Structural checklist for investment headwinds

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Systematic models are very useful and important for disciplined investing, but the
percentage of the variation explained by most models in asset markets is relatively low especially over short horizons. The question for most managers, even quants, is determining how to deal with this percentage that is unexplained. There is no simple solution but applying a structural headwinds/tailwinds checklist may provide a good first pass for addressing the problem.

A structural headwinds or tailwinds checklist groups or categorizes issues that may provide a tilt to returns. These tilts on expected returns may lead investors to make a tilt or base adjustment to asset class allocations. Instead of starting with a base allocation of zero, there could be a negative or positive base allocation.

There could be more categories to this checklist, but these eight may get any discussion started. Some of these issues can be quantified, but we believe they often cannot explain short-term variation except if there is a shock. These factors can have an impact on returns through impacting the risk premiums in markets but only over long horizons.

Structural headwinds – A checklist

  • Demographics – 
    • The era of aging is upon us and it has an impact on capital flows and savings rates; just ask Japan or Europe. Demographics may include issues like the flow between rural and urban areas in China. It will drive return patterns even though it will not affect short-term volatility.
  • Government –
    • It could be the type of government that is place and how this will affect investment options. Government impact could include gridlock.  Venezuela is a perfect example where government matters. The same can be said for Argentina or Russia.
  • Regulation – 
    • The Dodd-Frank regulation has an impact on returns but it is hard to model the impact directly. All of these rules on banks impact credit and the financial sectors. More regulation will have a greater impact on small cap stocks.
  • Elections –
    • BREXIT will impact all of the globe. The US presidential election may have a profound change on trade and global relations. The election dates are well known and may outweigh other model factors.
  • Geopolitical risks (war – terrorism)-
    • These risks usually lead to shock effects, but the changing probabilities of geopolitical risks will impact all returns; nevertheless, it is hard to include in any model. 
  • Global trade –
    • This factor refers to the overall integration of capital, labor, and good around the globe and not the trade balance of any one country.Globalization will impact capital market integration will effect the correlation across markets. 
  • Climate – weather-
    • While there has been much talk about climate change, the impact on investment returns is less clear-cut. Obviously, there are weather events that impact returns, but these can be diversified. 
  • Technology – 
    • Technology can provide a boost or a drag on specific industries. In the global macro arena, technology is less clear but the impact of technology on finance is real and does affect liquidity which is being priced in the markets.
Even if these factors are not explicitly modeled, they will affect allocation decision and should at the least be catalogued and discussed.