Hougan: Vanguard announced plans to launch active factor ETFs in the U.S. Why go active?
Ameriks: There are multiple reasons, but the big one is philosophical: We wanted to make sure investors understood what they were getting.
Vanguard’s biggest concern with factor strategies is that, when you tell a client they’re investing in an index fund, they think they’re getting broad-based exposure to the market.
To the extent investors are trying to outperform or get an exposure that’s different from the market, we think that’s an active strategy. So, part of offering active ETFs is ensuring investors know they’re getting something different from the market as a whole.
The second piece has to do with how we manage the fund on a day-to-day basis. For starters, an active approach allows you to maintain a more consistent exposure to a given factor and to the stocks that are most attractive in that factor at all times.
If you have a momentum factor index, for instance, and it rebalances quarterly, the stocks you hold may lose their momentum characteristics between each rebalance. Having an active approach allows you to rebalance as needed to maintain consistent exposure.
At the same time, you aren’t forced to rebalance and trade if that trading isn’t going to impact your factor exposure, so you can be more efficient in the management of the portfolio.
Hougan: How should investors compare and contrast competing factor ETFs?
Ameriks: It gets increasingly hard, as there are more and more options in the space.
The advisor should first screen available strategies on a variety of core metrics: cost, diversification, level of risk, transparency. Once you narrow the list to those options that meet your core criteria, you can start doing due diligence on the underlying methodology and practice.
If you’re looking at value funds, for instance, you need to ask how the funds define value: There are concepts within value investing that look at distressed companies and beaten-down stocks, and there are others that look more toward fundamentals like revenues, sales and profitability. Which do you want? You need to understand the philosophy and the approach.
Hougan: You didn’t mention past performance. We both know investors always look at past performance. Is it valid, or completely irrelevant, in factors?
Ameriks: You have to be very careful when looking at performance in any category, but particularly in factors.
To make just one case against it: Consider factor intensity. Let’s imagine you’re looking at value funds, and you evaluate them over the past three years. And let’s say that the last three years were terrible for value. You wouldn’t want the best-performing value fund over that time, because it probably doesn’t have much real exposure to value.
In fact, you might want the worst-performing value fund, because it probably has the most intense loading on that factor. So you always have to be careful with past performance, but you have to be extra careful in the factor world.