Regime Change and Your Investment Portfolio

By Alton Cogert |

This is not a blog entry about how the current government of (fill in the name of a country) has changed. In fact, I will attempt to steer as clear from political commentary as possible, although actions by political actors can indeed impact financial markets, both positively and negatively.

Instead, let’s discuss how a change in the economy can materially impact your portfolio. A regime change is not a small or short-term change. It is a change that is abrupt and produces materially different economic and financial results that many times are unexpected within traditional asset allocation models.

Academics and others are working on developing regime-switching models that attempt to understand both when there has been a regime change and what it means for changes in key estimates of asset classes, such as expected return, standard deviation, and correlations. One of the goals would be to take advantage of this ‘new world’ of key estimates that will then impact what our revised most ‘efficient’ portfolio should be.

In fact, getting regime change correct might supply the missing link between long term estimates used in the efficient frontier Markowitz model and the stress testing of what happens in the ‘worst’ case. That missing link might provide a set of strategies that can be used to buffer against the negative impacts of regime change and help determine the cost of doing so.

For those looking at a deeper dive into the subject, I would recommend the academic paper from Ang and Timmerman, which can be found at this link. Here is how they look at what they call regime-switching models:

Regime-switching models can match the tendency of financial markets to often change their behavior abruptly and the phenomenon that the new behavior of financial variables often persists for several periods after such a change. Although the regimes captured by regime-switching models are identified by an econometric procedure, they often correspond to different periods in regulation, policy, and other secular changes. In empirical estimates, the means, volatilities, autocorrelations, and cross-covariances of asset returns often differ across regimes in a manner that allows regime-switching models to capture the stylized behavior of many financial series including fat tails, heteroskedasticity, skewness, and time-varying correlations. In equilibrium models, regimes in fundamental processes, such as consumption or dividend growth, strongly affect the dynamic properties of equilibrium asset prices and can induce nonlinear risk-return trade-offs. Regime switches also lead to potentially large consequences for investors’ optimal portfolio choice.

To say research in this area is important is an understatement, as regime change in financial markets can come from the markets themselves (e.g. a material change in investor perceptions) or from outside those markets (e.g. a material change in monetary or fiscal policy).

The big question then becomes: How can I spot a regime change early in its development?

This is akin to spotting a ‘bubble’ in an asset class or sector of the economy and then knowing exactly when it will burst. Good luck on that. But, by asking the right questions of your investment consultant and managers you might get close.

With that in mind, submitted for your thoughts are the possibility that we may be seeing the beginning of a regime change event spurred by the trade battle between China and the U.S. We believe that, followed to its logical conclusion, this battle has the potential for much economic disruption.

Underlying this trade battle there may be much more than just a tit for tat series of tariff threats (and actions). The underlying theme appears to be about requiring China to modify its mercantilist economic model, which includes, to an extent, intellectual property theft. And that is specifically related to the ‘Made in China 2025’ initiative.

There has been some excellent work done on China’s strategy in this area by an independent group called Strategic News Service, which can be found here. China’s activities in this respect was also highlighted in a 60 Minutes segment in early 2016 called, ‘The Great Brain Robbery.’

However, please note that I said, ‘followed to its logical conclusion.’ The actors involved in this drama will likely move in many directions while this drama plays out. So, one cannot say with great certainty that the trade tiff between the two largest economies in the world will play out in a manner that will cause a regime change. Stay tuned as developments occur.

Related to regime change is another issue worth discussing: Diversification.

As we all know, many extreme, unexpected events are not a regime change, but will nevertheless impact financial markets in the short term – and likely many asset classes will move in the same direction.

That’s where the excellent article in the Financial Analysts Journal, “When Diversification Fails” comes into play. Page and Panariello survey different asset classes in ‘normal’ and ‘stressful’ times and come to one conclusion that perhaps the only true asset mix decision that can still be less correlated in stressful times is equities versus bonds:

When market sentiment suddenly turns negative and fear grips markets, government bonds almost always rally because of the flight-to-safety effect. In a sense, duration risk may be the only true source of diversification in multi-asset portfolios. Therefore, the expected stock–bond correlation is one of the most important inputs to the asset allocation decision.

However, even there the correlation can change from negative to positive in some instances. With that in mind, their conclusion is a heady one that would be difficult for most (if not all) insurers to implement:

Finally, investors should look beyond diversification to manage portfolio risk. Tail-risk hedging (with equity put options or proxies), risk factors that embed short positions or defensive momentum strategies, and dynamic risk-based strategies all provide better left-tail protection than traditional diversification. The strategy of managed volatility is a particularly effective and low-cost approach to overcome the failure of diversification. Based on the empirical observation that risk is more predictable than return, this strategy adjusts the asset mix over time to stabilize a portfolio’s volatility. It is portable and can easily be applied as an overlay to smooth the ride for almost any portfolio. Importantly, because managed volatility scales down risk assets when volatility is high, it often offsets left-tail correlation spikes and thereby reduces exposure to large losses without sacrificing returns on the upside.

So, where does that leave insurers, whose allocation to core fixed income bonds must start with an awareness and understanding that their first obligations are related to the size of the core fixed income allocation versus required reserves and an appropriate level of capital and surplus? And how do other very important issues such as cash flow, matching assets and liability duration, liquidity, rating agency and various accounting treatments impact this issue?

I believe it gets us back to the basics of keeping an eye out for the potential of regime change of varying types and an understanding of how and when we might act if it should occur. We can act in advance, but at what cost? Or, we can act when we see a regime change, but would that be too late? The questions can easily multiply, but how often have you discussed this within your Board, Investment Committee or senior management?

We believe that going forward, the tasks surrounding identifying, understanding and acting due to regime change will grow in importance over the years ahead.