Real Economy Portfolio: The Market Risk Premium as a Source of Alpha

Abstract

We all know that the stock market does not perfectly reflect the overall economy. The author shows that this fact has exciting implications for active equity management. If standard cap-weighted benchmarks fail to reflect the economy, they contain uncompensated risks and will underperform the true market portfolio. Although we can never hold the true market portfolio because of nontraded human capital and other constraints, the author builds a sector-level model that captures returns to labor, capital, and intermediate inputs in the entire US economy. A portfolio designed to replicate these exposures generates statistically significant alpha that is distinct from existing factors. TOPICS:Security analysis and valuation, portfolio construction, performance measurement Key Findings ▪ The market risk premium refers to all assets in the economy, and even broad stock market indexes are an imperfect proxy. ▪ We leverage classic results from input–output analysis and international trade theory to construct a real economy portfolio from listed equities that better replicates the underlying economy. The key is to upweight labor-intensive and under-represented economic activities. ▪ The real economy portfolio has delivered significant alpha that is distinct from known factors.