Efficiency based on macro factors
Investment managers can contribute to and benefit from information efficiency. A simple and practical approach is [i] to create indicators with meaningful macroeconomic and market information and [ii] to condense them into meaningful conceptual macro factors that can guide specific investment strategies. The usage of macro factors has great benefits
- Macro factors make quantitative information manageable. In international macro trading there are way too many economic data series to keep track of, even for the most diligent investment manager. Selected pre-filtered macro factors effectively outsource part of the production of information to research.
- Macro factors support consistency. Often enough investors are myopic: they overrate that latest “fashionable” factors that happened to coincide with recent market moves, regardless of causality and long-term relations. This constitutes a form of “overfitting” of information (view post here). This “overfitting” can lead to the misinterpretation of fundamental information, a phenomenon that has been labelled “scapegoat theory” view post here.
- Macro factors are applicable across strategies. Detecting changes in economic growth, for example, matters for both equity and FX strategies. If returns across asset class strategies have little or now correlation (view post here on equity and FX), macro factors can become important building blocks for diversified multi-strategy portfolios.
Using more than one macro factor in a single strategy is a major challenge. In dealing with different ideas or signals, investment managers veer towards “rules of thumb” of dubious origins, while academic researchers veer towards complex mathematical models. The former are evidently inefficient, while the latter are usually intractable. Hence, for practical purpose and in order to avoid the worst excesses of double-counting, mis-interpreting and forgetting information it is helpful to structure macro factors into three groups.
- Valuation gaps are defined as differences between the market price of an asset or derivative and its estimated value. There are two basic methods of tracking valuation gaps. The first is to estimate an asset’s fundamental value directly, maybe based on discounted cash flows, and then compare it with the quoted price. The second method works indirectly, by efficiently “nowcasting” the trend in key valuation-relevant factors and then estimating the gap between this trend and market perceptions.
- Implicit subsidies are defined as premia paid or discounts offered to financial investors by market participants other than those that maximize risk-adjusted returns. Typically, subsidies are paid by central banks, governments, highly-regulated institutions or non-financial institutions.
- Endogenous market risk or setback risk is defined as the probability of a mark-to-market drawdown on a position for reasons that are unrelated to fundamental value. Related macro factors typically measure the positioning or “crowdedness” in a trade as well as the probability that investors will exit the trade in the near term.
Importantly, these three types of indicators are complementary, not competing. Indeed, it is not wise to use them in isolation. Thus, a price-value gap often arises as consequence of implicit subsidies: the subsidized asset becomes overpriced for a reason. Also, typically setback risks arise alongside subsidies, causing sudden large losses to subsidy receivers.
This site also presents a fourth principle of value generation, based on the research of price distortions. This principle is explained in a separate summary page (view here) because the exploitation of price distortions is not primarily an issue of macro information efficiency. Value generation based on apparent price distortions typically depends on the investor’s basic understanding of market flows, easy access to markets and funding, and freedom to operate without the constraints and conventions that trap many institutional investors.