Risk and diversification are critical interests of every investor, especially when things go south since the correlations across assets tend to rise during stressful times. Therefore, in the asset allocation, the risk parity allocation is one of the key topics. Factors are commonly known as underlying sources of both risk and returns, and it is assumed that they can be utilized to achieve superior risk-adjusted returns and diversification. However, there seems to be a lack of research that would be related to the macro factors. This gap is quite striking since there is a general consent that macro factors (for example, inflation) largely influence the broad set of assets. Amato and Lohre (2020) research paper fills the gap and studies the usage of macro factors as diversifiers in asset allocation.
The authors divide the macro factors into two groups, where the first consists of TERM, MARKET, USD, OIL and DEF (default risk), and the second group consists of CLI (a measure of output by OECD), G7.INFLATION, G7.Short.Rate and VIX. The research shows, that when the diversification matters the most, only the second group improves both the risk and returns, acting as a successful diversification during various economic regimes and particularly, during high economic uncertainty. Overall, the paper offers exciting insights into diversification and macro factors, accompanied by more complex mathematical models definitely worth looking into.
Authors: Livia Amato and Harald Lohre
Title: Diversifying Macroeconomic Factors — For Better or for Worse
It is widely acknowledged that asset returns are driven by common sources of risk, especially in challenging times when the benefits from traditional portfolio diversification fail to realize. From a top-down perspective, investors are mostly concerned about shocks in growth or inflation that ultimately govern the pricing of broad asset classes. To this extent, we propose a natural asset allocation framework to achieve a diversified exposure to orthogonal macro risk factors and to harvest the associated long-term premia. We examine the role and usefulness of different types of macroeconomic variables, as systematic sources of risk or state variables that drive time variation in the asset returns, and compare their diversification potential across different states of the world.
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