Macroeconomic Factors in a Fundamental World

Mar 1, 2007

In this article, we examine the relationship between macroeconomic and fundamental factors and demonstrate how fundamental factor models can be used to extract the macroeconomic perspective and enhance our understanding of the common sources of portfolio risk and return. We start by assessing the importance of macroeconomic factors, both from a theoretical as well as a practical perspective, and we discuss the reasons why we have seen renewed interest in these factors in recent years. The main part of the article focuses on how we should model the relationship between macroeconomic factors and equity returns. We highlight some of the difficulties associated with the direct approach and show how fundamental factor models can be extended to measure and attribute macroeconomic risk in a robust and consistent manner. We conclude by discussing various practical applications of the proposed macro-modeling framework in the investment process. Specifically, we discuss applications of this framework in the areas of return forecasting, portfolio construction, and risk management of equity portfolios.