Are Your Tail-Risk Estimates Reliable?

Few aspects of risk management come with higher stakes than estimating tail risk.[1] Just as a chain is no stronger than its weakest link, an investment strategy will be judged (at least in part) by the depth of its biggest losses. Unfortunately, tail risk is one of the toughest challenges for investment analysts for a simple reason: the supply of data for studying extreme events, by definition, is scarce.   In some cases, there may be just enough historical data to offer a hint of how returns behave at the outer edges of worst-case scenarios. The deepest 1% losses, for…

Do You Know What Macro Factors Are Driving Your Portfolios?

You may not be actively targeting macro factors in your portfolios, but it’s impossible to sidestep these elephants in the room.  Intended or not, we’re all running macro-factor portfolios to some extent. BlackRock recently analyzed nearly 10,000 portfolios managed by financial advisors using a macroeconomic lens and found “large common patterns and significant exposures to just a few factors.”  The main factor exposure: economic volatility.  “We find that advisor portfolios are dominated by exposure to economic growth,” writes Brian Lawler (a member of BlackRock’s portfolio solutions group) and several colleagues in “Factors and Advisor Portfolios.”  Accordingly, if you’re interested in…

Inverted Yield Curve: The Flaws in a “Infallible” Recession Indicator

As you undoubtedly know by now, the yield on the 10-year treasury fell lower than the yield on the 2-year treasury, albeit briefly, on August 14th.  If you follow the markets closely, you may have seen it coming.  After all, the spread between the 3-month and the 10-year treasury has been inverted since May of this year.  What many did not see coming was the resulting anxiety, surprise and massive sell-off that followed. A yield curve is simply a graphical depiction of the yields (or interest rates) for bonds having equal credit quality but different times to maturity.  Normally, the…

Pulling Your Risk Estimates Up By Their Bootstrapped Simulations

London Business School’s Elroy Dimson, an emeritus finance professor, memorably defined risk as the possibility that more things can happen than will happen. Picking up on this description, the late, great institutional investment adviser Peter Bernstein once explained that Dimson’s view of risk points investors on a particular analytical path. “If more things can happen than will happen, we can devise probabilities of possible outcomes, but — and this is a big ‘but’ — we will never know in advance the true range of outcomes we may face.” Certainty, as always, is off limits when attempting to forecast the future….

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