Factor investing another step in the evolution of the adviser’s role

The growth of factor-based investing, as explored in last week’s cover story by Jeff Benjamin, underscores the evolving nature of portfolio construction. The trend also indicates how the role of a financial adviser is being morphed by an environment shaped by rapid advancements in technology and changing consumer preferences — raising fundamental questions about financial decision-making for advisory clients.

As the story explained, factor-based investing looks at several characteristics associated with higher returns or lower risk in deciding which equities should be included in a portfolio. These characteristics include momentum, value and volatility, among others. According to a recent report by Morningstar Inc., almost $800 billion is now invested in nearly 1,500 factor-based exchange-traded products, up from approximately $700 billion a year ago and $600 billion two years ago.

In addition to increased use of factor-based ETFs, advisers are doing more factor-based analysis themselves. Following the lead of institutions and academics, many advisers now believe that factor-based analysis constitutes an improvement in portfolio construction and risk management, and that it also tends to yield better results than trying to find active managers who can consistently outperform the market.

More than just the adoption of a new way to analyze stocks or a new product, the move to factor-based investing and factor-based ETFs marks a shift in where investment decision-making actually takes place and who is making those decisions.

Traditionally, of course, financial advisers — whether registered representatives or investment adviser representatives — made investment decisions themselves, often based on suggestions and research from their firms (and sometimes based on what the broker-dealer employer of a rep had in inventory). To be sure, the investment menu was rather limited: stocks, bonds and actively managed mutual funds, which themselves often were derided as “packaged products” by advisers who felt they could do better than the “packagers.”

The deregulation of commissions, the inflation of the 1970s and changes in the tax law in that decade, as well as the rise of independent broker-dealers, created a new landscape. The arrival of discount brokers meant some clients would handle investing themselves. The growth of money-market funds, which paid more than regulated bank deposits at a time of rising inflation, exposed millions of investors to mutual funds for the first time and turned many former savers into investors.

And the rise of independent broker-dealers and the RIA channel gave advisers the freedom and flexibility to craft client portfolios themselves.

As these changes unfolded, many advisers continued to construct portfolios themselves, but increasingly they turned to professionals — through mutual funds or separately managed accounts — after a general allocation was made. Choosing managers, therefore, became the financial adviser’s role, while individual security selection was ceded to professional managers.

The growth of index mutual funds and ETFs created new opportunities for portfolio construction, since an investor’s core equity exposure to a diversified universe of stocks could be handled in one low-cost investment.

With the rise of factor-based investing or any other strategy that drills down on particular screens, decision-making has come to include the makers of the analytics tools that measure securities’ exposure to various factors.

In one sense, factor investing can be seen as the latest in a long series of steps that remove the adviser from direct investment selection. But in fact, as advisers step away from — and find less demand for — their role as stock- or investment-pickers, their role in financial decision-making on behalf of clients becomes more important and their value potentially greater.

Helping clients frame their overall financial goals around their children’s education and their own retirement, for example, and then helping them construct realistic spending, saving and investment plans designed to achieve those goals, while taking into account their individual risk tolerance, is becoming the core of financial advice.

While advisers may wind up making fewer decisions about specific investments, in the future they will be helping to make more decisions in the areas of their clients’ lives that matter most.