The benefits and impact of including satellite factors in MAC3 equity models

In order to best assess risk in a portfolio, it’s critical for portfolio managers not to rely on a one size fits all approach to modeling. The most exacting approach will take regional concerns into account, ensuring a more complete vision of a portfolio’s potential vulnerabilities.

Bloomberg’s new MAC3 GRM (multi-asset class global risk model) represents the most advanced suite of risk factor models available today, delivering unparalleled forecast accuracy for all types of portfolios, universes, and investment styles. This new suite of models incorporates a host of first-to-market methodology innovations, establishing MAC3 GRM as the industry’s next generation of risk modeling. Many MAC3 equity models, in the process of helping portfolio managers better understand and mitigate risk, employ the notion of “satellite” factors, accounting for investments within specific regions and any risks associated with them.

By explaining how satellite factor exposures and factor returns are estimated and interpreting the satellite pure factor portfolios, we are able to provide an empirical example illustrating the benefits of satellite factors from a risk-forecasting point of view.

How local models and satellite factors work together

The MAC3 suite of equity factor models consists of the MAC3 Global Equity Model and 13 local equity models: Asia Pacific (APAC), Australia, Canada, China A-shares, Europe, Europe/ME/Africa (EMEA), India, Japan, Korea, Latin America, South Africa, UK, and US. The MAC3 Global Equity Model provides universal coverage of publicly traded equities across the globe and describes portfolio risk and return using a single set of global equity factors. The global estimation universe is comprised of a globally diversified basket of stocks spanning both developed and emerging markets.

Local models, by contrast, limit coverage to sub-regions within the global equity market. Moreover, the estimation universe of a local model is composed exclusively of stocks from within its own region. For example, the estimation universe of the MAC3 Europe Equity Model consists of stocks in Developed Europe (excluding UK). Similarly, the estimation universe of the MAC3 UK Model consists only of UK stocks (excluding Continental Europe).

It is generally considered best practice to use a risk model whose estimation universe closely reflects the investment opportunity set of the portfolio manager. Hence, a European portfolio manager would be better served using the MAC3 Europe Equity Model rather than the MAC3 Global Equity Model, since the latter may misconstrue the risk and return of a European portfolio.

While local models do not provide universal coverage, many local models do extend coverage to certain “adjacent” markets. For instance, in the MAC3 suite of equity factor models, Europe and the UK are considered adjacent markets, not only because of their geographical proximity, but more importantly because their local factors behave quite similarly. Hence, the MAC3 Europe Model covers UK stocks, and vice versa. Another example of adjacent markets is given by the US and Canada.

The key question is how to model the risk and return of adjacent markets. One option is to impose the view that stocks in adjacent markets are “just like” the stocks that form the estimation universe of the local model. In this approach, UK stocks would be exposed to all European factors (market, industries, and styles), while any return component not explained by the European factors would be considered idiosyncratic.

In reality, we know that there are meaningful differences between UK stocks, French stocks, and German stocks. This is where the notion of satellite factors comes into play. Satellite factors provide a mechanism to capture the unique behavior of the adjacent market without compromising the integrity of the estimation universe for the local model. For example, since the UK is a satellite factor within the Europe Equity Model, UK stocks are entirely absent from the pure factor portfolios associated with European factors. Nevertheless, the UK satellite factor will capture the country risk of UK stocks that cannot be explained by the European factors.