How Macro Factors Diversify Portfolios
Macro factors can help investors navigate the cycle of growth, recession and in-between.
Investors preparing for slow economic growth, or even recession, may think their portfolios are ready for either. To limit losses, they thoughtfully diversified their portfolios among asset classes: stocks, bonds, alternatives and real assets. But if a crisis hits, the outcomes might not be what they expect. Why not? Because it’s not about diversifying just asset classes. It’s about diversifying the underlying economic forces, or macroeconomic factors.
Asset Classes vs. Macroeconomic Factors
Macroeconomic factors, or macro factors, include inflation, interest rates, economic growth in emerging and developed markets, as well as currencies and commodities prices (see Exhibit 1).They have proven to be robust tools for building diversified portfolios that limit losses, as they historically have done a better job than asset classes (bonds, stocks, real assets) of acting independently across the business cycle. Asset classes, on the other hand, are more likely to move together, especially during financial crises. That can result in larger losses.
Even though investors can’t invest directly in macro factors, their portfolios are exposed to macro factors through the asset classes they hold. While that still may result in portfolios exposed to an array of asset classes, investors’ focus should really be on whether their investments are diverse in terms of macro factors.
Macro Factors in Times of Stress
The key driver behind a diverse portfolio is to what extent the exposures in the portfolio are correlated, or tend to move together. If they are highly correlated (perfect correlation statistically is +1.0), then larger losses are more likely to occur when markets plunge. If that occurs, then the purpose of diversification is defeated.
As the roots of the 2008 Global Financial Crisis started to dig in, investors worried about increasing correlations. They were right. Exhibit 2 shows how correlations between traditional asset classes spiked toward +1.0 at the start of the crisis. However, as shown in Exhibit 3, this did not occur with macro factors, demonstrating their value during times of stress.
Macro Factors Applied
To see how macro factors can be applied, we compared a generic 60/40 global portfolio (60% MSCI World Index and 40% Bloomberg Barclays U.S. Aggregate Bond Index) with our 60/40 mix of asset classes based on the 2019 Northern Trust Strategic Asset Mix recommendations.
Northern Trust uses macro factor-based analytics and an optimization process to create two asset groups that we call risk-control and risk-asset portfolios. The risk-control portfolio, used to provide stable returns, includes U.S. Treasury inflation-protected securities (TIPS) and investment grade bonds. The risk-asset portfolio, used to maximize diversified returns, includes U.S. high yield bonds; developed market equities; emerging market equities; global real estate investment trusts (REITs); global infrastructure equities; and natural resources equities. The overall portfolio is 60% risk-asset and 40% risk-control.
Exhibit 4 compares how much each macro factor contributed to portfolio risk. While developed market growth still contributed a significant amount of risk in both portfolios, Northern Trust’s strategic portfolio had a lower concentration of risk to the developed markets growth macro factor. This resulted in more diverse exposure to other macro factors.
When measuring the performance of the portfolios in each stage of the economic cycle, Exhibit 5 shows that the Northern Trust portfolio outperformed generic 60/40 portfolio. Risk-adjusted returns also improved, indicating that the fully diversified portfolio has been achieving the improved performance in a more efficient manner with more return per unit of risk.
Investors can use a diversified portfolio of macro factor exposures to navigate economic and market cycles. They help investors to understand the underlying exposures in their portfolios in order to determine whether they are comfortable with those risks, or whether they need to be managed away.
We recommend that investors get their portfolios checked to ensure they are truly diversified through macro factors. This can be done through regression analysis as long as the underlying economic data is available. Investors also can contact us to further explore how to apply macro factors to their investments.
Asset Class Indexes and Inception Dates: U.S. high yield — Bloomberg Barclays U.S. Corporate High Yield July 1983; U.S. equity — MSCI USA IMI June 1994; World ex-U.S. equity — MSCI World ex USA IMI June 1994; Emerging markets equity — MSCI EM IMI June 1994; Public real estate — MSCI ACWI IMI Core Real Estate December1994, FTSE EPRAA/NAREIT Developed January1990; Public Infrastructure — S&P Global Infrastructure December 2001 and previously blend of Global BMI World Energy August1989, Global BMI World Industrials August 1989, and S&P Global BMI World Utilities August 1989; Public Natural Resources — S&P Global Natural Resources December 2002 and previously blend of Morningstar Global Upstream Natural Resources January 2001and Morningstar category Natural Resources fund peer average May 1972
Macro factor definition: Developed markets growth: MSCI World IMI Index (Local) minus IA SBBI U.S. 30 Day T-bill; Unexpected inflation: Duration matched BBgBarc U.S. Treasury minus BBgBarc U.S. TIPS; Real rate uncertainty: BBgBarc U.S. TIPS minus IA SBBI 30 Day T-bill; Commodity risk: BBg Commodity Spot minus IA SBBI U.S. 30 Day T-bill; Developed markets spreads: Duration matched BBgBarc; Emerging markets spreads: blend of JPM GBI-EM Global Diversified & JPM EMBI Global Diversified minus BBgBarc; Emerging markets growth: MSCI Emerging Markets IMI (Local) minus MSCI World IMI (Local); Currency: nominal major currencies to U.S. dollar (inverse)
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