Factor Perspectives

Macroeconomic factors: important diversifiers

Feb 28, 2018

Six macroeconomic factors explain more than 90% of the returns across asset classes.

Investing today is harder than ever amid uncertain earnings growth and periods of high market volatility. Equity market returns have, in many cases, leapt ahead of economic fundamentals, making future returns dependent on earnings growth. Adding to investors’ difficulties are drawdowns occurring during periods of stress, which can be particularly painful and persistent. To navigate these challenges, many investors diversify their portfolio across stocks and bonds.

However, even a well-diversified portfolio may still be exposed to tremendous risk given the historically high correlation between the performance of a traditional 60/40 balanced strategy and equity markets. The problem is that a seemingly unrelated collection of assets can still be exposed to common sources of risk — like inflation, central bank policy moves or a slowing global economy. As a result, the diversification that investors need can often be very difficult to find.

The good news is that factor investing can potentially deliver more effective diversification to help investors achieve their investment goals. Factor investing is about identifying and precisely targeting broad, persistent and long recognized drivers of returns. With today’s advances in data and technology, factor investing has been taken to new levels empowering investors to become more informed of what they own and in turn seek a better balance of those return drivers in portfolios.

Six primary drivers of returns

BlackRock’s research suggests that we can explain more than 90% of the returns across asset classes through six primary drivers of returns, or factors. Economic growth, real rates and inflation are the most important drivers of returns across asset classes; credit, emerging markets and liquidity are also important drivers to understand and manage, particularly in times of crisis. Over the long run, our research has shown each of these have delivered a positive return due to bearing additional risk.

Icon: Economic growth

Economic growth

The reward for taking on the risk of economic uncertainty

Key fundamental question: What is the overall health of the global economy?
Economic rationale: Growth-sensitive assets rely on economic expansion to generate strong returns, and will suffer when the global economy is weak. Investors can be rewarded a long-run premium for taking on the risk of a potential economic decline.
Measured by: Surprise in GDP, i.e. the difference between expected and actual growth
Investment exposure: Equities (public and private), real estate and commodities

Icon: Real rates

Real rates

The reward for taking on the risk of interest rate movements

Key fundamental question: What is the current central bank policy?
Economic rationale: Rising interest rates decrease the present value of future cash flows, notably the market value of nominal bonds. Investors can be rewarded a long-run premium for taking on the risk that interest rates will rise. Rate-sensitive assets have tended to perform well when real rates are falling, and suffer when rates rise.
Measured by: Surprise in real interest rates
Investment exposure: Global inflation-linked bonds

Icon: Inflation


The reward for taking on the risk of changes in inflation

Key fundamental question: What are inflation expectations?
Economic rationale: Inflation-sensitive assets are those that do not adjust in value when price levels rise. For example, a fixed coupon of 5% becomes less attractive if prices rise, while the coupon remains unchanged. When inflation expectations rise, inflation-sensitive assets decrease in value.
Measured by: Surprise in inflation levels
Investment exposure: Nominal bonds

Icon: Credit


The reward for taking on default risk

Key fundamental question: What are default expectations?
Economic rationale: Investors can earn a premium for lending to corporations (rather than governments), bearing the risk of issuer default. Credit premiums are also linked to the strength of the global economy and the cost of capital, but offer more downside and less upside than growth-sensitive assets.
Measured by: Surprise in default rates
Investment exposure: Corporate bonds, high-yield bonds

Icon: Emerging markets

Emerging markets

The reward for taking on political and sovereign risks

Key fundamental question: What is the current geopolitical climate in emerging markets?
Economic rationale: Investors can earn a premium for bearing the additional risk associated with investing in less developed and stable markets. This includes the risk of political turmoil, currency devaluations and seizure of foreign assets. Emerging market securities are inherently more volatile and can sell off suddenly when market sentiment changes, so identifying and appropriately sizing exposure to emerging markets is critical to managing risk.
Measured by: Spread between emerging and developed securities
Investment exposure: Emerging market equity, emerging market debt

Icon: Liquidity


The reward for holding illiquid assets

Key fundamental question: What is the global demand for liquidity?
Economic rationale: Investors holding less liquid securities accept the risk that they may not be able to immediately sell their investment in certain environments. By forgoing immediate access to capital, investors can be paid a premium for bearing that cash strain and delaying consumption.
Measured by: Spread between small- and large-cap equities, volatility levels
Investment exposure: Small-cap equities, selling volatility

Which factors are in asset classes?

Multiple factors can impact individual asset classes. For example:

  • Nominal bonds can earn a premium for bearing the risk of inflation and the risk of rising interest rates.
  • Corporate bonds can earn a premium for bearing credit risk in addition to rate and inflation premiums.
  • Equities are driven largely by exposure to economic growth, plus a modest premium for inflation and interest rate exposure.
  • Small-cap equities are generally less liquid and more expensive to trade, earning an additional liquidity premium.

Different asset classes, common risks

Different asset classes, common risks

Which factors are useful?

We believe that navigating today’s markets requires a balanced mix of these macro factors. Most investors require a hearty dose of economic growth in their portfolios, which potentially can provide an attractive long-run reward associated with the growth of the global economy. Exposure to real rates provides an effective ballast to soften the impact of equity market drawdowns. Exposures to inflation, credit, emerging markets and liquidity provide four additional sources of potential return and diversification.

A factor-based view cuts through investment structures to focus on the underlying drivers of returns, and translates what can be often unintelligible into intuitive factor exposures. Moreover, factor investing can expose overlapping risks that could be lurking in your portfolio.

Building a portfolio of factors

Macro factors provide the means to create investment strategies that are deliberate and diversified in both risk and reward. An equal-weighted combination of macroeconomic factors, for example, is a simple but robust method to realize the potential diversification benefits of this approach.

For investors with unique investment goals, these same factors can be custom-weighted to create a portfolio to meet bespoke requirements. Market conditions may also drive allocations: when volatility rises and returns are suppressed, many investors seek flexible allocations that can adapt to different market conditions.

Focusing on these macroeconomic drivers of return focuses portfolios on the fundamentals that matter most, and provides the means for better diversification from inevitable market volatility. Armed with a better understanding of portfolio risk and return, we can build robust portfolios and seek to better meet desired investment outcomes.

Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro ...
Ked Hogan
Head of Investments for BlackRock’s Factor-Based Strategies Group
Ked Hogan, PhD, Managing Director, is a member of BlackRock's Factor-Based Strategies Group. Dr. Hogan is the Head of Investments which manages factor based ...