Vanguard, the company known for its low-cost index funds, is now wading deeper into the world of smart beta investing.
The passive investment giant announced plans last week to launch six factor-based active ETFs, and one as a mutual fund. This might seem like a contradiction to the statement a Vanguard spokesperson told me three months ago that they had “no plans” to launch non-market-cap-weighted index funds. However, these are technically active funds rather than index funds.
In fact, Ben Johnson, director of global ETF research for Morningstar, told me they will not be characterized as strategic beta funds (Morningstar’s categorization of smart beta). “These will be classified as ‘active’, as is the case with their London- and Toronto-listed predecessors,” Johnson stated.
The proposed funds will be launched in mid-February 2018 and include:
- Vanguard U.S. Value Factor ETF, which invests in stocks with relatively lower share prices relative to fundamental values as determined by the advisor.
- Vanguard U.S. Quality Factor ETF, which invests in stocks with strong fundamentals as determined by the advisor.
- Vanguard U.S. Momentum Factor ETF, which invests in stocks with strong recent performance as determined by the advisor.
- Vanguard U.S. Liquidity Factor ETF, which invests in stocks with lower measures of trading liquidity as determined by the advisor.
- Vanguard U.S. Minimum Volatility ETF, which invests in lower volatility relative to the broad U.S. equity market.
- Vanguard U.S. Multifactor ETF and Vanguard U.S. Multifactor Fund Admiral Shares, which invest in stocks with relatively strong recent performance, strong fundamentals and low prices relative to fundamentals as determined by the advisor.
Rob Arnott, CEO of Research Affiliates and sometimes referred to as the “godfather of smart beta,” told me the Vanguard announcement was unsurprising. Vanguard hired Denis Chaves, a top smart beta researcher from Research Affiliates, in 2015. Arnott views the announcement as “good news for investors and for Vanguard,” but doesn’t see Vanguard as a competitor to his firm’s RAFI fundamental funds. Arnott stated that “fundamental indexing breaks the link between price and weighting, but I suspect the Vanguard products will start with cap-weighting.”
All funds will have a 0.13% annual expense ratio with the exception of the multifactor funds, which will have a 0.18% expense ratio.
I spoke with John Ameriks, the head of Vanguard Quantitative Equity Group, which developed these ETFs. Ameriks noted he was limited on what he could say during the SEC quiet period before the funds are launched. He said that, in general, the Vanguard approach to factor-based investing is rules-based with some manager discretion and, like smart beta funds, any fund that isn’t market-cap-weighted is active. When asked if these ETFs would be less tax efficient, he replied “any fund that isn’t cap-weighted will be less tax efficient than a broad market-cap-weighted index fund.” I asked Ameriks if, like the RAFI indexes, these funds will also break the link between price and weighting. He responded that, for now, he could not comment on the specific methodology.
Perhaps the most revealing comment is his response to my question as to whether Vanguard viewed these new funds as competitors to smart beta. Ameriks replied that Vanguard Chairman and CEO Bill McNabb, said it best: “If anybody is saying smart beta is a threat to us, I disagree. It’s an opportunity.” Arnott and Vanguard appear to have different views on whether these new ETFs will be competitors to smart beta.
Over the past few years, factor-based investing has generally underperformed the broader market, according to Morningstar. Because of that underperformance, more money has been flowing into plain-vanilla cap-weighted index funds rather than smart beta funds — both in percentages and absolute amounts. Thus, it’s curious that Vanguard enters the field now.
Like smart beta funds, I consider these new Vanguard funds to be viable low-cost active strategies. But active investing is a zero-sum game before costs, and some fail. They especially fail when too much money chases the same factors. For years, I’ve been critical of the Vanguard Market Neutral fund (VMNFX) which, according to Morningstar, has delivered a 10-year annualized return of 0.41%, less than the Vanguard Prime Money Market (VMMFX) 10-year annualized return of 0.53%. (Both numbers are as of November 28, 2017.) The fund returned less than cash but with far more volatility, illustrating just how hard it is to beat the market.
I have no plans to buy or recommend either smart beta or the Vanguard factor funds, even though they are viable active strategies. I’ve found the guarantee that comes with market-cap indexing has a huge psychological advantage. William Sharpe’s simple paper, “The Arithmetic of Active Management,” proves a broad market-cap-weighted portfolio must outperform active portfolios as a whole in the same asset class because of lower costs. Neither smart beta nor the Vanguard factor funds offer this guarantee though, and of course, any equity fund can lose money.
That said, I wish both Vanguard and RAFI-based factor funds all the best. Both are active bets and active bets keep markets efficient, allowing investors in plain-vanilla market-cap weighted index funds to get a free ride. And with so much money flowing into those plain index funds, we need all the active bets we can to keep getting that free ride.
The urge to beat the market is so strong — I don’t worry about markets becoming inefficient anytime soon.