Pimco’s Bhansali discusses asset allocation and risk management in a ‘Bimodal World

Vineer Bhansali, managing director and portfolio manager at Pimco, says there has been a shift in asset allocation modelling away from reliance on a single mean point, towards multiple points of equilibrium.

For many years, market participants have confidently relied on a modeling framework that considered a single “equilibrium” – or system in which competing influences are in balance – when constructing portfolios. The most popular assumption under such an equilibrium model has been a probability distribution curve that is unimodal (i.e. has only one peak) and a mean that coincides with this single peak.

However, a key impact of the recent bout of crises hitting global markets has been the possibility of the emergence of multiple equilibria, which might happen if one or another competing force takes the upper hand.For example, the policy risk that pervades the markets today causes high correlations among asset classes and a temperament of “risk on/risk off” among investors. This phenomenon can be traced to the connectedness of markets, the ease by which market participants can access these connected markets, and the speed of assimilation of information in response to political events. (See V. Bhansali, The Ps of Pricing and Risk Management, Revisited, Journal of Portfolio Management, Vol. 36, No. 2, Winter 2010.) This environment creates the possibility of multiple equilibria in the market, as well as trends that move markets between these equilibria, and once settled, restraining forces that trap markets in those equilibria (See V. Bhansali, Market Crises — Can the Physics of Phase Transitions and Symmetry Breaking Tell Us Anything Useful?, Journal of Investment Management, 2009).

Even though predicting which force will win is next to impossible given the real-time evolution of the interaction between markets and policy, we can still ask an important question: What would happen if the distribution of returns from a hypothetical portfolio looked more like the one shown in the chart on the right of Figure 1, i.e. a “bimodal” distribution with more than one peak? The bimodal distribution has two peaks, and interestingly, even though it is generated as the result of mixing two normal distributions, each from a different regime, it can exhibit both fat tails (a higher probability of larger losses due to unusual events results in a “fat tail” on the left side of the distribution curve) and skewness (a lack of symmetry between the left and right sides of the peak).

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