Vanguard Takes Active Factor ETF Approach

February 15, 2018

Today Vanguard is entering a space no one really thought to see them in, and it’s doing it entirely on its own terms. The firm is rolling out a family of factor ETFs, which is typically thought of as being part of the smart-beta trend, except these funds are actively managed and are Vanguard’s first actively managed ETFs.

The six ETFs rolling out today comprise five single-factor funds and a multifactor fund. The products, their tickers and expense ratios are as follows:

The family of funds lists on Cboe Global Markets, the parent company of ETF.com.

All of the ETFs can select their holdings from across the size spectrum of U.S. stocks, and rely on a quantitative model to evaluate potential holdings. The funds use a rules-based screen to ensure diversification and limit exposure to certain less liquid stocks, according to the prospectus.

“For us, this kind of rounds out a suite of offerings for investors, ranging from our active products to our index products, and now factor products. We think that these can play a role in certain investors’ portfolios,” said Matthew Jiannino, head of quantitative equity product management at Vanguard, whose group manages the funds.

“The exciting thing for us is this idea that the technology advancements that have happened over recent years really allow investors to look at their portfolios through a factor lens,” he added. “These are products that, once they understand what those exposures are, can … potentially help them reach some sort of goal in their portfolio.”

Surprising Development

At first glance, the launch seems like it’s coming out of left field. Vanguard has been consistently skeptical of popular trends like smart beta. While it has $1.2 trillion invested in its actively managed funds, it really is known as the firm that originated and popularized index funds under its founder John Bogle.

Its products could almost all be described as “plain vanilla” and broad based, which makes actively managed funds targeting individual factors a bit of a surprise.

Moreover, Vanguard is very thoughtful in how it brings new products to the market, with maybe one or two funds launching a year. A cluster of six launches is practically unheard of.

Forging Its Own Path

However, Vanguard is also known for doing things its own way and doing things in its own time (consider how long it took the company to launch international fixed-income ETFs), and the new fund family occupies a space all its own. These are actively managed factor funds, for one thing, even if they are quantitatively driven. Virtually all of the funds currently marketing themselves as multifactor or single-factor ETFs are index-based.

Jiannino says the decision to use an active approach relates to how Vanguard thinks about markets in general.

“For cap-weighted portfolio management, indexing makes perfect sense. With factor funds, you’re really now deviating from a market-cap weighting, and to us that’s an active decision.” he explained. “It was very important for us to manage that portfolio the way we would manage any of our other active strategies.”

“This allows us to maintain a targeted exposure to the factor over time, so that as the factor may decay in the portfolio, the portfolio manager is going to have the discretion to turn over the portfolio as needed to maintain exposure to that factor long term,” Jiannino added.

 

In other words, an index wouldn’t give the fund managers the ability to use their discretion to adapt to changing markets. With market cap weighting, he notes that the market does the adjusting for you.

“Here, we’re no longer weighting by a stock’s market capitalization. We’re using the stock’s exposure to the factor to determine its weight in the portfolio,” said Jiannino. “So now as that factor changes in the marketplace, we want to have the flexibility to turn over the portfolio as needed to maintain that exposure.”

Different Perspective

Perusing the list of new funds, someone familiar with factor investing might be surprised to see the liquidity factor ETF, VFLQ, in the lineup. After all, there are no other ETFs that specifically, solely target that particular risk premium.

Another interesting point is the fact that there’s no ETF among the new offerings focused on the small-size factor. That all has to do with Vanguard’s unique perspective.

“We really think [VFLQ is] a differentiated product for us. When we look at size and small-cap, we really feel that when investors are investing in that space, a lot of times what they’re trying to get exposure to is liquidity,” said Jiannino. He further notes that Vanguard sees factors as phenomena that can be seen across the market capitalization spectrum.

“We liken the exposure to how when you think about real estate or private equity, a lot of what you’re trying to get exposure to or get compensated for in those spaces is liquidity,” he noted. “The same thing exists in the equity market. Less liquid names tend to outperform the more liquid names over the long term.”

Another interesting aspect of the factor ETF lineup is the construction of VFMF, the multifactor fund. Rather than taking a top-down or sleeve approach to creating the fund by combining three separate strategies, Vanguard implements a bottom-up approach.

“We’re going to combine momentum, quality and value into a factor score for the individual stocks and then create a portfolio that gets exposure to that combination of individual factors,” Jiannino said. “It’s not that we’re combining a separate value portfolio, momentum exposure or quality portfolio. It’s the interaction of all of those signals that determines a stock’s exposure in the portfolio.”

VFMF primarily targets the quality, momentum and value factors.

Advisors In Focus

Despite the fact that they’re actively managed, some investors might be tempted to lump the new Vanguard ETFs into the ubiquitous smart-beta category where most factor ETFs end up. However, that would be a mistake.

“We’ve always taken the view that the term ‘smart beta’ is really a marketing term. It’s kind of become a catch-all phrase for a lot of different products, but we see factors as really what we’re trying to provide investors in this space,” Jiannino said.

He says Vanguard designed the funds primarily for advisors, and that the firm believes the new funds should be a strategic hold in a portfolio.

“For example, if you want to have a long-term tilt in a client’s portfolio, you might tilt toward a factor, noted Jiannino. “You might have a high-cost active fund where you were getting exposure to value, you’re paying a lot for that exposure, and you might substitute [in] a factor to get that exposure at a much lower cost.”

However, he is also quick to point out that these are products that come with a certain amount of risk.

“This is not market-cap weighting. These are active portfolios,” explained Jiannino. “There’s a lot of risk involved, a lot of variability and tracking error to the broad market. We really feel strongly that these are for advisors to use potentially in their portfolios.”

Finally, when it comes to expense ratio, Vanguard—always known for its low costs—has again forged into new territory. These are by far the cheapest actively managed equity ETFs by at least 20 basis points, given that they cost just 0.13% for the single-factor funds and 0.18% for VFMF. That’s cheaper than the vast majority of plain-vanilla index-based ETFs.

“We’re going to offer the funds at what it costs to run the funds,” Jiannino promised.

Contact Heather Bell at [email protected]

Find your next ETF

Reset All