How macro factors can aid asset allocation

Asset class correlations have risen significantly since the global financial crisis, making traditional portfolio diversification strategies challenging. We discuss how three key macro factors can aid asset allocation.

Often, portfolios are built around the correlations between asset classes. But, such an approach is not without its shortcomings – especially since the familiar correlations of the past changed during the financial crisis. In this paper, we present an alternative approach to portfolio construction, one that is based on correlations: but here the focus is on co-movements of asset classes with various macro factors.

A primary aim of portfolio allocation is to balance returns versus risk by adjusting an investment’s size within an overall portfolio. Typically, an investor must take into account his or her own risk tolerance, investment goals and investment timeframe when making allocation decisions. This makes correctly measuring risk a central problem for the asset allocator.

Traditionally, risk has been measured by examining asset class volatilities and correlations between asset classes. Investors typically examine the long-run return, correlation and volatility of each asset class to determine its size in the portfolio.

However, the global financial crisis and subsequent response of policy makers to stabilize asset prices through quantitative easing upended the traditional asset allocation model by changing historical correlations and volatilities, making them less meaningful in allocation decisions. Simply put, post-crisis diversification across assets no longer provided investors with their intended risk diversification. This is because cross-asset class correlations have risen significantly since 2008, making traditional diversification strategies more challenging.

As an alternative, we offer an approach to portfolio allocation built around the correlations of asset classes to three key macro factors: growth, inflation and financial conditions.

Read more about our “macro factor” approach

Important information

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Where Jay Raol has expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.