When boiled down to the basics, investing is a combination of risk and return. These two seemingly simple variables are both incredibly complex and challenging to forecast. Over the last two decades, progress in computational power and availability of data has advanced the practice of valuing and forecasting investment returns.
These advancements in technology and availability of data have ultimately decreased the cost and complexity of constructing indexes, which has spawned millions of indexes. The major index providers each calculate over 800,000 indexes per day and there are more indexes than single stocks. Many would argue that this is excessive; however, there is value in the precision and informational value provided by these constructs.
Indexers can now organize securities across a multitude of dimensions, generating a larger variety of risk and return profiles than previously imagined. When partnered with an investment vehicle, such as an exchange-traded fund, investors can attain real time performance and attribution against each dimension. This precision allows investors to target idiosyncratic risks and risk premia they would have historically attempted to attain with single stocks, but now they get the benefit of diversification1 provided by an index.
With any new innovation, there is always an educational challenge for advisors. Shifting investors mindsets from traditional views constructed around size and style investing is very difficult, even though this new paradigm provides improved diversification and risk adjusted returns. We find this challenge similar to the patient education encountered by the medical profession as they moved from relying on patients’ vital signs for diagnosis to mapping and analyzing DNA. These additional factors can make advisors far more effective at assessing risk than if they had access to each clients’ “pulse and temperature,” but many investors have not shifted into thinking of their portfolio health through a comparable “DNA” model.
Trillions of dollars are allocated across size and style box investment constructs, but organizing securities by risk premia factors such as low volatility, momentum, quality and small size still seems relatively new to many investors. Although many advisors understand the academic underpinnings of factor investing that have been around since the 1960’s, ETFs that offer simple, convenient and low-cost access to factors are still only 15 years old.
I often hear from investment professionals who are still trying to figure out how best to use the flood of new data and technology when constructing portfolios. Given the enormity of this shift, we have learned that while it is important to educate financial professionals, it’s just as important to help advisors explain this new paradigm in a straight-forward way when speaking with their clients
Unlike the education of a financial professional, a process which can be steeped in data, analytics and proprietary systems to deconstruct or evaluate portfolios, bringing end clients up to speed often starts with the basics. It’s difficult to break down the expected factor exposure in a portfolio if a client doesn’t have an actual definition. Advisors we spoke with explained that it was challenging to talk to their clients about factor based investing without introducing a lot of investment jargon. For example, while we could discuss the benefits of, “being sector unconstrained to the parent index” with a financial professional, a statement like that could be perceived as negative among a client.
It is important to simplify the terminology you use when approaching a factor discussion, and understand it’s not just about what you say, but what your client hears. Anchor the discussion to terms that are familiar to investors, so they are included in the conversation, rather than distanced by phrases like “Sharpe ratios.” A client already has factor exposure through mutual funds and stocks. Pointing out the factor tilt in investment vehicles they already recognize gives them a way to draw new parallels to investments constructed for factors purity.
Decoding factor exposure can be as easy as defining individual factors as “building blocks” for different investment outcomes. This can help investors understand that their own unique factor profile of risks and returns. Emphasize that investment factors offer more customization, allowing a client to create a portfolio that uniquely focuses on their personal objectives. We also find that it is helpful to create analogies that speak to real world paradigm shits, such as likening factors to the improved diagnostics that came from incorporating a patient’s DNA into the medical profession. Defining the building blocks that create an investor’s portfolio as their “investment DNA” can offer the same level of understanding.