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A different approach to factor-based funds

09 November 2018 | Investing

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 The market is saturated with factor-based funds, and they're getting loads of attention in the financial press.

Some financial services providers who offer factor-based funds take significantly different investment approaches, despite the fact that the products have similar investment objectives. The way the funds are marketed by providers can also be quite different.

This interview with John Ameriks, global head of Vanguard Quantitative Equity Group (QEG), seeks to help you make sense of the sector and understand how Vanguard approaches these products.

Over the last few years, there have been literally hundreds of new products launched that attempt to provide factor exposure. Can you talk about the process Vanguard takes in developing new products?

The past few years have seen dramatic changes in technology that allow investors to better understand and interpret the underlying factor exposures that exist in their portfolios. In light of these changes, the increasing supply of investment vehicles that allow investors to directly target factor exposures is not surprising. Sadly, it's also no surprise that many asset managers have tended to oversell potential benefits and undersell any risks in an attempt to establish market share in a new area. Vanguard has been far more deliberate in approaching this space for a simple reason: We don't have an incentive to launch products simply to take advantage of "profit" by selling what's hot.

How should investors be using these products?

The key to our offering, and to helping investors use these products effectively, is a clear articulation of the basic nature of these products. Like any strategy that deviates from the goal of representing the performance of a market, factor-based strategies are fundamentally active investment strategies. Their goal is not to represent a market – it's to get exposure to a targeted factor. As such, we manage our factor strategies actively and our ETFs as active products.

We believe our factor ETFs allow investors to far more directly control their exposures to important factors in a very transparent and low-cost way. Once the factor exposure of an existing portfolio or a fund is understood, our ETFs can potentially be used as a substitute for high-cost active approaches that deliver similar exposures. The ETFs can be used to offset undesired exposures or to fill a portfolio gap. They can be used to tilt a portfolio more in a direction that an investor believes will enhance return or decrease volatility.

What makes Vanguard's factor ETFs different?

Even though factor investing is an inherently active decision, the vast majority of our industry has adopted what they sell as an "index" approach, offering products that passively track an investment strategy developed by a third party and delivered as an ETF. In many cases, the primary objective of index providers is high capacity and investability. For this reason, "indexed" options tend to focus on large-capitalisation stocks and rely on some form of market-capitalisation-based weights, at the expense of factor exposure. The cynic in me says that choice, in the end, again, is about others' incentives and the need for expediency in getting product to market.

We have taken the opposite approach. Since our research began on factor-based funds, our primary design objective has been to provide the strongest exposure to the targeted factor that we can, in a highly diversified, low-cost, transparent, long-only format. It's well known that factor exposure exists and can be obtained across the market-capitalisation spectrum. In fact, we believe the best opportunities to obtain strong factor exposure are often found in smaller-capitalisation name To be able to capture that factor exposure intensively and effectively, we need to weight securities very differently than their market capitalisation, and because of that, we need to be able to operate flexibly and carefully as we trade our portfolios and buy, sell and rebalance portfolio constituents.

How does Vanguard's active approach to factor management benefit investors?

Our active approach allows us to alter our holdings on a daily basis, so when the characteristics of an underlying security change, we can consider trading immediately, without waiting for an index reconstitution to do so. We believe the design choice by others to rely on market-capitalisation weights is ultimately a compromise that allows an indexed approach to be feasible, but it clearly dilutes factor exposure.

Apple isn't a stock that has particularly strong value characteristics. So why should it be a large fraction of your value factor fund? (Have you looked at what's in your value factor fund?) In market-capitalisation-weighted index funds, built to track the cap-weighted performance of a market, changes in market prices do most of the work needed to rebalance. This is, in part, what makes index funds so great. But in a factor fund that targets characteristics other than cap weight, active management is, to us at least, a necessity for peak effectiveness.

The QEG team has 25 years of experience running quantitative active funds and managing the trade-off between trading cost and maintaining desired exposures to stocks with targeted characteristics. We believe that the methods we use in our factor funds allow us to achieve a broader and stronger factor exposure that is more diversified across individual stocks and give us great flexibility to maintain a consistent exposure over time. Active implementation helps us keep costs to a minimum by carefully considering the trade-off between rebalancing needs and trading costs. Our factor funds also rely on a rules-based approach to the way we define the factors and build the portfolios, which gives investors significant transparency into what we are trying to achieve.

* Vanguard is owned by the Vanguard funds, which, in turn, are owned by their shareholders.

Important information

Investment involves risks, including the loss of principal.

Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from broader stock markets. Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.

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