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.
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.)
