Scientific Beta

This paper proposes a method of targeting exposures to macroeconomic risks in equity investing. We propose firm-level measures of exposures that improve robustness when compared with standard estimation approaches. These measures enable the construction of systematic equity strategies that offer stronger and more consistent macro exposures than commonly used off-the-shelf ingredients, such as sector or factor portfolios. We also find that, in our sample, targeted macro strategies do not come with significant costs relative to holding a broad market index.

Investors’ equity portfolios may come with substantial exposures to not only stock market risk, but also to broader macroeconomic risks, such as interest rate risk, inflation risk, recession risk. Beyond the exposure that the broad market index may have to such macroeconomic factors, investors may pick up cross-sectional differences in exposure. There is ample evidence that such differences in stocks’ macro exposures can be substantial. For example, Chen, Roll and Ross (1986) found that portfolios sorted on market-capitalisation had different exposures to various macroeconomic variables, including term spread and credit spread. Similar findings were documented by Petkova (2006) across double sorted portfolios on book-to-price and market capitalisation (Fama-French) and by Boons (2016) across stock-level returns. Such implicit exposures will not necessarily align with what an investor would target when considering macroeconomic risk exposures explicitly. If an investor is already exposed to a given macroeconomic risk outside their equity allocation, the total portfolio will not be well diversified and suffer losses if given macroeconomic risk materialises. For example, an increase in credit spread would often signal a slowdown in economic activity, and hence labour income might be at a greater risk. Investors who also take some exposure to credit risk in their equity portfolios would see their capital at high risk during the times of increasing credit spread. Similarly, the liabilities of an investor will increase with declining interest rates. Holding stocks with positive exposure to interest rates will lead to poor diversification and greater capital at risk during the times of negative rate shocks.

Investors would benefit from understanding how different stocks are exposed to macroeconomic risks. This would allow them to build equity portfolios that hedge some of the undesired macro risks in their existing non-equity allocation. The resulting allocation will hence be less dependent on the economic risks that investor is worried about. In addition, investors who have views on the future economic conditions can gain extra performance if their predictions materialise.

However, this is easier said than done. One of the major challenges to efficiently managing macro risks in equity portfolios is to reliably estimate the exposures. In contrast to popular practice, we propose a systematic approach that is transparent and replicable. We also go beyond analysing sector differences and instead exploit the firm-level heterogeneity of risk exposures.