Identifying Economic Regimes: Reducing Downside Risks for University Endowments and Foundations

摘要

Institutions must protect their capital from erosion over long time horizons, with special attention paid to downside risks-especially contagion during severe economic conditions. Contagion negates the anticipated diversification built into a portfolio, and returns become correlated, causing securities to move downward together in a tight pack. Drawdown can be severe, causing setbacks to long-term investors who depend on capital to pay future liabilities.Asset performance over long time periods can be separated into distinctive classes, called regimes, which display common characteristics. In order to identify distinct regimes, John Mulvey and Han Liu of Princeton University applied trend filtering, a type of machine learning, in which an algorithm categorizes regimes and thus helps to model downside risk. They present their research and findings in Identifying Economic Regimes: Reducing Downside Risks for University Endowments and Foundations, published in the Fall 2016 issue of The Journal of Portfolio Management.For investors who depend on endowment capital to provide a steady source of income, the authors use a two-regime approach. By studying phases of growth and contraction in relation to historical economic patterns, they are able to identify strategies that protect the long-term viability of invested assets. Mulvey and Liu also demonstrate the advantages of adjustable-spending rules during drawdown periods to improve the worst-case outcomes.