There’s so much noise out there in factor-land: promises of spectacular return, philosophical arguments about the nature of markets, competing Nobel Prize awards … it’s hard to keep track.
At Inside ETFs 2018, one of the marquee panels is “Beyond the Hype: Strategically Implementing Factor ETFs.” We’re gathering five of the world’s leading experts to discuss the truth about factors and factor strategies. One of the people joining that panel is John Ameriks, global head of Vanguard’s Quantitative Equity Group. Vanguard recently filed to launch a suite of actively managed factor ETFs.
Inside ETFs CEO Matt Hougan recently chatted with Ameriks to learn Vanguard’s plans and what he intends to talk about at the conference.
Matt Hougan: There’s a lot of noise about factor investing in the market. What do investors need to know about factor investing they don’t know already?
John Ameriks: One of the things that’s really important is you should approach thinking about factor-based investing the same way you do investing in other active strategies. Factor investing simply brings a quantitative discipline to the choices active managers make about investing.
Hougan: Active strategies?
Ameriks: Yes, factors are active strategies. The truth is, chartered financial analysts, academics and researchers have been thinking about investing through a factor lens for some time; we’re just now getting into an era where practical tools to implement those strategies are available to investors. My goal at the upcoming Inside ETFs conference is to try to get people to understand why that matters, and what it means about how they approach evaluating factor strategies.
Hougan: Let’s take a step back first: What problem do factor ETFs actually solve for investors?
Ameriks: The one that gets the most attention—and possibly too much attention—is, historically, certain factors have been associated with excess returns.
Over time, at least some subset of factors has delivered higher-than-market returns, with total levels of risk similar to the market as a whole (although the nature of that risk is different). Moreover, there are well-developed reasons and out-of-sample data suggesting there’s a high likelihood this may persist over time.
Factor-based investing gets at the systematic sources of return that successful active managers have been able to capture. Factor-based strategies do so in a package that’s more transparent, better-constructed and potentially lower cost.
Hougan: You sound skeptical about the true sustainability of those excess returns.
Ameriks: Only because it’s easy for people to get swept up in the excitement of the idea without understanding the nature of the risks they’re taking on. We want people to fully understand they’re making active bets when they buy factor ETFs, and active bets come with the potential to both out- and underperform.
Hougan: What other problems do factor ETFs solve?
Ameriks: They help diversify the risks in a portfolio. If you have a portfolio you’re passionate about, factor analysis can show you if you’re over- or underweight certain factors, and factor ETFs can help you balance out those risks.
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.