A financial advisor may want to consult with their legal or compliance advisors to ensure that they are explaining their current diversification efforts adequately to their clients. This may be especially true for those clients asking about factor investing who are influenced by social media, like younger generations.
As we head into what might be yet another round of market volatility, risk management may be top of mind for many advisors. You may also hear about factor investing and rotation from your clients. In fact, its all over social media like Youtube, with videos explaining it gathering nearly a quarter of a million views in the last few months. As to investing, factor investing is an approach that targets specific variables involved in asset classes with the goal of isolating what might drive return. In general, the goal of factor investing is to increase diversification and decrease volatility while maintaining portfolio goals. Blackrock explains factor investing to it’s potential clients as creating a balanced portfolio across asset classes.[1] The factors involved may be classified as high momentum, high quality, and low volatility.[2]Usually factors fall into two main areas: macroeconomic and style. Macroeconomic factors include unemployment, and inflation. Microeconomic factors, seldom used but also of note, include a specific company’s share liquidity or price volatility. “Style factors encompass growth versus value stocks; market capitalization; and industry sector.”[3]
Rotating the factors relied on to direct investment is called factor rotation. Rotating factors used in factor investing can, in some situations, be a prudent way of managing risk while keeping performance goals on track. Rotating factors may also allow advisors to use strategies targeted to evolving market conditions and respond to trends among factors. In other words, factor rotation involves harnessing data to find new elements to explain performance, and ensuring those elements are balanced across risk and return. Financial advisors may want to listen deeply to what clients are saying when they ask about factor investment and rotation. A conversation about factors may actually be a request for other assistance.
Some clients may bring up factor rotation or factor investing when what they actually are seeking is investment monitoring or investment oversight. As we’ve explained before, investment monitoring is a “growing field of advisory services that blend traditional accounting oversight skills, like tax basis analysis and verification, with other compliance-like skills, such as internal control evaluations and risk assessments.”[4] Clients worried about how their portfolios are performing due to tax or other implications may need a meeting with a variety of advisors, including their legal and tax counselors as well as your services.
Other clients may be thinking that their portfolios aren’t currently using an appropriate method to diversify assets and moderate risk. They may be seeking assurance that this is happening. Factor investing can be a diversification method. Diversification is part of the prudent investor rule. The Uniform Prudent Investor Act (1994) requires that “[a] trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.” And, a trustee must “diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.”[5]This definition is intentionally loose, so that a fiduciary can work best with their beneficiary or client’s needs. But the wiggle room left in the law may create concern. Factor investing’s intention is to enhance traditional diversification strategies while side stepping the potential problem if multiple asset classes move in a pattern. But, as noted, the appropriate diversification for your client depends on their specific needs.
Now may be the best time to talk to your compliance and legal counsel about how to respond to requests from clients about using factor investing and rotation. A financial advisor may want to consult with their legal or compliance advisors to ensure that they are explaining their current diversification efforts adequately to their clients. This may be especially true for those clients asking about factor investing who are influenced by social media, like younger generations.
[1] https://www.blackrock.com/us/individual/investment-ideas/what-is-factor-investing
[2] https://aaiihouston.org/category/monthly-meetings/2021-may-meeting
[3] https://www.investopedia.com/terms/f/factor-investing.asp
[4] https://www.bcgbenefits.com/blog/investment-monitoring
[5] https://www.bcgbenefits.com/blog/diversification
These articles are prepared for general purposes and are not intended to provide advice or encourage specific behavior. Before taking any action, Advisors and Plan Sponsors should consult with their compliance, finance and legal teams.
Before leaping into the unknown, we recommend a thorough examination of your plan. Because we are experts in the field, we know the marketplace and know what your existing vendor is capable of offering. Through this examination, we can help you optimize the service you receive.
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