Vanguard wrestles with orthodoxy in quant unit's smart beta push
Are smart-beta funds active or passive? For Vanguard, the cost of debating that point has been nearly $800 billion.
At least, that’s how much the rest of the mutual fund industry has amassed in the investment strategies, money management’s hottest innovation since the ETF itself. Only the smallest sliver has gone to Vanguard, thanks to years of soul-searching over how to market the concept without alienating clients trained to resist Wall Street innovations.
But the trend is no fad, and incoming CEO Tim Buckley seems finally ready to pull the trigger on smart beta ETFs in America. Competitors are watching closely, desperate to see if Vanguard has waited too long in its quest for intellectual purity to make up the five-year head start given the rest of the industry.
“Their view is that we have to be very careful in entering any space, and the terminology describing it,” said Dana D’Auria, director of research at Symmetry Partners, which oversees more than $8.5 billion. “It’s a big organization, and I don’t think there’s necessarily the same view on smart beta and factor investing across the whole organization.”
Most of the firm’s reticence has come down to a marketing debate tied to Vanguard’s core identity as an index investor. Executives have been paralyzed by the question of what to call mutual funds and ETFs that group like stocks in categories such as high-momentum or low volatility, known as investment factors. Are they active or passive?
Outgoing CEO Bill McNabb, loath to offend a clientele that has pumped more than $4 trillion into his funds, parses the nomenclature with a deliberation that borders on goofiness.
“I’ll call them mechanical active,” McNabb says during an interview at the company’s offices. ”I don’t believe in this smart beta concept. I don’t think anything is smart about it.” On the other hand: “Some of the factor stuff, we think, is very legitimate.”
Ambivalence at the world’s second-largest asset manager has made smart beta a goldmine for everyone else. BlackRock said the category expanded at a 37% organic rate in 2016, making it one of its biggest growth segments.
It’s not that Vanguard is opposed to active management — about one-third of the firm’s assets are in stock picking strategies. It’s just that it likes a clear distinction between those types of funds and index-tracking passives. And that is a line smart beta was designed to blur. Billed as hybrids, the idea is to let computers armed with an idea of which stocks beat the market assemble portfolios that are only rarely tweaked.
At Vanguard, obstacles to its adoption reflected skepticism at the highest level. Everyone from legendary founder Jack Bogle to longtime chief investment officer Gus Sauter lambasted the concept for years, saying there’s no better “beta” than market-cap weighted indexes.
A big break in the opposition came when Buckley took over as CIO from Sauter in 2012. It was then that Vanguard began to test more experimental strategies like smart beta. Though Buckley voiced skepticism about quant and beating the market in general, he was more open to the idea from a business perspective, according to a former employee who requested anonymity to speak freely.
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That employee worked for a key player in the saga, Vanguard’s Quantitative Equity Group, established in 1991 and long relegated to managing old-school quantitative products that use accounting metrics to mimic fundamental active managers.
A QUESTION OF SEMANTICS
A year after Buckley’s appointment, QEG executives pitched and won Vanguard’s first contract to manage a close cousin of smart beta ETFs, factor-based mutual funds that exploit market anomalies like size or volatility. The first, Vanguard’s Global Minimum Volatility fund, started in 2013. Since 2015, it’s launched three more global factor mutual funds and eight factor ETFs abroad.
Vanguard says it was always a question of semantics, not disapproval of the concept itself. Executives especially hated the term smart beta because of its connotation of passivity — "beta" is Wall Street lingo for the market’s overall return.
“Very early, there was an enormous amount of noise and confusion in the industry as to what this was. It was being pitched as a replacement for indexing, and that really got people riled up,” said John Ameriks, head of QEG. “That’s one of the reasons why you haven’t seen more stuff from Vanguard. We’ve been very consistent with saying this is active.”
Vanguard has struck an intellectual workaround of sorts. The products are active, and shouldn’t be based on an index at all, they argue. Instead, Vanguard sells active factor ETFs in Canada and U.K., and has sought permission to sell actively managed ETFs in the U.S. That way, the funds aren’t based on an index, but are managed by QEG to allow for more frequent rebalancing and purer factor exposures.
QEG manages $2.2 billion in factor investing portfolios, and $222 million in its Canada and U.K. ETFs. The firm decided to pursue not just factor mutual funds but ETFs because “investor appetite for these products are most pronounced among those who prefer ETFs,” said Rich Powers, head of Vanguard ETF product management.
But in the U.S. ETF market, the company will be entering a mature space, where smart beta assets have more than doubled in four years. While Vanguard already offers U.S.-list value and growth ETFs, many managers and industry experts don’t consider them smart beta since they’re market-cap weighted.
But there’s still an opportunity for Vanguard to chip away at BlackRock’s stronghold. It’s targeting advisers, one of the largest consumers of smart beta, known to trust the Vanguard brand. Still, their products may not be as straightforward or familiar as their competitors, considering actively managed ETFs only make up 1% of the entire ETF industry.
“The right answer for us was to sell these as an active fund, even if that means it’s a harder slog,” Powers said. “It’s more difficult to be a sales person with these products. That’s OK because we wanted to structure these products right.”