Factor investing: How macro factors can aid asset allocation

How macro factors can aid asset allocation

Jul 18, 2017 | Jay Raol, Invesco Fixed Income

In brief

In this paper, we establish our set of macro factors — growth, inflation and financial conditions — which display quite stable correlations to the returns of various asset classes, irrespective of their country of issuance. Furthermore, we analyze how asset class volatility moves with the macro factors. We believe that, by looking at the sensitivities of asset class returns and volatilities to changes in the macro factors, allocation within global multi-asset portfolios can be improved.

Often, portfolios are built around the correlations between asset classes. But, such an approach is not without its shortcomings — especially since the familiar correlations of the past changed during the financial crisis. In this paper, we present an alternative approach to portfolio construction, one that is based on correlations: but here the focus is on co-movements of asset classes with various macro factors.

A primary aim of portfolio allocation is to balance returns versus risk by adjusting an investment’s size within an overall portfolio. Typically, an investor must take into account his or her own risk tolerance, investment goals and investment timeframe when making allocation decisions. This makes correctly measuring risk a central problem for the asset allocator.

Traditionally, risk has been measured by examining asset class volatilities and correlations between asset classes. Investors typically examine the long-run return, correlation and volatility of each asset class to determine its size in the portfolio.

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