Moreover, because of the complex and broader involvement, real and perceived, of governments in the economy, separating policy signal from noise, and execution vs. intent, has become as important as â but harder than â 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 âunusually uncertainâ 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 âmelt downâ positions but rarely âmelt up.â 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 recognized, the better.
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