Alpha Measurement in Macro
I've been a bit curious about how alpha is measured and preserved in the macro space. From my understanding in equity funds, once you compute how much of your return is attributable to the market risk premium using CAPM, the spread between your portfolio return and that is alpha. And then after that, you calculate your idio risk by understanding your factor exposures to get 'pure' alpha.
In macro though, how are the risk premia assessed? My guess is in macro because of the higher comparative variance in types of trades, horizons, and processes, idio risk can be easier to define by analyzing how much of your book is tilted to commodities, rates, geography, etc. How do PMs then assess their systematic risk exposures? Are they benchmarked against a macro index and then from there are returns attributed to said index of choice?
In the macro investing space, measuring alpha involves a nuanced approach due to the diverse nature of assets and strategies employed. Unlike equity funds where CAPM and specific market indices can serve as benchmarks for calculating alpha, macro funds engage in a broader spectrum of investments including commodities, currencies, interest rates, and geopolitical events, making the assessment of alpha more complex.
Risk Premia Assessment: In macro funds, risk premia are assessed by identifying the underlying risk factors that drive returns across different asset classes. This involves a deep analysis of global economic trends, monetary policies, and geopolitical risks. The identification of these risk premia is crucial as it helps in understanding the sources of returns beyond what could be expected from a traditional equity or bond market exposure.
Idiosyncratic Risk: For macro funds, idiosyncratic risk or 'idio risk' is often defined by the fund's specific exposures to various asset classes, regions, or economic indicators. This is where the fund's strategy and the portfolio manager's (PM's) expertise play a critical role. By analyzing the portfolio's tilt towards certain commodities, interest rates, currencies, or geographies, PMs can better understand the unique risks their portfolio is exposed to. This analysis helps in isolating the 'pure' alpha generated by the fund, distinct from the broader market movements.
Systematic Risk Exposures: Assessing systematic risk in the macro space can be challenging due to the lack of a single, universally accepted benchmark. However, PMs often benchmark their performance against a macro index or a combination of indices that closely align with their fund's strategy and asset allocation. These benchmarks could include broad market indices, commodity indices, or even custom-made indices that reflect the specific risk factors the fund is exposed to. By comparing their returns to these benchmarks, PMs can attribute part of their returns to the systematic risk captured by the index, with the residual being attributed to alpha.
Return Attribution: After establishing the benchmarks, return attribution in macro funds involves dissecting the portfolio's performance to understand how much of the return is due to market movements (captured by the benchmark) and how much is due to the PM's decisions and strategy (alpha). This process is crucial for evaluating the PM's skill in navigating the complex macro landscape and generating returns that exceed the systematic risk exposure.
In summary, measuring alpha in macro funds requires a comprehensive approach that accounts for the diverse and global nature of their investments. By carefully assessing risk premia, understanding idiosyncratic risks, and benchmarking against relevant macro indices, PMs can effectively evaluate their systematic risk exposures and isolate the 'pure' alpha generated by their strategies.
Sources: Is the common view of financial risk completely wrong?, Reflections from year 4 as an equity analyst, On the Job With Simple As… My Research Process, January 2016 Data Update 1: The US Equity Markets, Q&A: First year macro hedge fund analyst
The only people at a HF who do this are middle office/risk players. This type of breakdown is done often at asset managers for sales purposes where they try for example to attribute how their small cap fund beat the R2k benchmark. Macro HFs don’t need to be invested at all times, and a good sign is knowing when to be risk on versus risk off, or knowing which factors to concentrate in. Academics will love to attribute a hedge funds performance to overly investing in tech or growth or some other factor/attribute, but it takes a lot of skill to know which factor/attribute/sector to be overweight/underweight.
I understand, thank you for your response.
this still sounds like factor trading still. I always thought traders have some intutively sense of the future factor risk & return in the future, how the factors are correlated, adjust portfolio accordingly. It not may all be optimized but there is a gut feeling of these relationships and breakdown of return and risk. Or if traders will trade RV, they will hedge out the factor part and try to trade the specified piece, which would hopefully be positive
Not too knowledgeable about relval but with those trades aren't you inherently flat on your exposure to a factor - like if you're doing a curve trade then directionally speaking you're exposed to interest rate risk but when you combine those two different views of the curve, e.g. you net out your directional exposure.
You’re exposed to curvature or convexity risk which u can consider a factor
Unless you want to use a treasury or commodities total return index I always thought macro and macro RV returns were all alpha. Mostly these funds are compared against each other rather than to a benchmark. The concept of alpha doesn't really make sense when you're comparing across so many different products.
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