Harvesting Macroeconomic Risk Premia

The authors measure the aggregate state of the economy using variables motivated by the macro-finance literature. In particular, they focus on three specific measures: macro-growth, fragility, and volatility. Macro-growth, a procyclical measure, combines information from a series of macroeconomic variables related to economic growth. Fragility, a procyclical measure, is a proxy for the distance to default of the median firm in the economy. Volatility, a countercyclical measure, summarizes the volume of information produced by investors in equity markets. The authors find that these variables are associated with economically large risk premia, which can be harvested using portfolios composed of stocks, global index exchange-traded funds (ETFs), and cross-asset ETFs. TOPICS:Volatility measures, analysis of individual factors/risk premia, exchange-traded funds and applications Key Findings • The measures of macro-growth, fragility, and volatility summarize information related to multiple aspects of the business cycle. This information can be used to construct portfolios that compensate investors for exposure to such aggregate sources of risk. • Long–short equity portfolios with exposures to macro-growth, fragility, and volatility earn 5.43%, 2.26%, and −2.40% per annum, respectively. • Traded versions of the three factors expand the efficient frontier in the factor space, allowing for significant improvements in risk-adjusted performance.