Ask the stock market how the economy is doing and they’ll say: just great, thank you.
Judging from the stock markets, the COVID-19 pandemic is well in the rearview mirror and has been since the vaccine was announced in November 2020. But all may not be as rosy as it once was. appears.
Northern Trust FlexShares Exchange Traded Funds analysts warn investors against complacency. Macroeconomic events, such as unprecedented fiscal stimulus and huge expansion of central bank balance sheets, could lead to inflation and higher interest rates. Both present risks for unprepared investors. The question is therefore how to prepare for these risks.
According to Northern Trust’s analysis, factor investing is the ideal way to manage macroeconomic risks. Factor investing involves investors targeting specific return drivers, such as value, size and quality, in their portfolio.
We spoke with Christopher Huemmer, Senior Vice President and Senior Investment Strategist for Northern Trust FlexShares Exchange Traded Funds, what factors financial advisors should pay attention to in today’s market and how they can implement investing. factorial in their clients’ portfolios. Here are edited excerpts from this interview.
How would you describe the current economic environment, and what are your expectations for the rest of 2021?
The global economy continues to recover from the lockdowns caused by the COVID-19 pandemic. Although parts of the world continue to struggle with the impact of the virus, developed economies have made progress in reopening trade with the help of budget support and the central bank.
The stock markets continue to see gains in the rapid reopening of the economy, particularly here in the United States. In general, business fundamentals have proven to be resilient, and state-owned enterprises have come out of the pandemic better than expected. A key trend we have seen is that the recovery has moved from a general reflation trade benefiting all stocks to a period when investors seem to be rewarding better quality companies. We hope this should allow for a more sustainable recovery and benefit investors for the remainder of 2021.
What equity strategies should advisors use in investor portfolios to maximize returns in this type of environment?
We believe that strategies that consistently target the factors that have historically compensated investors, such as value, quality, size and low volatility, should be considered by most investors now.
Our research shows that historically, factors of size, value and quality have worked well during times of economic recovery, and the current environment appears to align with these historical trends. In the first five months of 2021, the size factor was positive, with the Russell 2000 index focused on small caps outperforming the Russell 1000 index (which tracks the top 1,000 companies by market cap).
The stock outperformed even more, with the Russell 3000 Value Index outperforming the Russell 3000 Growth Index. Even controlling for sector biases within these indices, we see that value stocks have significantly outperformed growth stocks since the start of the year.
Strategies that effectively give exposure to size, value and quality factors while controlling risk, such as sector bias, are a good way to introduce factors into your portfolio.
How does the rate environment and the Federal Reserve’s future movements play into this factor analysis?
We are always attentive to how changes in rate expectations and central bank policy may affect equity markets and factor strategies. As we saw at the Federal Reserve’s June meeting, investors can react even in the absence of a change in the Fed’s target interest rate or continued monetary stimulus. Markets interpreted the changes in the Fed’s dot plot as an acceleration of the first potential rate hike from 2024 to 2023, causing the short end of the Treasury yield curve to rise while the the longest of the curve has fallen.
This type of rate environment is known as “bear flattening,” and historically we find that size and value factors have worked well during these time periods. This has led to increased client interest in our FlexShares Morningstar US Market Factor Tilt Index ETF (ticker: TILT), which seeks to incorporate size and value factors into the design of the fund’s portfolio.
What type of market event would signal investors and advisers to look to a more defensive factor?
A risk scenario that would push investors to turn to defensive strategies would be for the Fed to act too quickly to raise target rates or remove monetary stimulus, jeopardizing the economic recovery and negatively affecting stock prices. Most likely, this change in Fed policy would be to combat persistent high inflation or an increased desire among voting members of the Federal Open Market Committee to return to a normal monetary environment.
In this scenario, investors might turn to low volatility strategies, but they should be very careful in choosing a low volatility product. Too often, low volatility strategies are too concentrated in sectors such as utilities and consumer staples, which are historically less volatile but also tend to be negatively correlated to changes in interest rates. So, in an environment of rising interest rates, one would expect these sectors to underperform sectors that are not as sensitive to interest rates. It is this scenario that led us to include sector controls in our FlexShares US Quality Low Volatility ETF (QLV) strategy, in order to mitigate these biases.
What are the potential benefits for advisors of employing factor strategies in client portfolios as opposed to traditional market cap weighting?
Factor strategies can help alleviate the concentration of market-capitalization-weighted strategies in a handful of mega-capitalization companies. Additionally, factors have been proven in the past to help advisors manage their clients’ investment goals, whether it’s growing assets, generating income or managing risk.
A key concept that investors should be aware of is that all equity strategies have factor exposures, whether positive or negative, including options weighted based on market capitalization. The difference is that factor strategies seek to systematically incorporate the factors that have historically compensated investors in their investment processes to achieve a desired investment goal, while exposures to various factors can change over time with a weighted approach. by the market.
What role can factor strategies play in client portfolios?
Depending on the client’s investment goals and preferences, the factors can be integrated in a number of different ways. The most common approach is to incorporate factor strategies into a basic asset allocation to equities. Other investors may view factor strategies as an alternative to active managers, seeing factors as a way to potentially outperform the general stock market at a lower cost than active management.
Factors can also be used to incorporate a view of the market, such as using a low volatility strategy to potentially help mitigate market declines, while participating in stock market rises. In the low interest rate environment, some investors saw this as an attractive alternative to switching from equities to fixed income.