Japan Post Bank and a selection of other regional asset owners have begun to increasingly using risk factors better to diversify their portfolios amid the low rate environment.
The Japanese investor believes investment peers should considering doing so too, although this would require many regional asset owners to strengthen their quantitative analysis capabilities.
“We use factor-based analysis to understand the diversification effect better… ensuring that risk factors are diversified across the portfolio,” Tatsuo Ichikawa, managing director and head of the quant team at the investment division of Japan Post Bank, told AsianInvestor.
Some investors may be satisfied with adding new asset classes to their portfolio, but they need to check if they are getting a genuine diversification benefit by doing so, by monitoring and analysing the underlying risk factors between them, said Ichikawa. They should diversify not only between asset classes but also among sectors and regions, he warned.
The bank is seen as being largely risk averse and focusing on defensive strategies as it believes that the global market will likely remain uncertain for the foreseeable future.
In an ideal world, Japanese investors such as pension funds and insurers would earn enough from fixed income products because they match the risk profile of their liability side, Ichikawa said. But in reality the current low rate environment is likely to continue for the next few years, and in Japan 10-year government bonds already have a zero yield.
As a result, asset owners are having to look to more portfolio diversification, to maintain return without increasing risk, he added.
It is a pressing issue for Japan Post Bank itelf. The asset owner had ¥207.52 trillion ($13.94 billion) of total assets as of March this year, but Japanese government bonds made up the largest individual proportion (25.84%).
Japan Post Bank is not alone in stressing the importance of risk factor-based strategies to spot investment possibilities. Korea Investment Corporation (KIC) said that it plans to ensure that risks in its portfolio are diversified across a broad range of alpha sources after experiencing the market turmoil caused by the pandemic.
Industry observers and quant specialists are advocating the use of factor-based strategies to better monitor risks in their portfolios.
“Most asset owners are aware of simple risk factor frameworks, but not all will use them to guide their strategic decision making. We would certainly encourage them to do more,” Kevin Jeffrey, director of investments for Asia at Willis Towers Watson, told AsianInvestor.
The overall uptake of risk factor-based strategies remain uneven regionally, but certain asset owners, primarily Australian and Japanese institutions, are paying more attention to risk premia beyond the traditional market premia in their portfolios, Albert Chuang, portfolio manager for quantitative beta strategies at JP Morgan Asset Management, told AsianInvestor.
As opposed to the traditional market segmentation by size, sector, country, factors help investors target the market in a much more granular way which, when supported by a robust portfolio construction process, can yield alpha over traditional approaches, Paul Sandhu, head of multi-asset quant solutions for Asia Pacific at BNP Paribas Asset Management, told AsianInvestor.
Factor investing, however, does require a higher level of quantitative capabilities. Even though there are many data providers in the market that provide factor attribution to securities, this “overload” of data could become an inhibiting to the creating of an effective portfolio, Sandhu said.
It typically takes a team of portfolio managers that are experienced and knowledgeable about the underlying mathematics behind each factor to use it properly. This multi-factor approach to investing in risk factors is essential to create highly effective portfolios, he said.
Alternative risk premia strategies, the most complex approach, involves identifying risk factors and then taking positions in multiple assets that can be either long or short. Advocates say it is a flexible and scalable strategy that is readily adaptable to different market conditions. However, many alternative risk premia strategies have failed to perform this year, leading some asset owners in the US to reduce their allocations. Investments based around the popular value factor have particularly struggled.
The two methods are not mutually exclusive. And investors should therefore take advantage of both forms of diversification, Ben Dunn, head of quantitative strategies at Eastspring Investments, told AsianInvestor.
There will always be periods where asset classes will perform in line with expectations and periods where the correlations spike and offer less diversification than expected. This tends to happen when clients need diversification most, namely in times of crisis, Dunn said.
Similarly, risk factor-based diversification can become less effective as factors converge. Investors should, therefore, take advantage of both forms of diversification, he said.