Although not a new topic, this article explores and documents the dependent relationship between factor returns and time-varying macroeconomic environments. It is well known that factor returns are cyclical and can be negative for long periods. It is common practice to implement factor investing by combining factors that are not perfectly correlated on an unconditional basis (Value and Momentum, for ex.) into a multifactor strategy in order to reduce risk and smooth returns. This is all well and good unless those uncorrelated factors are in reality, regime dependent. The authors find substantial differences in correlations across macro regimes suggesting the unconditional correlation is a poor estimate of how any pair of factors will actually behave under specific macroeconomic conditions.
Using a well-reasoned set of criteria, six macro indicators were selected and were observed not as a “level” variable but as a surprise or unexpected change. Each variable was required to meet 3 criteria: it had to be a “fast-moving” variable in order to capture changes in expectations contemporaneously with factor returns; must contain information predictive of economic conditions; and must have been shown to be linked to equity factor returns previously. The final set included: the short interest rate, the term spread, the default spread, dividend yield for the market, market illiquidity (aggregate bid-ask spread), and market or price impact. Six factors were studied including size, value, momentum, low volatility, profitability, and investment.
I think the results speak for themselves. The authors do an excellent job highlighting the dangers that exist when factor exposures to macroeconomic conditions are not included in the allocation decision. Reliance on unconditional correlations without attention to regime dependencies that drive cyclicality in factor returns can lead to very poor risk management for investors. 1 Part 2 of this summary will be a deeper dive into insights the authors have so ably provided in this article. Stay tuned!
There is a consensus that equity factors are cyclical and depend on macroeconomic conditions. To build well-diversified portfolios of factors, one needs to account for the fact that different factors may have similar dependencies on macroeconomic conditions. The authors provide a protocol for selecting relevant macroeconomic state variables that reflect changes in expectations about the aggregate economy. They show that returns of standard equity factors depend significantly on such state variables. Factor returns also depend on aggregate macroeconomic regimes reflecting good and bad times. These macroeconomic risks have strong portfolio implications. For example, some equity factors depend on interest rate risk. Investors who already have exposure to this risk through bond investments may increase loss risk when tilting to the wrong equity factors. The authors also show that standard multifactor allocations do not sufficiently address macroeconomic conditionality. Combining factors may not reduce macroeconomic risks even for factors with low correlation. Understanding macroeconomic risks is a prerequisite both for risk transparency and for improving diversification of equity factor investments.
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Macroeconomic Risks in Equity Factor Investing: Part 1 was originally published at Alpha Architect. Please read the Alpha Architect disclosures at your convenience.