Chances are good that advisors have been hearing quite a bit about factor-based exchange-traded funds (ETFs) in recent days. This shouldn’t be surprising, given that these strategies have grown by 46% annually over the past five years, while equity ETFs have only grown by 17% annually over the same period. Mainstream media have been reporting on the rising popularity of factor investment models, and this is leading many clients to ask their advisors about the possible use of these funds to achieve their financial goals.

(See Factor-Based Investing on the Rise; Will Be Focus of Morningstar Conference.)

In order to explain the potential advantages and risks to clients, advisors need to understand how factor-based models differ from typical buy-and-hold approaches. They also need to determine whether and how factor models can strengthen their clients’ portfolios; how to implement or blend these strategies into their planning approach; and the difference between using factors for long-term allocation versus market prediction.

After the Financial Crisis, a Granular Approach

First, a bit of history is in order. Until 2008-2009, there was a general consensus that most investors were well diversified by portfolios that included a number of different asset classes — for example, stocks, bonds, currencies, commodities, hedge funds and real estate. The financial crisis proved otherwise, revealing that diversification, in and of itself, offers little protection if most asset classes begin to move in the same direction at the same time. 

As a result, factor-based models began to emerge focusing on the various broad, underlying forces that can protect against risk and contribute to returns across dozens of asset classes and millions of securities. With this more granular perspective, every asset class is seen to carry elements — or factors — of risk and return, such as volatility, momentum, size, value and quality. And just as a healthy diet requires a proper balance of micronutrients, regardless of cuisine or recipe, portfolios also need the right mix of factors across asset classes and strategies.

(See: Factor Investing Explained.)

Why Factor-Based Funds Are Growing

Investors seeking alternatives to the strategies that collapsed during the financial crisis are fueling the recent surge of interest in factor-based strategies. From 2006 to 2016, assets under management (AUM) of equity factor ETFs have grown from $6.650 billion to $77.979 billion. These strategies should continue to grow over the next 5 to 10 years.

Although investment factors can be expected to generate excess return or outperform market cap-based benchmarks over market cycles, it is important to remember that these drivers can be influenced by the macro environment over shorter time frames. Within a shorter time horizon, factors respond to cyclicality and consequently may underperform. Advisors should therefore be clear in conveying to clients that rather than seeking to predict the market, they need to adopt a longer-term view in order to achieve the benefits of factor-based investing. Practical Applications for Advisors

No single factor should be seen as a one-size-fits-all portfolio solution. To uncover the power of factor investing, advisors should stress diversification when implementing these strategies. Remember, factors are the building blocks of tailored portfolios for modern investors. So, as one example, an advisor with a risk-averse client may suggest blending a low-volatility strategy with high dividends. This blended approach may provide the investor some protection from downside market moves, while the dividend component can still provide desired income from quality stocks.

As factor-based models become more available, they can help investors target a range of portfolio outcomes, from reducing risk and enhancing returns to generating income. Next week, my colleague Nick Kalivas will dive deeper into the practical applications of using factor strategies in the current market conditions of slow growth and low or negative interest rates. He will also address the potential impact of ongoing events such as the upcoming elections and the after-effects of Brexit on factor-based funds.

More generally, we will be looking at the factors that are likely to be significant over the next six to 12 months — and beyond. By keeping the focus on this longer-term horizon, advisors can provide appropriate answers to the questions their clients may have about factor-based investments, and offer solutions that help them to achieve their financial life goals.

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