Creating Alpha Through Beta Funds

October 11, 2018

Think an old-fashioned market-cap-weighted basic index fund can’t add alpha by beating its benchmark? Think again.

The Vanguard Small-Cap ETF (VB) not only bested the benchmark, but it’s likely to continue to do so. And I’ll tell you why. But first, some background.

Dumb Articles Can Lead To Good Insights

A few weeks ago, I ran into the following article from Zacks Investment Research: Is Vanguard Institutional Index Plus a Strong Mutual Fund Pick Right Now? Aside from picking a share class of the S&P 500 index fund requiring a $100 million minimum investment, and noting it had a beta of 1 (equal to the benchmark), the article offered this puzzling analysis: “With a negative alpha of -0.01, managers in this portfolio find it difficult to pick securities that generate better-than-benchmark returns.”

That a fund meant to mimic the total return of the S&P 500 Index underperformed the total return of that same index seems like a no-brainer to me. The minor insight is that it underperformed by less than the expense ratio. I discovered years ago that Vanguard made up some of the expense ratio through securities lending and trading techniques. Still, after costs, there is no net-positive alpha.

Vanguard Small Cap Index ETF Bests The Benchmark

The ETF share class of this index fund (VB) was launched on Jan. 26, 2004, returning 9.81% annually through Sept. 30, 2018. Yet it actually bested the total return of the index (presently CRSP US Small Cap) by 0.06 percentage points annually, and actually created alpha.

While it currently has a 0.05% expense ratio, the simple average since inception was a 0.10% expense ratio, implying that it created gross outperformance average of 0.16 percentage points annually, which is far more than the S&P 500 Index fund.

So, I decided to delve into more detail to determine where these 0.16 percentage points a year came from.

Jim Rowley, Vanguard’s head of Active/Passive Portfolio Research, explained that small-cap stocks have a “scarcity premium” and command a greater rate to borrow the securities. Thus, Vanguard can charge a higher rate to lend those securities.

Though practices vary by institution, Vanguard returns 100% of all lending revenue, net of operating costs, to the investors who own each Vanguard fund. That’s not always the case among other issuers, which make a profit from lending shares to short-sellers.

Rowley noted that Vanguard minimizes risk from securities lending in two ways. First, it takes collateral of at least 102% of the value of the securities lent. Then it invests that cash received as collateral in a money market fund managed by Vanguard rather than take risk with the collateral.

With rising money market rates, it’s possible that securities lending could be more profitable than in the past several years, all else being equal. (More specifics can be found in this Vanguard paper on securities lending.)

In addition to securities lending, Vanguard says it also gains a few basis points or more from trading practices, though I have little specifics.

Alpha Implications To Your Investing

I’m a believer in William Sharpe’s Arithmetic of Active Management, upon which one can extrapolate and reach the conclusion that, properly measured, alpha is a zero-sum game before costs, and negative in the aggregate after costs.

Sharpe is mostly right, but if the financial institution is skilled in securities lending and trading practices, and returns those gains to its fundholders, it can add alpha before costs. And in certain situations and types of funds, even after costs.

While .06 percentage points of annual alpha may not seem like much, Morningstar shows small-cap core funds on average underperformed VB by 1.68 percentage points annually, so contributed a large amount of negative net-alpha. Your best odds for alpha may be in this beta fund.

Though low expense ratios are critical, perhaps we should be looking at “net expense ratios” that would add back profits from securities lending returned to shareholders, and the amount of value added from trading practices. Of course, we won’t know those gains going forward, but in this rare case, past performance probably is indicative of future performance.

Author’s note: The Vanguard benchmark for VB was the MSCI US Small Cap 1750 Index through Jan. 30, 2013, and CRSP US Small Cap Index thereafter.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.

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