns, stuffed the funds with significantly higher risk instruments.
What about commodities such as gold which has experienced a nice run since the beginning of February? Sure, when visibility is low and the threat of systemic risk rears its ugly head, gold seems to be a safe bet. It is in a way the collective expression of distrust towards monetary authorities across the globe. At the same time, gold, just like other commodities, exhibit a tremendous amount of volatility as it is very much guided by sentiment which tends to be fickle when tensions run high.
At the end of the day, the only effective method in facing these challenges is to diversify. Not just any sort of diversification mind you, but one that involves a well thought out approach where the underlying risks are clearly identified.

A slight exaggeration in the making?

Earlier this week the U.S. government published its forecast for the budget deficit in coming years. In summary, the deficit is expected to narrow as a result of planned cuts on expenses but also, and this is where there seems to be a bit of an exaggeration, a substantial increase in receipts which, believe it or not, is hoped will come from expectations of a recovery combined with a planned increase in taxes and other forms of income. The goal is that the deficit drops from the current 10% of GDP to 3% by 2017.

So how realistic are these projections? I have a hunch that a large amount of the reduction actually bets on a strong recovery and that is where the problem lies. In the context of the current environment, it is difficult to see how the recovery can take on a sustainable path. Short term, maybe so, given the extension in tax breaks and the impact of the second round in quantitative easing, but longer term, probably not. In other words if the deficit, instead, remains stagnant or, worst case scenario, continues to widen, we can expect further pressure not only with regards to borrowing costs but also on the greenback. A weaker currency should undoubtedly help boost the economy by boosting exports to emerging countries, but if you factor in the brewing inflation troubles facing those same countries, the outlook suddenly looks bleak when compared to the "goldilocks" scenario of the government.

Reconciling Asset Allocation and Market Exposure...

According to a paper published by Gary Brinson in the 80's, the asset allocation decision was thought to be the single most significant contributor to performance, explaining roughly 80% of overall performance in a portfolio. His work was quickly noticed and widely adopted by the industry, remaining unchallenged for almost 3 decades. In early 2010, Ibbotson et al. published a research paper in the Financial Analyst Journal (FAJ) in which they disproved Brinson's original assertion. According to them, Brinson had mistaken asset allocation for market exposure. In other words, it was market exposure rather than asset allocation that contributed most (60%) to performance although, combined with asset allocation, the contribution hovered again around 80%.

The conclusion from this study would be that most of the effort in portfolio construction and investment policy should be put into determining market exposure and asset allocation rather than asset allocation by itself.

Controlling market exposure would require a form of market timing but, as any honest investment professional will tell you, trying to time the markets over the long run is a futile and sometimes very costly exercise, mainly because of the inherent randomness of markets.

On the other hand, studies have shown that if it were possible to mitigate the degree of drawdowns over the long run, doing so would substantially improve the end performance result.

Since controlling market exposure may require large changes in asset classes, isn't combining asset allocation and market timing a contradiction in terms? Dont you actually substantially change your asset allocation if you fully apply market timing? The answer is yes, but you have to think of the asset allocation element as a sort of structural backbone or foundation of the portfolio. The asset allocation decision is a pure function of the risk profile of the investor. It is the default portfolio exposure when the market conditions are "normal" or when asset classes behave as expected. Market exposure is more of a tactical overlay, its main purpose, at least in this context, is to mitigate the impact of drawdowns. In other words there is no contradiction to speak about when the roles of asset allocation and market exposure are clearly defined.

Coming back to timing markets, it is a futile exercise if human judgement is involved in the decision process. There are certainly ways around this, and if done properly, it can lead to a much better control of performance.

Negative Tail risks in 2011 and beyond...

The world will probably not come to an end in 2011 or even in our lifetime for that matter but there is something else that is likely to rock the rest of our lives: "black swan" or "fat tail" events.
They have always existed but, unfortunately, human memory suffers from a bout of short termism, we tend to forget longer term experiences, especially if they are unpleasant. I guess it is an inherited trait of our ancestors which explains why the human spirit tends to be on average optimistic. Because of our short term memory bias, however, we dont realize that "fat tail" events in fact occur more frequently than we think they do. Also I would add that a "black swan" event can also be a pleasant one such as when a major market rally occurs but we like to concentrate on the negative end because that is what needs to be controlled.
For this year, we see several risks that have negative "black swan" potential. The table above summarizes the more important ones.

Can the Eurozone survive?

The more time goes by, the worse it looks. The Eurozone frailty is getting more difficult to manage by the day and to understand why, we need to dwelve into the mechanism behind the Euro. Both Europe and the U.S. are in deep trouble but the source of their troubles and, in turn, the approach to resolve those troubles are very different.

The Euro project, from the very beginning, was meant to unify Europe on the economic front only. By creating a single currency, it was believed, trade would flourish and mobility would increase. A single currency makes it far easier and less costly for industries to plan ahead with production.

What everyone seems to forget is that there is also an implied cost to this, which may not seem evident when things are going well. A single currency without a political overlay can be problematic in certain situations like the one that is currently unfolding in the European continent. By joining a single currency, a country is effectively giving up independence on the monetary front. Without political unification, however, fiscal policy stays local. This is in stark contrast to the U.S. with its federal government in which both monetary and fiscal policy is managed at the federal level. What this means is that a state is unlikely to find itself in a situation like many of the peripheral European countries are facing today, having trouble raising capital to pay for maturing debt. This is because such issues are dealt with at the federal level.

So what actually happens when you lose monetary independence but keep fiscal independence and you are facing the type of challenges that we are seeing today? Well, you get hit by a so called double whammy. Let me explain: The booming years inflated prices and now that the crisis has hit and the asset price bubble burst, costs such as wages need to come back down. For a country with an independent monetary system the solution is rather straight forward. Instead of cutting wages, you just depreciate your currency and the problem is pretty much resolved as it is the equivalent of cutting wages. In a country that does not have monetary independence the only real solution is to cut wages, and if history is any guide, this can be a slow and painful process. Prices tend to be sticky on the downside, producers will wait for wages to come down before cutting prices (to preserve margins) and workers will wait for deflation to hit before agreeing to have their wages cut. This is exactly the problem facing a highly unionized Europe, which, through austerity will have to apply the painful cost cutting process as it is the only possible solution at their hands short of regaining monetary independence or defaulting on their obligations which are unlikely to happen any time soon.

Stagflation in Europe?

The euro zone's annual rate of inflation hit a 2 year high in December, driven by fuel, food, alcohol and tobacco prices at a time when the ECB is dealing with a major sovreign debt crisis.
Consumer prices rose 0.6% from November, pushing the year-to-year rate up to 2.2% from 1.9% the previous month, the highest annual rate since October 2008 when it stood at 3.2%.

A surge in cost price inflation that is likely to be passed on to consumers, just as European governments are embarking on an austerity program limits the ECB's flexibility on the monetary front somewhat. But at the same time it should not be forgotten that price stability (i.e. low inflation) is the primary objective of the ECB, in contrast to the Fed that targets both price stability and unemployment.

Applying the brakes at a time when stimulation is most needed could bring Europe closer to the brink of stagflation. Considering the sovreign debt related uncertainty surrounding Portugal and especially Spain, the austerity measures and a whole lot of other problems, a rate hike might just prove too much to handle.

Risk vs. structure based asset allocations

2008 reminded us that diversification can fail spectacularly when risky assets are clumped together. This is because when panic sets in, there is a sort of hoarding activity in the markets as investors jump ship from risky to less risky assets. By doing so, the correlation between risky assets spike, leading to simultaneous losses from investments of different asset classes. This is why, for example, at the peak of the crisis, high yield and emerging bonds and commodities followed the exact same path as equities at the very moment when the benefits of diversification were most needed. What use to be diversified suddenly becomes concentrated.

How can we avoid or at the least minimize such serious pitfalls? One method would be to implement a risk based asset allocation, grouping together investments according to their risk characteristics.

The traditional approach to asset allocation has been to classify assets according to their structure. Genotype/phenotype are good biological analogies to help illustrate the differences. Genotype describe hereditary characteristics (structure based classification) whilst phenotype are the observed properties (risk based classification). As an example, grouping together fixed income investments comprised of bonds with characteristic cash flow streams that include coupons and a final payment at maturity would belong to a traditional structural classification. The problem with the traditional classification is that the investment landscape has changed substantially over the last decade. The risk spectrum of investments with a similar underlying structure has broadened substantially. Today, for example, bonds can include low risk, short duration treasuries as well as high yield/emerging debt that share risk characteristics that are comparable to that of equities.

There are effectively two ways to tackle this problem:

• Managing the risk internally, within the asset class by implementing strict guidelines
• Defining risk at the asset class level

The first method would involve limiting the choice of underlying investments for more effective risk control. One such approach would be to implement a core/satellite approach in which the "larger" core would comprise of less risky investments in contrast to the satellites.

The second method is best explained as a target based approach in which the asset classes are defined as targeting specific objectives. We could very well imagine, for example, a portfolio comprised of four "asset classes" with the following defined objectives:

1. Longer term high returns (equity like risk/reward characteristics)
2. Hard assets (namely for inflation protection)
3. Liabilities matching (high quality low duration fixed income)
4. Pure excess return (de-correlated to the rest of the markets)

This method has the advantage of providing greater transparency and better risk control, at the same time allowing for a greater degree of specificity in matching investor objectives and constraints. A person close to retirement, for example, would typically allocate a large portion of their wealth to liability matching instruments in contrast to someone at the prime of their career, in which case the attributions would probably be more balanced between the four classes.

The two proposed methods aim for the same objectives, the big difference is in the approach.