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Agrowing number of investors have come to view their portfolios as a collection of exposures to risk factors. "Risk-based investing" can mean different things to different investors, but the common feature is the emphasis on improved risk diversification. Although many investors identify risks primarily as asset class exposures, others may look at underlying macroeconomic exposures, such as inflation sensitivity. The difficulty with the latter approach is that macroeconomic factors are not directly investable.
With this in mind, we provide a framework for investors to think about how investable return sources tend to relate to non-investable macro factors. We present empirical evidence on the sensitivity of investments (traditional long-only asset class premia and alternative long/short style premia)1 to macro risks (such as economic growth and inflation).2 We begin by describing the key macroeconomic dimensions we study and the indicators we use to represent them. We follow earlier research in focusing on growth and inflation dimensions and explore them with U.S. data,3 but later analyze three other dimensions: real yield, volatility, and liquidity. Such macro mapping results can be presented through various lenses. Here, we focus on the variation of Sharpe ratios across different environments, providing some complementary correlation and cumulative return results in an appendix. We provide evidence that style premia are less sensitive than are asset-class premia to macroeconomic environments, and that diversified composites are more resilient than are a single asset class or single style portfolio.
Before we describe our approach in detail, we must stress the limitations of this type of analysis. Any empirical result is to some degree specific to the sample period (here, 1972 to 2013), as well as dependent on design choices. Moreover, if investors want to use environmental analysis for tactical timing decisions, they must be right in both their estimates of their investments' sensitivities to the macro environment and their forecasts of the future macro environment itself. We believe a more valuable application is in constructing well-diversified portfolios that may better withstand unexpected macro shocks.
WHICH MACRO ENVIRONMENTS MATTER?
One can debate the most important macroeconomic dimensions to study, but conventional wisdom suggests that economic growth and inflation have the largest effects on investment returns. We agree and begin with these two; but we also study three other...