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.