As if it hasn’t done enough this year, Vanguard Inc. is shaking up the world of factor investing and smart beta by introducing six new exchange-traded funds and one mutual fund that rely on those strategies. This represents a major expansion of the offerings by the fund company that all but invented low-cost passive index investing.
Before going further, two quick definitions are called for. First, factor-based investing involves assembling portfolios based on specific quantifiable characteristics such as valuation, capitalization size, earnings quality, momentum and so on. Academic research suggests these attributes can potentially generate above-market returns. Second, smart beta is a way to assemble an index by means other than the traditional weighting by market capitalization, again with the goal of outperforming the market As we have previously discussed, it has attracted lots of capital, even as some have dismissed it as a mere marketing gimmick.
Vanguard has been offering funds that are variants of smart beta and/or factor for a while. For example, the Vanguard Dividend Appreciation exchange-traded fund, with about $27 billion in assets, is made up of large capitalization companies selected based upon their history of increasing dividends; the $35 billion Vanguard Value ETF is based on a classic value factor screen. Both are passively managed and tied to an index, and both have been around for more than a decade. The firm has other similar funds as well.
What makes the new factor and smart-beta offerings from Vanguard different is that they are actively managed, using a rules-based approach to factors. As of now, about a quarter of Vanguard’s funds are actively managed, but most of its earlier offerings that were factor or smart-beta based were passively tied to an index.
Perhaps it was inevitable that the capital flows into smart beta and factor would attract the company’s attention. Senior management has been debating a more aggressive approach for a while. Chief Executive Officer Bill McNabb hinted at this in our last conversation in 2016, saying the company was “looking carefully at the space.”
This internal debate has been described as an identity crisis, at odds with founder Jack Bogle’s philosophy. I don’t believe it is. How can we reconcile what looks like a deviation from Bogle’s investment philosophy with these new products? I would argue it is consistent with the core philosophy as espoused by Bogle since the formation of Vanguard more than 40 years ago.
If you reduce the Bogle philosophy to its key elements, you end up with a list that looks like this:
• Put the interests of clients first
• Focus on keeping costs low
• Diversify holdings