— Paul Amery's Blog

Vanguard sidesteps smart beta

The widely used distinction between passively and actively managed funds dates to the introduction of index funds in the 1970s. Similarly, finance courses teach students that investment portfolios can be separated into beta and alpha components.

Beta is the return you get through systematic exposure to an asset class as a whole. It’s accessible by purchasing an index fund or ETF based on the capitalisation-weighted index. Alpha is then the excess return targeted by active managers. It’s long been standard practice among professional investors to use this mental shortcut and allocate assets accordingly when designing portfolios.

But these simple categorisations don’t help us when it comes to smart beta, the label commonly attached to rules-based investment strategies.

If you want an equity strategy focused on US value stocks, high-momentum shares or quality Japanese companies, there’s a range of smart beta indices available for purchase off the shelf. Many ETF issuers include index-tracking smart beta funds of this type in their product ranges.

For example, iShares’ European ETF range includes funds focused on size, momentum, quality and value factors, all tracking indices from MSCI. Lyxor offers smart beta ETFs targeting quality income, minimum variance, value beta and a number of market factors, based on indices from Société Générale, FTSE Russell and JP Morgan.

So why, when launching a range of similar strategies as ETFs this morning, has Vanguard decided to sidestep the index part of the strategy altogether?

Vanguard’s new ETFs—global liquidity factor, global minimum volatility, global momentum factor and global value factor—are instead labelled as active.

Although these funds offer exposure to essentially the same strategies as index-based ETFs from other providers, Vanguard says its new ETFs will not track an index and there’s no mention of smart beta in the firm’s marketing literature.

Instead, the new Vanguard ETFs use the (cap-weighted) market index as a reference benchmark, while the fund manager’s investment objective is long-term capital appreciation, rather than tracking or relative outperformance.

Vanguard’s approach is consistent with a research paper it published this summer, in which it suggested that smart beta indices should be labelled as rules-based active strategies. The firm has long argued that index-based investing should involve cap-weighted benchmarks and nothing else.

Are these semantic differences important? Perhaps not. But I take Vanguard’s move as a sign of an intensifying turf war between asset managers and index firms over smart beta.

Index firms argue that their smart beta strategies operate on the basis of transparent index rules, providing reassurance to investors that a tracker fund is not going to diverge hugely in performance from what the index does. There are plenty of examples of quantitative investment managers getting their models wrong and blowing up.

Asset managers can claim that they have the quantitative investment expertise to produce smart beta in-house, and that by managing the money themselves they are freed from the obligation to rebalance their portfolios according to a set schedule, something that exposes index-based funds to front-running. And avoiding the use of an index in a smart beta strategy means saving on the licensing fees paid to the index provider.

In Vanguard’s case, the firm is clearly betting that its own name carries more weight amongst potential fund purchasers than the name of an index firm attached to the product.

Regulators may yet become more involved in the competitive battle between fund and index firms. There’s long been a legal loophole by means of which asset managers are prohibited from advertising products that use back-tested performance data, whereas index firms—since they are not treated as product promoters—may do so when describing how indices work.

If you think smart beta is a good thing, rather than a marketing gimmick, this turf war is good news, since fees are coming down. Vanguard’s new factor ETFs cost 0.22 percent a year, undercutting similar strategy ETFs from other providers. But the increasing confusion over terminology means navigating your way around competing investment products isn’t getting any easier.

  • Frederic

    The idea that a capitalisation weighted index of a subset of assets is the market portfolio of the CAPM and/or an efficient portfolio are common misconceptions grounded in the observation that active managers (on the whole) fail to over-perform such a gauge of the market – the same observation that led John Bogle to start a revolution in the investment management industry (on the absence of link between finance theory and such indices, refer to: http://www.edhec-risk.com/edhec_publications/all_publications/RISKReview.2010-06-29.1943 ). And finance theory did not stop with the single-beta CAPM, whose insights but poor fit with the data spurred an intense research activity which led to the first multi-beta models in the 1970s, starting with Merton’s ICAPM and Ross’ APT. Smart beta indices and strategies seek to address the two main issues of broad capitalisation-weighted indices: their inefficiency (the tailed distribution of capitalisations causes them to be concentrated in a small number of securities) and their less than optimal exposure to the various rewarded factors beyond broad market risk.

    The Vanguard move and choice of vocabulary are consistent with the company’s characterising smart beta as active https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/article/IWE_InvComSmartBeta and its reservations about some non capitalisation-weighted indices – the company’s 2012 paper titled Joined at the Hip https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/article/IWE_InvResJoined observed that a majority of ETFs launched with indices less than 6M old and it provided indication that live index performance was disappointing relative to simulated performance, pointing towards robustness risks.

    To the extent that a strategy is systematic and robust, availing of a long-term simulated track record can be extremely useful to make a decision to invest and subsequently risk manage an investment. FINRA has acknowledged that much in a 2013 interpretative letter https://www.finra.org/industry/interpretive-letters/april-22-2013-1200am that listed conditions for the use of pre-inception performance data in institutional communications (including notably total transparency of methodology allowing users to “clearly understand how the PIP data could be replicated, using readily-available market data” and information about performance conditionality and robustness risks). Likewise the 2012 ESMA rules on ETFs and other UCITS intended to protect investors by requiring tracked indices to not only be systematic but also fully transparent to allow investors to assess the robustness of methodologies and audit track records (looking at some of the new products out there, implementation has been patchy to be kind).

    Naturally, where an index is non-transparent, the assessment of its systematic nature and other sources of robustness risks becomes more difficult (key risks to consistent performance in the same market conditions are: in-sample mining of factor definitions and/or overall model and/or model ad-hoc constraints producing alluring back-tested performance; relevance of assumptions and quality of parameter estimation, where relevant; diversification of idiosyncratic and control of other undesired risks – for more, refer to this 2015 article on the topic of robustness of smart beta strategies: http://www.scientificbeta.com/download/file/robustness-smart-beta-strategies-jii-summer-2015).

    Against this backdrop, it is regrettable that the index provision industry has very effectively lobbied against regulators’ efforts to improve transparency of indices leading to the IOSCO Principles for Financial benchmarks which enshrine opacity and the proposed European Regulation on the same which has been stripped of the transparency ambitions initially set forth by the European Commission. Ironically, having condoned opacity of indices, regulators are now voicing concerns about the risks of smart beta in relation to inadequate disclosure and transparency…