RT Journal Article
SR Electronic
T1 Factor Investing Using Capital Market Assumptions
JF The Journal of Portfolio Management
FD Institutional Investor Journals
SP jpm.2021.1.291
DO 10.3905/jpm.2021.1.291
A1 Elkamhi, Redouane
A1 Lee, Jacky S. H.
A1 Salerno, Marco
YR 2021
UL http://jpm.pm-research.com/content/early/2021/09/30/jpm.2021.1.291.abstract
AB Capital market assumptions (CMAs), which are long-term risk and return forecasts for asset classes, are important pillars of the investment industry. However, applying them reliably in portfolio construction has been (and still is) a challenge in the industry. This article demonstrates that, despite the difficulties, CMAs are useful for building an investment portfolio using a factor approach. Using a small set of macroeconomic factors, the authors detail a methodology for deriving a factor model from CMAs and then use it to show that (1) these factors price the expected returns from CMAs and (2) the mean–variance factor allocations are substantially more stable than the mean–variance asset portfolios. Furthermore, this article outlines a new approach to building an asset portfolio that respects a desired factor allocation. Overall, this article helps reduce the barrier to entry for factor-based portfolio construction by providing a recipe for building factor models and performing factor-based portfolio construction using publicly available CMAs.Key Findings▪ This article presents a methodology to show that CMA returns can be cross-sectionally priced by a small set of underlying macroeconomic factors, which suggests that the CMA’s risk and return assumptions follow a factor structure.▪ The mean–variance factor allocations generated by CMAs’ implied factors are intuitive and stable through time under unconstrained mean–variance optimization.▪ This article presents a new approach to building an asset portfolio that respects a desired or target factor allocation with weights that are practical.