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Most investors like to think of financial market risks as measured through a normal distribution. In reality, we know that it is not the case. However, how we incorporate and discuss fat-tails is not always clear. One thing that is clear is that fat-tails can be created when there is a mixed distribution or a combination of distributions that represent different regimes. A simple example will be the mixing of growth versus recession or good versus bad states of the world. This has been our theme for 2017 with a new year post. The potential for two different economic regimes will create fat tails in the return distribution of financial assets.

Money management is all about the talent, yet there is little economic analysis of human capital as an input in the creation of returns for the money management industry. That gap in research has changed with the new paper, “On the Role of Human Capital in Investment Management”. This provocative paper studies over 10,000 RIA’s across a number of years and asserts that more human capital may not help return generation. Having more advisory personnel may help with attracting assets. More investment advisor employees creates the appearance of more talent, but having more bodies is more likely to generate behavior like a closet index with less active shares and lower tracking error. They call it – money management – and staff is needed for management and the gathering of assets. Investors just have to be careful understanding why more staff is needed.

The development of FX style betas has changed the way investors think about their foreign exchange trading exposure and risks. The approach is simple – trading risks in FX can be decomposed into four style factors, trend, carry, fundamentals, and volatility. The argument states that an investor can easily manage or decompose FX returns using these beta styles or strategies. It is an effective way to show how returns can be generated in currency markets.

The VIX index is an effective measure of volatility expectations. The CBOE VVIX index measures the volatility of volatility for the VIX. If the volatility of volatility is increasing, there should be the expectation that volatility itself should also be increasing. We are seeing that the ratio of the VVIX to VIX is at high levels. Granted the VVIX index is off from recent highs, but the VIX index has continued to move lower even with the heightened policy uncertainty we have discussed in the past with our post on the one chart to look at for the new year.

“I would’ve created CAPM around semi-variance, but no one would have understood the math and I wouldn’t have won Nobel Prize…” H.Markowitz

It will be a tough investment world going forward for the simple reason the odds are against you. If you are a blackjack card counter in Vegas, you always know the odds, or the count. You know that on any draw, you can get lucky, but in some environments, the chance of success is just lower. Regardless of how smart you are, if the odds are not with you, your chances of getting good returns are lower. Your job as an investor is to know the odds and deal with the consequences.

The World Economic Forum (WEF) Global Risk Report serves as a useful guide on the broader set of risks that may impact the world over the next year. This report is important because it moves outside the narrow focus of finance and looks at a broader set of risks. Nowhere are economic issues in the top five for impact or likelihood in 2017. This is a big change from the 2007-2010 period. This is the first time economic issues are neither in the likelihood or impact top five. The dominant category is environmental which suggests that commodities markets are most likely to have the immediate impact if there is a shock. Extreme weather and natural disasters have the highest impact and likelihood combination from WEF analysis

Managed futures, as measured by the SocGen index, finished negative for the year. Many would have thought this was an odd 12-month return performance given the events of the year. Let’s list some of the big moves: the large equity decline in the first quarter, the equity gains in the fourth quarter, the bond gains and subsequent fall through the year, the dollar move higher, the BREXIT event, the US presidential election, and the comeback in oil to name a few. We could go on with some of the minor markets, but the overall conclusion is that there were trends and there were some large moves.

The market euphoria since November is all based on expectations of future US policy. Rational expectations of future policy and not the current economy are driving markets. Albeit the US economy has positive sentiment and has shown economic growth improvement, there are still headwinds that may only be mitigated through a change in policies. 2017 will be defined by the implementation of those policies and their effectiveness at reducing the ongoing credit recession.

The euphoria of the US presidential election is over. The market jumped under a new wave of optimism associated with an end to fiscal austerity, tax cuts, and regulatory reform, but now the reality has to set in and investors have to see the actual policies and believe they will be effective. This new sense of reality may describe the current price action for asset classes. You can call it mean reversion or a response to an earlier over-reaction.

Our commentary for the new year is not filled with predictions but describes an uncertain world of extremes for 2017. This uncertainty exists because the rise of populism seen in 2016 will have to be converted into macro policies during 2017.

Hedge fund managers are supposed to show skill during periods of higher risk and uncertainty. If there is more uncertainty or ambiguity concerning market, skill-based managers should be able to do better than those who just buy a market index. This is one key reason behind choosing hedge funds. When there is uncertainty and risk, alpha should be generated by skill managers.