Factor Investing Using Capital Market Assumptions

Abstract

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.