Saturday, April 15, 2017

Factors, smart beta, and global macro

What has been at the vanguard of thinking in finance is the breakdown of returns into its constituent parts or risk factors. Finance has moved well beyond market beta. The primal breakdown for a portfolio is not returns by asset class but returns by risk factors. Some have criticized the current situation a factor zoo; however, even factor excesses does not change the fact that factorization is the paradigm used more and more by investors. 

There are many factors and many assets to map with factor weighting. The shear size of the problem lends itself to computerization and data mining. The role of the analyst as story-teller is diminished when a stock can be described through a set of modeled factor. Investors now buy risk premia not stories or names. Individual names are just the means to the end of gathering beta risks. Smart beta is just the realization that if factors can be used to describe stocks they can also be used to weight stock portfolios. This may be smart or it could just be the outgrowth from how the finance world is being viewed. 

Factors can be classified into two main categories: micro factors which are asset specific and macro factors which are related to macro events like the business cycle or changes in rates and credit availability. Hence, the type of hedge funds chosen by investors is bases on whether the manager focuses on micro or macro factors.

So what is the essence or purpose of global macro? In this new factor world view, global macro investing is a focus on economic wide factors which can be dynamically adjusted to generate excess return. Since factors move in and out of style or importance, the macro investor tries to find ways to exploit these changing weights. 

The issue is which factors are relevant for global macro investing. We are aware of the criticism of factor timing, so we have to be precise for what factors we are discussing.   Global macro has the overarching theme that the manager is trying to identify global business cycles or growth recessions which spill-over to the behavior of specific asset classes. Along with business cycle are credit and financial cycles which impact asset classes around the globe differently. The growth/inflation mix impacts policy choice which feed back on asset classes. What makes global macro so difficult is the low predictive skill by managers at forecasting these macro factors.

The difficulty with forecasting macro factors calls for managers to stay diversified, follow market trends, and take high probability tilts to specific factor opportunities. The poor performance for global macro is a function of the high uncertainty associated with the major macro factors. There is no smart beta in global macro if the macro factor directions cannot be identified. Global macro returns will only improve if the degree of uncertainty concerning growth, inflation, and liquidity falls to levels that allow for bets to be identified and managed.

The relatively better performance with managed futures programs is based on the core focus toward momentum and diversification and not fundamental macro factors. Managed futures captures macro events through the movement in asset prices, yet if there are no string trends there will ne only limited opportunities.

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