Subject: Uncertainty changing investment landscape _ FT
From: "Michael Andrews" <[email-masked]>
To: "Thad Brown" <[email-masked]>, "Ronnie Mainieri" <[email-masked]>, "Curt Hastings" <[email-masked]>, "Hunter Biden" <[email-masked]>, "Eric Schwerin" <[email-masked]>
Date: Mon, 2 Aug 2010 20:58:27 -0400

Uncertainty changing investment landscape
By Richard Clarida and Mohamed El-Erian
Published: August 2 2010 18:06 | Last updated: August 2 2010 18:06
Federal Reserve chairman Ben Bernanke’s characterisation of the  
economic outlook as “unusually uncertain” has attracted much  
attention, and rightly so. It speaks to the immediate impact of a  
series of ongoing national and global realignments whose effects are  
consequential but not yet sufficiently appreciated.

At a fundamental level, the unusual uncertainty reflects the  
disruptive combination of deleveraging, reregulation, structural  
unemployment, and other ongoing structural changes.

EDITOR’S CHOICE
Bernanke cautions on US recovery - Aug-02

Econoclast: Gavyn Davies on the US ISM survey - Aug-02

Text of Bernanke’s speech - Aug-02

Lex: US public sector layoffs - Aug-02

US factory output slows in July- Aug-02

In depth: US states’ budget crises - Jul-27

The phenomenon is not limited to the US. It is also visible in other  
industrial countries. Just look at the latest inflation report issued  
by the Bank of England, which points to unusual dispersion in  
policymakers’ expectations for such basic economic variables as growth  
and inflation.

It is the shape of such dispersion that strikes us as particularly  
important. It seems that, wherever we look, the snapshot for  
“consensus expectations” has shifted: from traditional bell-shaped  
curves – with a high likelihood mean and thin tails (indicating most  
economists have similar expectations) – to a much flatter distribution  
of outcomes with fatter tails (where opinion is divided and  
expectations vary considerably).

We should all feel sorry for policymakers who face such distributions.  
The probability of a policy mistake is materially higher, especially  
as policy measures are subject to lags. What is less appreciated is  
the extent to which this changing shape of distributions affects  
conventional wisdom in the investment world, together with the rules  
of thumb that many investors have come to rely on.

We can think of five implications, some of which are already evident  
while others will only be obvious over time.

First, investing based on “mean reversion” will be less compelling.  
Even though flatter distributions with fatter tails have means, the  
constituency for mean reversion investing will shrink as those means  
will be much less often realised in practice. A world where the  
realised return rarely equals the expected valuation creates a bigger  
demand for liquid, default-free assets; it also lowers the demand for  
more volatile asset classes such as equities. These shifts are already  
taking place.

Second, frequent “risk on/risk off” fluctuations in investors’  
sentiment are here to stay. Investors, based on 25 years of rules of  
thumb that “worked” during the great moderation, thought they knew  
more about the distribution of risk than they in fact did. This led to  
overconfidence during the bubble. The crisis reminded investors that  
these rules of thumb are less useful, if not dangerous.

With declining confidence in a reliable set of investing rules,  
markets have become more susceptible to overreactions to daily news  
and, are, therefore, more volatile. Just think of the number of triple- 
digit days in the Dow.

Moreover, because of the complex and broader involvement, real and  
perceived, of governments in the economy, separating policy signal  
from noise, and execution versus intent, has become as important as –  
but harder than – forecasting the macro data.

Third, tail hedging will become more important. An understandable  
consequence of the crisis is less trust in diversification as the sole  
mitigator for portfolio risk. We are already seeing increased investor  
interest in tail hedging, though the phenomenon is still limited to a  
small set of investors.

Fourth, historical benchmarks and correlations will be challenged. In  
this new “unusually uncertain” world, many investors will need to  
fundamentally rethink the design of benchmarks and the role of asset  
class correlations in implementing their investment strategies. The  
investment industry is yet to give sufficient attention to this.

Finally, less credit will be available to sustain leverage and high  
valuations. Even apart from the inevitable response to regulatory  
actions aimed at derisking banks, a world of flatter and fatter  
distributions will reduce available supply of leverage to finance  
trades and balance sheet expansion.

This is not just because extreme bad scenarios “melt down” positions  
but rarely “melt up”. Even with a balance among good and bad  
scenarios, the provider of leverage does not benefit from the fatter  
good tail, but faces greater likelihood of loss with the fatter bad  
tail.

Investors had 25 years to get comfortable with the great moderation.  
Its end poses challenges that extend well beyond policy circles as it  
fundamentally undermines the rules of thumb that served so many  
investors for so long. The sooner this is recognised, the better.

This article was co-authored by Richard Clarida, global strategic  
adviser at Pimco and professor of economics at Columbia University,  
and Mohamed El-Erian, chief executive and co-chief investment officer  
of Pimco