IR&M report - Regime testing

Executive summary:

Nowcasting is the economic discipline of determining a trend or a trend reversal objectively in real time. Nowcasting is fact-based, focuses on the known and knowable, and therefore avoids forecasting. Nowcasting is the basis of a robust decision-making process.

 Regime testing is one aspect of nowcasting. The more factual the input into the investment management decision process, the higher the conviction the investor can have. Knowing the current regime, therefore, allows for better decision making.

 Economist Hyman Minsky is famous for the concept of stability not being very stable. Things change. Every mariner knows that a storm requires a different trim than calmer weather. The key is not to predict the next storm but to respond when circumstances start changing.

Changing circumstances can be measured and assessed, resulting in decision-making becoming more robust. The practical relevance to Minsky’s instability hypothesis is that, both at sea and in economics, the current calm is nothing else than the build-up of the next storm.

 A regime test should reveal an asymmetry in probability. Related to risk management this means we seek to identify regimes in which large negative outliers are more likely to occur. We cannot predict the negative outliers. However, we try to identify the regime in which the negative outliers are more likely to occur.

 There is a time to make money, and a time not to lose it. The wind is in the investor’s favour, or it isn’t. A trend is a self-reinforcing positive feedback loop on the way up and a negative feedback loop on the way down. The key is to measure these trends in real time. Regime tests can be helpful in this regard. A trend is a departure from randomness. This departure from randomness reduces uncertainty and therefore allows for a higher conviction in the trend. This higher conviction allows for a more efficient investment process. It allows for a speedier up or down-sizing of exposures or can reduce costs of hedging.