The real-world challenges of dealing with fat tails—the higher frequency of extreme returns than a normal distribution implies—have received a lot of attention since the market crashed in 2008, and rightly so. Modeling asset prices based on an assumption of normally distributed performance runs into trouble when Mr. Market throws a hissy fit. As a result, a lot of models crashed and burned during the Great Meltdown in late-2008. We’re all older and presumably wiser now. But while it’s tempting in the post-crash era to allow non-normal distribution modeling to dominate portfolio analysis and design, reality is a bit more nuanced.
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Asset Allocation and Bad Habits
Andrew Ang, et al.
September 17, 2014
This article documents the “bad habits” of investors in asset allocation practices. Whereas financial markets exhibit momentum over multi-month horizons but more reversion to the mean over multi-year horizons, many investors act like momentum investors even at these longer horizons. Both these patterns are well known anecdotally but have not been well documented statistically, especially together. This article therefore addresses two empirical questions. First, How do funds reallocate based on past returns? The authors provide direct evidence using the CEM Benchmarking data on pension fund target allocations over a 22-year period. Second, What are momentum/reversal patterns in financial markets returns? Evidence is provided using more than a century of data. Merging the findings from the two data sets provides evidence consistent with the premise that investors chase returns over multi-year horizons, which is likely to hurt their long-run performance. However, the statistical evidence on pro-cyclical multi-year asset allocations and multi-year mean reversion patterns in asset-class returns is on the borderline of statistical significance.
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Barry Ritholtz asks the right question—Why hedge?–in the wake of last week’s announcement that California Public Employees’ Retirement System (Calpers), the elephant in the room in the world of pension funds, is ending its decade-long experiment with hedge funds. The allure of these products in the wider world has been driven primarily by the hope that the funds will deliver outsized returns relative to the usual suspects. But smart investors like Calpers have also been drawn to the risk-management aspects of these hedge funds—i.e., low correlations with conventional portfolios of stocks and bonds. After the financial crisis of 2008, the focus on owning stuff that acted differently in times of elevated market stress while offering relatively high expected returns through time required no explanation. But a funny thing happened on the way to nirvana—the results fell short of the sales literature.
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US economic activity decelerated more than expected in August, according to this morning’s update of the Chicago Fed National Activity Index. The three-month average for the business cycle benchmark (CFNAI-MA3) declined to +0.07 for last month’s reading vs. a revised +0.20 for July. The latest figures still reflect an “above-trend” pace of growth for the world’s biggest economy, according to the Chicago Fed. Nonetheless, today’s release raises more doubts about the recent assumption that the US economy is accelerating.
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US economic growth will decelerate in the third quarter, according to The Capital Spectator’s median econometric nowcast. Today’s revised GDP estimate anticipates an increase of 2.2% (real seasonally adjusted rate) for the July-through-September period—down sharply from the 4.2% pace in the previous quarter, according to the Q2 report published by the Bureau of Economic Analysis (BEA) in late-August.
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● American Power After The Financial Crisis
By Jonathan Kirshner
Summary via publisher (Cornell University Press)
The global financial crisis of 2007–2008 was both an economic catastrophe and a watershed event in world politics. In American Power after the Financial Crisis, Jonathan Kirshner explains how the crisis altered the international balance of power, affecting the patterns and pulse of world politics. The crisis, Kirshner argues, brought about an end to what he identifies as the “second postwar American order” because it undermined the legitimacy of the economic ideas that underpinned that order—especially those that encouraged and even insisted upon uninhibited financial deregulation. The crisis also accelerated two existing trends: the relative erosion of the power and political influence of the United States and the increased political influence of other states, most notably, but not exclusively, China.
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The three-month average of the Chicago Fed National Activity Index (CFNAI) is expected to rise slightly to +0.29 in Monday’s update for August, according to The Capital Spectator’s median econometric point forecast. The projection is marginally above July’s +0.25 reading, which reflected above-average economic growth relative to the historical trend. Only values below -0.70 indicate an “increasing likelihood” that a recession has started, according to guidelines from the Chicago Fed. Based on today’s estimate for August, CFNAI’s three-month average is expected to remain at a level that’s historically associated with growth at a moderately above-trend pace.
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The latest economic releases look wobbly in some corners–yesterday’s report on housing starts, for example. But the monthly comparisons for several indicators, although weak, appear to be noise at this time in terms of evaluating the business cycle. Indeed, reviewing macro conditions across a broad set of figures still points to growth. True, the outlook for expecting an acceleration in economic activity has fallen on hard times again. But the moderate expansion that’s prevailed lately will likely roll on, based on the August update of a diversified set of 14 economic and financial indicators.
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I’m off to Manhattan, where I’m a panelist at today’s 360 Exchange conference hosted by Bloomberg. My session focuses on volatility in macro and markets. My co-panelist is Dan Farley, chief investment officer for the investment solutions group at State Street Global Advisors. The usual routine for The Capital Spectator resumes tomorrow.

Housing starts are expected to decrease to 1.050 million in tomorrow’s update for August, based on The Capital Spectator’s median econometric point forecast (seasonally adjusted annual rate). The projection represents a marginal decline from 1.093 million starts in July.
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