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Written by: Yazann Romahi , Chief Investment Officer of Quantitative Beta Strategies and Lead Portfolio Manager of JPMorgan Diversified Return International Equity ETF at J.P. Morgan Asset Management
With talk of strategic—or smart—beta increasingly becoming more prevalent across the investment landscape, we ask Yaz Romahi, portfolio manager and CIO for Quantitative Beta Strategies, about how portfolio construction is as important as factor exposures in solving for potentially smoother returns.
Yaz, what is your approach to portfolio construction?
If we see strategic beta as an alternative to traditional index investing, it is worth bearing in mind why investors choose index funds in the first place. An index fund is meant to provide investors with diversified exposure to capture market returns. Investors do not expect such funds to be biased towards any particular concentration of risk. Smart beta indices have been mainly focused on building in factor exposures—for good reason—to access other sources of economic return. However, there is another dimension that is often ignored: the risk dimension. Indeed, it is no surprise to most people that market cap indices are highly concentrated. The top 150 stocks in the S&P 500 Index, for example, represent most of its risk!* Sector exposures can also be very concentrated and—worse—unstable.
In our approach, therefore, we essentially look to distribute risk more evenly spread across regions, sectors and stocks by balancing the market-cap index’s inherent concentrations. As uncontrolled risk concentrations are unlikely to be rewarded over the longer term, we believe investors should strive for maximum diversification when constructing a core equity exposure. Redistributing these risk weightings can lead to potentially less volatility in down markets and an overall smoother experience for investors.
How, in practice, do you redistribute risk across regions and sectors? What goes into determining your allocations?
In order to build in maximum diversification, the typical approach would be to allocate an equal amount of volatility to each market segment. In this way, we balance risk exposure between the buckets available. Whereas in market cap-weighted indices sector weights deviate significantly over time, by more evenly distributing weightings, the strategic beta index’s allocation is more stable through time, and potentially more diversified.
How often do you rebalance sector weightings?
Quarterly. Four times a year is not a magic number—the process will still work if rebalanced semi-annually or even monthly. But quarterly reallocation gives a nice balance between maintaining disciplined risk control and factor exposures. The ETF rebalances at the same time as the index to minimize tracking error.
Related: How to Manage Bond Market Pain and Seek the Gain When Rates Are Rising
How does market cap factor into sector weightings?
It doesn’t! Our disciplined approach maintains a balance of risk between sectors whenever possible. During periods when market cap becomes most frothy and concentrated in bubble sectors, our deviation from market cap will be at its greatest. We are stable and consistent, while the cap-weighted benchmark can be quite volatile in its allocation.
As a result, we aim to capture most of the upside, while providing less volatility in down markets, helping to keep you invested across market cycles. Learn more about how we use a multi-factor screening process to select securities Better index investing: The benefits of multi-factor security selection and explore our suite of equity ETFs here .
*Source: Bloomberg; as of 7/12/17. Based on the weighted sum of stand-alone volatility measured daily over the latest 12 months.RISK SUMMARY
Investing involves risk, including possible loss of principal. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investment returns and principal value of an investment will fluctuate so that an investor's shares, when sold or redeemed, may be worth more or less than their original cost. ETF shares are bought and sold throughout the day on an exchange at market price (not NAV) through a brokerage account, and are not individually redeemed from the fund. Shares may only be redeemed directly from a fund by Authorized Participants, in very large creation/redemption units. For all products, brokerage commissions will reduce returns.EndFragment