Factor Investing using Capital Market Assumptions

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. Despite the difficulties, this paper demonstrates that 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 paper outlines a new approach to building an asset portfolio that respects a desired factor allocation. Overall, this paper 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