Vanguard's New Smart-Beta ETFs: Advisors Wonder, Why Bother?
Tilting investment portfolios to market factors that a wealth of academic research points to as driving returns over time is finding a growing audience among American investors. Indeed, a wave of factor-based funds are pouring into the market. By some estimates, such "academic rigor" now accounts for 20% of the U.S. ETF market alone.
So it’s not surprising industry heavyweight Vanguard is finally jumping into the fray. The funds giant launched five ETFs last month that focus on single elements believed to be key to driving long-term market performance. Those are: value, earnings quality, momentum, liquidity and minimum volatility. Another ETF, along with a sister share-class mutual fund, combines such tilts into an all-encompassing "multifactor" offering.
Each single-factor fund comes with bargain basement expense ratios of 0.13%. The multifactor version charges an annual management fee of 0.18%. "Vanguard isn’t the cheapest in the factor market -- J.P. Morgan, for one, actually has a low-volatility product that costs even less," says Todd Rosenbluth, director of ETF and mutual fund research at CFRA.
What makes Vanguard’s funds unique, he adds, is that they combine a predefined set of rules to build a portfolio and target specific stocks. That should appeal to index fans, Rosenbluth observes. But on the edges, he points out positions are subject to change by each fund’s managers as they see fit.
Such an indexing and active management combination probably presents Vanguard’s factor funds as a more sophisticated pitch to investors, Rosenbluth says. As a result, he expects the asset manager to target advisors to help sell the new lineup to their clients.
And the veteran ETF analyst believes Vanguard’s hefty brand recognition along with the low fee structure should prove a compelling proposition for advisors and their clients.
Officially, Vanguard’s new factor ETFs are being marketed as its first actively managed equity portfolios.
Through January, some 785 mutual funds and ETFs with a "strategic beta" emphasis were being sold in the U.S., estimates funds researcher Morningstar. The vast majority (711) were through ETFs. Combined, all open-end funds falling in that category had nearly $927.2 billion in assets.
But not everyone is sold on the Vanguard methodology to attack factor-based investing, which is sometimes also referred to as smart beta.
"I’m a big fan of Vanguard and use a lot of their funds in our client portfolios," says Pittsford, N.Y.-based advisor Mark Armbruster. "But these are considered part of their active funds group, which goes against the grain of how many of the biggest players are approaching this type of investment strategy. It’s not what a lot of factor investing enthusiasts expected from Vanguard."
With strictly index-based factor funds, he’s willing to dip into new offerings from time to time. But given that these Vanguard ETFs are being categorized as active strategies, Armbruster is applying a philosophy he uses with other actively run funds: "We don’t jump into active strategies without several years of performance and portfolio-level data available -- we demand to see a strong track record from any active manager we invest alongside."
Another issue he sees is that the Vanguard reps he works with aren’t giving him back-tested data or corresponding information relating to how different factors trying to be captured by these new funds interact with the broader market. Such factor coefficient data, Armbruster suggests, is critical for evaluating a new smart-beta fund.
"There are a ton of factor-based funds on the market today," he says. "So the overriding question is how much tilt to each factor these funds are providing compared to everything else out there."
Other advisors also are voicing frustration at a perceived lack of detailed information about the new ETFs. Indeed, requests by FA-IQ for back-tested and specific factor-related data have been greeted by a Vanguard spokeswoman with the following written response: "(The) short answer is we can’t. Per Finra rules, we are unable to show back-tested results for the U.S. factor funds because these are active products."
Advisor Roger Hewins, another Vanguard fan, also isn’t planning on adopting its new factor ETFs into client portfolios. He points out that such a debut comes more than 35 years after theories incubated at the University of Chicago were put into practice by the formation of a commercial asset-manager, Dimensional Fund Advisors.
"Our approach is very consistent with the core DFA philosophy -- we’re sticking to a rules-based strategy and not doing a lot of trading," says the president of Hewins Financial Advisors, which manages nearly $5 billion and is headquartered in Redwood City, Calif.
He’s also concerned about using Vanguard’s factor funds without understanding how extensively each strategy tries to dive into each factor. "We know that our clients can get exposure to deep value stocks using DFA funds," Hewins says. "But we’re still not clear how much of the value factor will be captured by Vanguard’s new factor funds. As active strategies, it’s going to probably take years to see just how they’ll perform through different market cycles."
Vanguard is making members of its factor investing team available to advisors and the media. A key point being emphasized by Matt Jiannino, the asset manager’s head of quantitative equity product management, is that none of these funds must adhere to a specific index.
"The objective here is to maintain exposure to each fund’s respective factors following a specific list of rules," he says. "But our management team does have some discretion around trading -- that’s where active management comes in, on the implementation side."
Also, the single-factor funds divide the Russell 3000 into three buckets by size: large, mid and small caps. "When we go to weight securities within each bucket, we don’t care about market size -- our rules-based system is looking at exposure to each different factor," Jiannino says.
The minimum volatility fund operates a bit differently than other single-factor funds, adds Vanguard senior portfolio manager Antonio Picca. "It has a very different objective than the other factor funds -- it’s constructed as a truly defensive portfolio," he says.
Other nuances are that the minimum volatility fund isn’t segmenting domestic stocks by market-cap size buckets and expects to hold as many as 400 different names. That might wind up being twice as many as several of its rivals hold, Picca notes. "The idea is to diversify this portfolio to take better advantage of how stocks move in comparison to one another," he says.