David Lebovitz: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management.  The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.

Today’s episode is a look at Strategic Beta: Past, Present, and Future, and has been recorded for institutional and professional investors, I'm David - I'm David Lebovitz, a Global Market strategist and host of The Center for Investment Excellence.  Today with me are Yasmin Dahya-Bilger, Head of Americas Beta Specialists, and Alistair Lowe, Portfolio Manager for our Quantitative Beta Strategies Team.

David Lebovitz: Welcome to the Center for Investment Excellence.

Yasmin Dahya-Bilger: Thanks for having us.

Alistair Lowe: Happy to be here, David.

David Lebovitz: All right, great.  So today, we're here with some of our colleagues from the beta business and you know, before we get going, I think it's just important to think a little bit about where we are in the cycle and kind of the way that beta can fit into portfolios and we'll talk about this in more detail over the course of our conversation today.

But, you know, whether you think there's a recession coming this year, or next year, or not for five years, maybe we're the next Australia.  We're going to have this 20-plus year cycle.  You know, as business cycles mature, as economic expansions mature, investors need to become more nuanced in their asset allocation.

And one of the things that we've noticed is, obviously, asset manager underperformance has been front and the center, and that’s led fees to really be in focus for institutional investors in particular.  And people understand that, you know, they need more of the beta in portfolios, pure beta in portfolios, but they don't necessarily understand what to do about it.

And so I think that part of what I hope to tease out during our conversation here today, you know, is not only talking about what is factor investing and why is it of interest, but talking a little bit about use cases, how clients are implementing these smart beta strategies in their portfolios, addressing some of the risks, some of the questions we get on the road in terms of, “Well, everybody is doing this.  You know, trees don't grow to the sky and maybe there will be a problem down the road.”

I think we've got some interesting insights to share on that before wrapping up on a more positive note, and thinking about some of the opportunities in the space which exists over the next three to five years.  So with that said, why don't we get things underway?

Ali, maybe I'll start with you, let’s set the stage, let’s talk a little bit about what factor investing is in its most basic form and then why is it of particular interest, you know, in the current environment?

Alistair Lowe: Yes, I think the first thing to think about is most people have been thinking about factor exposure for quite some time using traditional factors.  Equity beta is probably the first factor people started thinking about. You could have long-term government bond as another beta.

What does some factors we are talking about in multi-factor are other things that cause groups of stocks or bonds to move together and value is probably the one longest discovered.  There are times when values (unintelligible) or values together so they group things quality momentum.

We think when you think about factors is there are exposures that we believe are compensated.  You get a long-term risk-adjusted return by taking this exposure.  We all believe in the equity risk premium and return premium.

We also believe based upon academic evidence and empirical evidence that there is a long-term risk-adjusted excess return to value, similarly to quality, similarly to momentum stocks.  So those are some of the three classic factors that many people talk about.

And so it is the way of building a portfolio where you get an exposure to this additional risk factor which is uncorrelated with the equity market (aim).  So it gets you long-term risks-adjusted return, not necessarily correlated with equity markets, and by doing that, you can improve your long-term risk-adjusted returns.

David Lebovitz: And so it sounds like as investors that found themselves in this low-interest rate and what looks like could be a low return environment on the equity side going forward, factors are really a way of saying, “You know, I have a view here and it's a view that I'll be compensated for, and then hopefully by taking this view and implementing it in my portfolios, I'll have a smoother ride with a better return at the end of the day, compared to w somebody who has just invested in the markets broadly.”

Yasmin Dahya-Bilger: And maybe worth adding to this - around factor investing -- I think Ali hit the nail on the head there -- it's been around for quite some time, so I think investors are hearing a lot more about it now.

But if you zoom out and look at the landscape, what you'll see is that there's over a trillion dollars in explicit factor exposure, that’s not even taking to consideration that many managers have actually been delivering exposures, as Ali mentioned, without really calling it back.

When you look so with the market, what you'll see is there are various types of factor portfolios in there.  So there’s long/short factor portfolios, that’s about a quarter of the market, and then there's long-only factor portfolio, that’s about three quarters of the market.

The long/short story is really very much one of a source of diversification in your portfolio and that’s the way in which many clients have been using it.

The long-only side I think has a larger (unintelligible) and use cases and I think it would be helpful to spend more time on them, but predominantly people who are doing exactly what you said, David, which is looking for that intersection between passive investing and active investing. The benefit of passive being transparency, low fees, a systematic approach, but delivering a differentiated risk and return profile.

David Lebovitz: And so I think that that actually kind of opens up the conversation to another one of the questions that I know we wanted to dive into which is, you know, how are you seeing clients use factors in the current environment?

Obviously, as Ali said, value has been around for a very long time and I think we'll get to whether the clouds are beginning to break over value later in our time today.  But could you talk a little bit about how you're seeing clients implement these strategies, if you notice any sort of typical chain of events in terms of which type of factors they're comfortable implementing today versus factors that they're comfortable implementing tomorrow.

Then, furthermore, right?  We're talking about a pie and there's a finite amount of dollars so maybe a little bit about where the funding is coming from for those factor exposures, assuming that they are a new part of the portfolio.

Yasmin Dahya-Bilger: Yes, absolutely.  So I think the first place to start is that we're seeing adoption and use of factor investing across the broad range of clients, public plans, corporate plans, healthcare institutions, so a variety of clients who are - who has already moved into the space or actively looking at the space.

There are a number of emerging trends we've seen when we look at the types of clients we've engaged with and how they are using it.  One, for example, would be on the type of investor and we know there are a lot of them who over the course of the last 10 to 15 years has heavily moved towards market cap passive because of the intense (unintelligible) fees.

Now, to where you were starting about what the macro considerations are right now, many of them are beginning to consider what future return expectations, high return threshold, how am I going to meet those returns?  So you're seeing a set of clients move out of market cap passive towards the factor-based strategy, the goal there being adding return to their portfolio, risk-adjusted return story, and the funding source being market cap passive.

I think a really interesting space where people are doing that is something like U.S. large cap because a lot of the money has moved into market cap passive there.

Now, that’s not the only place where people are using factor-based investing.  There’s also a use case of folks that’s coming from active and this is really the story around either not being able to find a manager with capacity that they like, or as they evaluate net of fee return, not feeling they had many options.

And so you're seeing a significant move towards factor-based investing as a way to still be delivering the differentiated risk and return profile, not moving straight to market cap passive, but keeping fees low in the portfolio.  A particular area where we've seen (unintelligible) international emerging markets where I think people do put a premium on the ability to deliver outperformance.

So I would say pretty evenly we've seen funding from market cap passive as well as active parts of the portfolio.

David Lebovitz: So it's almost like why don’t you just meet me in the middle, right?

Yasmin Dahya-Bilger: That’s perfect.

David Lebovitz: In the middle of active and passive, the intersection of these two types of investment strategies.  And I think that that begs another question, and Ali, I'd like to bring you into the dialogue to get some of your thoughts on this.

But, you know, outright I'm the economist, I’m an investment strategist.  The people always want to know, you know, growth versus value, small versus large, cyclical versus defensive.  They forget that trading is really exciting, but the probabilities aren't on your side.  Investing is kind of boring, right, and it's not going to be as tactical as perhaps they would like it to be.

So with respect to the factor universe broadly, you know, how do you think about building factor strategies in aggregate, and can you time which factors to use based on where we are in the cycle, what you're seeing across the capital markets broadly?  Can you talk a little bit about the actual implementation of these (defensive) strategies?

Alistair Lowe: Yes, so the first thing is you want to make sure that you’ve got factors that you believe will continue to give risk-adjusted excess returns going forward and avoid things that are perhaps being data-minded a bit and I could talk at length later on about some of the things we do there.

Secondly, you want to think about in building them, you want diversification.  Do I have factors which are naturally uncorrelated with each other?  

So value, typically both logically and statistically seems to be uncorrelated with momentum.  Often when momentum is working, things are getting more and more expensive.  Therefore value isn’t working - simply when value is working, momentum isn’t working.  So if you think logically, they shouldn’t be.

We believe there are the three big factors that have stood the test of time and by trying to diversify evenly between those three because we think they have about the same long-term risk-adjusted return.  So we evenly weight them, build portfolios, and they’re not really trying to time factors.

Why do we not try to time factors is the question I get asked, and the answer is that if you look at the history that we have, we have maybe six cycles of big, you know, value working, value not working.  It is very, very easy for any quant to take the data, torture it, and come up with something that looks really good.

However, you have over-fitted for a small number and you are very sensitive to the parameters.  If you built that model before the global financial crisis, you might have added or subtracted the factors too soon and got yourself into a huge drawdown beyond your pain point when you give up on the strategy.

So we think by not trying to time, although we continue to do research to see whether you can, on a pure quantitative basis, it's hard and we do know that by timing, you incur some transaction costs.

David Lebovitz: Yes, so, I mean, it sounds like a lot of the principles that apply to more traditional asset classes continue to apply to the factor space, you want to diversify.  It's about, you know, building (unintelligible) to (rank) for achieving your long-term goals much more than it's about trying to, you know, catch the hot (unintelligible) when it's outperforming.  You know, all of that makes sense.

I think the question from where I sit though is you sit and watch CNBC, if you open up the FT, if you open up The Economist, I would be surprised if I didn’t see some sort of advertisement for a factor-based strategy whether it’d be our own or competitor, so on so forth, factors kind of seem to be all the rage.  And, you know, do you worry that factor crowding will impact returns over the long term?

I know you and I chatted a little bit about one of the oldest factors that there is and you actually mentioned it in your opening remarks, but do you have any concerns that the space is getting a little bit crowded and that may - you know, one, could it impact those traditional factors that we have a lot of scientific and quantitative evidence supporting the fact that they do exist?

Two, could it impact some of these newer factors that have come to market and may not have perhaps as much as staying power?

Alistair Lowe: Yes, so when people say, “Has it been arbitraged away?” I always say, “Well, how long have we known about the equity risk premium?”  And yet somehow despite everyone knowing about it, we continue to believe that there is a long-term return staking it.  Why?  Because when it doesn’t work, it hurts.

So when looking at factors, we're looking at factors where there is a behavioral bias, either a risk-based bias that it hurts from time to time and so a lot of people avoid it; or behavioral bias, things like momentum or quality.  We think there is good behavioral finance explanations for them.  So you want to pry on why it should work.

Secondly, when people say, “Is it getting crowded?”  There’s a lot of different ways that people express so it's not like every manager on the planet has the exact same definition of a factor tinged on the exact same day.  So you would expect that there's going to be some diversification.

Thirdly, we can actually measure it.  If factors would become crowded, we would notice that the correlations between the factors would go up because everyone was doing the same thing at the same time.  We’d look to that and even in this rest period in the quarter one last year, when factors really had a big drawdown, you didn’t see an increase in the correlation between factors.  They were still behaving in the way they were 20 years ago in (back tests).

David Lebovitz: And arguably, if we think of some of the principles that we apply when evaluating active managers, right, you want somebody who had a consistent process, somebody who’s going to change their strides depending on the broader environment and it sounds like the same applies when it comes to thinking about factors and smart beta more broadly.

Yasmin, you spend a lot of time out in the road, dealing with our clients, building these types of questions.  I'd love to get some of your thoughts about tracking error and how to think about performance across a number of different factors.

But I'd also be interested in just, you know, kind of what you have picked up on over the past couple of months.  It's been a pretty wild ride here since Christmas Eve through the end of the first quarter.  You know, as of yesterday’s close, the S&P up nearly 20% year-to-date.  If I was a betting man, I would say we're not going to continue to compound at this rate through the end of the year.  And if I'm wrong, you guys can all hold it against me.

But how do you think about performance and how do you think about, you know, some of the questions that clients have been coming to you with in light of a very significant turnaround in broader market performance over a relatively short period of time?

Yasmin Dahya-Bilger: Yes, I think you've got some good odds there.  I think this is the single-handedly one and most important questions in the space around performance expectations because if I do see a hurdle that we as an industry need to overcome, it's helping our clients understand what to expect out of these types of products.

So I think a couple of points that are just important to hit on from a high level and the first is around tracking error.  What is important to ground ourselves on on these products is that they are systematic.

In fact, one of the philosophical benefits of factor investing is transparency (by your mentor).  There are rules behind what’s being done which means you don't have manager drift.  And so you can develop a fairly good expectation understanding of how the product is supposed to work.

Now, the other element on tracking errors is important, is it’s customizable to what you're looking for and I think that’s a really important point that various - clients are looking to get something out of these portfolios that may differ.

Some clients are more focused on Sharpe ratio.  Some clients are more focused on information ratio, how you actually construct that (thought) around those design considerations will help alleviate the consideration and concern around tracking error.

For those that are very benchmark (oriented and care a lot), you can design your strategy to have a lot more benchmark alignment.  And I think that’s really important because it helps to put some parameters on deviation.

Now deviations are exactly what you're hoping to achieve out of these products.  The only reason to be in them is you hope they're giving you something different than market cap benchmark, but at least then you have some idea of what to expect in terms of how far that can go.

The other thing that I think helps the performance expectations is this conversation around single factor versus multi-factor.  If anything (unintelligible) has taught us how incredibly cyclical individual factors are and they are - there is a specific use case for a single factor in a portfolio that I think has a real need for (clients).

But by and large, the multi-factor mix is going to help overall with a smoother exposure.  So for those who really can’t live the high-highs and the low-lows relative to their benchmark, a multi-factor mix is probably a better solution around this question of performance expectation.

(It rises) overall when we are talking to clients.  While we're giving a solution depending on their needs, I say our bias tends to lean towards a multi-factor model for that very reason.

David Lebovitz: Yes, I mean, we've talked about this ad nauseum in a number of different venues and on a number of these different podcasts.  But, you know, diversification, having a chip on every square particularly for long-term investors is oftentimes the most prudent approach to take.  So I want to close with one (unintelligible).

Alistair Lowe: So I want to close with (unintelligible).

David Lebovitz: So I want to close with one final question here, Yasmin, for both of you and Ali.  You know, we've talked about what factor investing is, why is it of interest, why the clients are coming to us and trying to learn more about this space, that it has grown relatively quickly over the course of just a few years in terms of the ability to access factors that have been around for, you know, 40, 50, even more years in certain cases.

We talk about some of the risks.  We talk about tracking error performance, crowding and the importance of having factors that, you know, maintain a certain level of correlation or maintain a certain level of non-correlation amongst each other regardless of the broader market environment.

Let’s wrap up on a positive note.  So this is a space that has garnered a lot of interests.  It's probably going to continue to garner interest going forward.  Where do you guys see the greatest opportunity across the factor landscape over the next three to five years?

I feel like we've talked a lot about where the puck has been.  Let’s think a little bit about where the puck is going and how our clients may be able to take advantage of that and Yasmin, maybe I'll start with you.

Yasmin Dahya-Bilger: Well, I can see there being a lot of tremendous tailwind for this space and I think it's a confluence of a couple of key things.  One, it's what you mentioned upfront which is the market.  I mean, to be honest, the last 10 years, exposure was enough.  The next 10 years, it won’t be for our clients, so they're having to think outside the box on how they traditionally have built portfolios.

But on top of that, with the increased dialogue happening about factor investing, there's a lot more education in the market for clients to really understand what they're investing in and there's track records.  So many of these strategies have been around for decades, and factors that have been around for decades, but people really want to understand how managers have been doing in this space and at the end of the day, you have to know and trust your manager.

So I think the growing amount of track record you've seen from a lot of managers will help drive that as clients are evaluating how to handle repositioning their portfolio for the next 10 years.

David Lebovitz: Awesome.  Ali?

Alistair Lowe: So I think that, you know, the last few years had been some of the toughest for multi-factor portfolios to deliver results because values in - and second was drawn-down that we've seen.

And if you study history, you know, what I said it’s hard to predict when it turns around, when value starts to work, it often comes back very sharply, very quickly and generates significant excess returns.  So in some ways, it's sort of buy on the dip, right now is a good thing.

The other thought I would add to what Yasmin said is quarter four was great for the space because in the U.S., it was really the first time we saw down markets and we could actually see in stressed markets, the benefits of a diversified multi-factor approach.  I think that helps clients understand what will happen because we're not - the last 10 years have been spectacular return to the equity risk premium.

David Lebovitz: Excellent.  Well, it sounds like a more informed focus on factors is probably going to be important going forward.  And I think, you know, the key takeaway from where I sit is that this isn’t about active or passive, it's about active and passive and figuring out how to stick together in your portfolio to drive the optimal outcome depending on what you're trying to accomplish.

So thank you both very much and looking forward to talking to you again soon.

Thank you for joining us today on JPMorgan's Center for Investment Excellence.  CFA Institute members are encouraged to self-document their continuing professional development activities in their online CE tracker.  If you found our insights useful, you can find more episodes on iTunes in our website.  Recorded on April 23rd, 2019.