Interview with Yazann Romahi, Managing Director, JP Morgan Asset Management for Evolution of Factor Investing 2016 Report

Zara Amer, Head of Content, Clear Path Analysis: What’s the attraction of factor investing for an asset manager and importantly from a client perspective?

Yazann: The key attraction to using factors is simple. Diversification. Factors provide access to risk premia whose sources of return are diversifying to traditional sources of return. Therefore, building in factor exposures into one’s asset allocation significantly improves the risk adjusted return achievable.

Zara: How important is the methodology / index construction in determining your choice of ‘factor’ index provider?

Yazaan: In selecting a provider, due diligence remains important. The growth of the space and the urge to differentiate one’s offering has resulted in what has been referred to as a factor zoo with providers defining broader and broader sets of “factors”. Indeed, a number of these factors are often variations on each other. The key is to find a provider that blends transparency, parsimony in design while efficiently capturing and delivering the risk premia.

Another aspect of efficient capture of factors that is often overlooked is the idea of maximizing diversification of uncompensated risk factors. Something like a sector exposure for example is merely a descriptor of risk rather than a compensated premium. Traditional market cap weighted indices do not correct for this and thus can be overexposed to a single sector. At the extremes, if we think of the S&P500 for example, the volatility contribution of the financial sector reached over 40% of the risk of the index at the peak of the financial crisis while technology formed an even higher percentage at the peak of the dot com bubble. Correcting for this by equal weighting the sectors is a very important aspect of index design.

Zara: What are your views on combining factors / which work together best, compliment from a risk /return POV?

Yazaan: As we mentioned, the key is maximizing the diversification between the factors. In other words, each factor has to be uniquely capturing a different risk premium. There are some for example who would include Minimum Volatility and Quality as two separate factors when these are in fact highly correlated and as such should be considered the same factor. By focusing on factors that are uncorrelated to each other while at the same time, ensuring that each factor being included has a very strong economic basis for the source of the return, we can significantly improve the efficiency of the portfolio.

Zara: What’s the attraction of an ETF wrap for a factor index from an Asset Manager POV?

Yazaan: I think more important than the wrapper itself, is the increasing ability of investors to access factors. From a wrapper perspective, ETFs are an ideal wrapper because of their tax efficiency, the intraday liquidity and of course the transparency – making them a suitable vehicle for asset allocators.

Zara: How does client interest vary across the states and Europe?

Yazaan: While there are lots of investors currently discussing and exploring the merits of factor based investing, we are still in the very early stages. In terms of geographic client interest, it is fair to say that it is the more sophisticated clients who have started to think of their portfolio in this way. The region that has been most advanced in this space is the Nordics generally, Australia and at the top end of the US institutional market. It is however increasingly gaining more traction across Northern Europe more broadly and with a broader client base in the US as well.

Zara: Which client segments are more/less engaged with smart beta and the factors story? How has this changed?

Yazaan: As mentioned, up till now, it has largely been the preserve of the most sophisticated institutional clients but this has changed significantly in the last few years with a broadening out of the appeal of factor based indices. The proliferation of product in the space is both a benefit as well as a hindrance to its growth. It is a benefit because its prevalence increases clients’ exposure to the topic and therefore investors seek out education on why this can be a more efficient way of accessing risk premia. It can act as a hindrance also though because the market place can get crowded and becomes more difficult to separate the wheat from the chaff with the less sophisticated investors needing to rely on advisors for help.

Zara: What’s next for factors?

Yazaan: While the focus has been very much on equity based factor investing, this topic is much broader than this. Factor based investing is fundamentally cross asset and therefore applies just as much to Fixed Income, Currency, Commodities and Alternatives. Fixed Income especially is likely to be a major growth area in the near term because traditional indices in this space have an adverse selection problem. In other words, market cap weighted fixed income indices, by definition; mean an increasing allocation to the most profligate debtors. Alternative weighting schemes in this space will become an increasing focus of fixed income investors. The other major area of growth for factor investing of course is long/short risk premia. Often referred to as alternative beta or hedge fund beta, the growth of this space will very much democratize access to hedge fund investing.

Download the full report on the Evolution of Factor Investing.