For advisors who expect relatively good economic growth, say in the 2.5 percent range, with tame inflation, they would likely invest in equities, he said. The factors to use would be to invest in high-quality, low volatility stocks. Adding these factors helps to reduce overall portfolio risk, he said, especially for advisors who have clients with reservations about being in the equity markets.
“This is the number one thing we’re doing now. We’re increasing or maintaining equity exposure, but decreasing the risk,” Hunstad said.
For advisors who have concerns about trade policy, they may seek out small-cap stocks since these have less exposure to trade wars than large caps. That expresses the size factor.
In a rising rate regime, Hunstad said, factors perform well. As monetary policy contracts, he said all factors give excess returns, and the best-performing factor is the quality factor. Further, factors can continue to give excess returns in a low-equity return environment. Northern Trust is expecting reduced equity returns, having lowered their forecast to just under 6 percent. In this environment, the low-volatility factor has the best performance.
To use factors strategically, he said consider the traditional risk-adjusted 60-40 portfolio spilt of 60 percent equities and 40 percent fixed income, which Northern Trusts forecasts to have a 5.9 percent return. But by adding a small mix of high quality, low volatility stocks, the risk is lowered, but the return goes to 9.1 percent. If your equity portfolio is a 50-50 mix of passive/active stocks, he said, make it one-third intentionally chosen factors, one-third active and one-third passive. In this example, the intentional factor mix is small cap and low volatility
Lastly, he said, when using factors, consider the tax implication. Some factors, like momentum, can have tax implications that might offset the alpha if they aren’t controlled, since it is a faster-moving factor.
“You want to manage them in a tax efficient format, so you’re taking strategic gains and losses,” he said.