Ask the stock market how the economy is doing, and it'll tell you: Just great, thanks.

Judging by the equity markets, the COVID-19 pandemic is securely in the rearview mirror and has been since the vaccine announcement in November 2020. But all may not be as rosy as it seems.

Analysts at Northern Trust FlexShares Exchange Traded Funds warn investors against becoming too complacent. Macroeconomic events, such as unprecedented fiscal stimulus and the huge expansion of central bank balance sheets, could lead to inflation and rising interest rates. Both pose risks to unprepared investors. The question, then, is how to prepare for those risks.

[Read: Advisors Urge Clients to Plan Ahead for Possibility of Inflation.]

According to Northern Trust's analysis, factor-based investing is the ideal way to manage macroeconomic risks. Factor-based investing involves investors targeting specific drivers of return, 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, about the factors financial advisors should be paying attention to in the current market and how they can implement factor-based investing in their clients' portfolios. Here are edited excerpts from that interview.

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How would you describe the current economic environment, and what are your expectations for the rest of 2021?

The global economy is continuing to recover from the lockdowns caused by the COVID-19 pandemic. Though some parts of the world continue to struggle with the impact of the virus, developed economies have made progress in reopening commerce with the help of fiscal and central bank support.

Equity markets continue to see gains in the rapidly reopening economy, particularly here in the U.S. In general, corporate fundamentals have proven to be resilient, and public companies have emerged from the pandemic better than expected. One key trend we have observed is that the recovery has moved from a general reflation trade benefiting all stocks to a period where investors look as if they are rewarding higher-quality companies. Our expectation is that this should make for a more enduring recovery and benefit investors for the remainder of 2021.

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Which equity strategies should advisors use in investor portfolios to maximize returns in this type of environment?

We believe strategies that systematically target 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, the size, value and quality factors have done well during periods of economic recovery, and the current environment looks to be matching those historical trends. Through the first five months of 2021, the size factor has been positive, with the small-cap-focused Russell 2000 index outperforming the Russell 1000 index (which tracks the 1,000 largest companies by market capitalization).

Value has seen even greater outperformance, with the Russell 3000 Value index outperforming the Russell 3000 Growth index. Even when controlling for the sector biases within these indices, we find that value stocks have significantly outperformed growth stocks year to date.

Strategies that efficiently give exposure to size, value and quality factors while controlling for risks, such as sector biases, are a good way to introduce factors into your portfolio.

How do the rate environment and future moves by the Federal Reserve play into this factor analysis?

We are always mindful of how changes in rate expectations and central bank policy can affect equity markets and factor-based strategies. As we saw with the June Federal Reserve meeting, investors can react even when there is no change in the Fed's target interest rate or continued monetary stimulus. Markets interpreted 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 longer end of the curve moved lower.

This type of rate environment is known as a "bear flattener," and historically, we find that the size and value factors have done well in these periods. That has led to increased client interest in our FlexShares Morningstar U.S. Market Factor Tilt Index ETF (ticker: TILT), which looks to integrate the size and value factors into the fund's portfolio design.

What type of market event would signal investors and advisors to pivot to a more defensive factor?

One risk scenario that would cause investors to pivot toward defensive strategies would be if the Fed moved too quickly to increase the target rates or remove monetary stimulus, impairing the economic recovery and negatively impacting stock prices. Most likely, this change in Fed policy would be to combat enduring high inflation or an increased desire among the voting members of the Federal Open Market Committee to return to a normal monetary environment.

Under this scenario, investors could turn to low-volatility strategies, but they need to be very careful in their choice of a low-volatility product. Too often, low-volatility strategies are overly 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 where interest rates are rising, the expectation would be for these sectors to underperform sectors that are not as interest rate sensitive. It is this scenario that led us to include sector controls in our FlexShares U.S. Quality Low Volatility ETF ( QLV) strategy, to help mitigate these biases.

[Read: Alternatives to the 60/40 Portfolio.]

What are the potential benefits for advisors to employ factor-based strategies in client portfolios as opposed to traditional market-cap weighting?

Factor-based strategies can help mitigate the concentration that market-cap-weighted strategies have into a handful of megacap companies. Additionally, factors have been historically proven to help advisors manage their clients' investment objectives, whether that be growing assets, generating income or managing risks.

A key concept that investors need to be aware of is that all equity strategies have factor exposures, positive or negative, including market-cap-weighted options. The difference is that factor-based strategies look to systematically incorporate those factors that have historically compensated investors into their investment processes to achieve a desired investment goal, whereas exposures to various factors can shift over time with a market-weighted approach.

What role can factor-based strategies play in client portfolios?

Depending on the client's goals and investment preferences, factors can be incorporated in several different ways. The most common approach is integrating factor-based strategies into a core equity asset allocation. Other investors may look at factor strategies as an alternative to active managers, viewing factors as a way to potentially outperform the general equity market at a lower cost than active management.

Factors also can be used to incorporate a view of the market, such as using a low-volatility strategy to potentially help mitigate market downturns, while still participating in equity market upswings. In the low-interest-rate environment, some investors have viewed this as a compelling alternative to shifting out of equities and into fixed income.

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