How Vanguard's Active Factor ETFs Are Different

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Vanguard recently launched a new lineup of factor-based exchange-traded funds. Here with me to provide an early read on the lineup is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, before we get into the specifics of this lineup, let's talk about what a factor-based ETF actually is.

Bryan: A factor investment strategy or ETF is basically a fund that's targeting stocks that have a set of characteristics that have historically been associated with better performance. That could be anything from low valuations to high profitability or strong recent performance. Those are characteristics that have historically helped explain the variation in stock returns that we see.

Benz: Most of the major factor-based ETFs on the market to date have been index-based. Vanguard's lineup is a little different in that these are active products. Let's talk about that. In what way are they active and how active actually are they?

Bryan: That's a great question. These funds are active in the sense that they don't track a benchmark. That gives the managers some flexibility in how they implement the strategies. Now, they are not active in the traditional sense; these managers aren't going out and doing some qualitative security selection. It's a rules-based process that's pretty formulaic. But where the managers have discretion is, they get to decide when they want to refresh the portfolios. If they determine that the factor characteristics of the portfolio are starting to decay because certain stocks that have had strong recent performance, for example, may no longer have those characteristics, they can decide when they want to remove those stocks. That helps them better manage the transaction costs or balance transaction costs against the benefits of trading. That flexibility can help on the margin and improve the fund's capacity, reducing their transaction cost.

Benz: There are five ETFs that will focus on specific factors: value, momentum, liquidity, quality, and low volatility. Those are common factors that various products track. There's also a multifactor fund. But you say that one big differentiator with this lineup and maybe some competitor products is that these funds truly graze across the market-cap spectrum. Let's talk about that and why that's important when you look at factor-based products.

Bryan: That's right. Most of factor strategies on the market today focus on specific segments of the market-cap spectrum. Most traditional factor strategies are focusing on large- and mid-cap stocks. These funds each look across the entire market-cap spectrum. They are targeting stocks with strong factor characteristics in the large-cap space. They are also doing that among mid-cap stocks and small-cap stocks. Now, that not only helps improve diversification, but that can also help improve performance, because historically the payoff to factor investing has tended to be the biggest among the smaller stocks. And I think the reason for that is, small stocks are more likely to be mispriced than large-cap stocks because there's fewer analysts that follow them, so there might be greater payoff for factor investing further down the market cap.

Benz: Let's talk about the multifactor product. What factors does it bundle together under the umbrella of that single product?

Bryan: It's looking for stocks with the best combination of value, momentum, and quality characteristics. The basic idea behind putting these factor strategies together is that although each of these factors on their own have a good long-term record, they each go through extended periods of underperformance. But you can help reduce the risk of underperformance by diversifying across different factor strategies. Because although these each tend to work over the very long term, they tend to work at different times. This particular fund isn't necessarily going to own the cheapest stocks or the stocks with the best momentum, but it's going to own the stocks that have the best overall combination of factor characteristics. I think that's important because that can lend itself to a stronger factor exposure at the portfolio level than trying to assemble a diversified factor portfolio from individual factor strategies.

Benz: One question I often have when I hear about multifactor products is, why not just own the whole market, what value is the multifactor product potentially adding.

Bryan: It's a great question. I think, starting with the markets, it's a good starting point, and for a lot of people, it's probably a good ending point, too.

Benz: Total market index.

Bryan: Total market index, keep your costs low, keep it simple. You don't have to worry about underperforming the market. I think that's a fine place to start.

If you are hoping to do something more than that, I think a multifactor strategy can be a good place to go. Multifactor strategies are basically capturing the drivers of long-term performance. And yes, it's not always going to outperform, but I think it has a good shot of providing higher returns than the market over the very long term. And in this case, Vanguard is offering this multifactor strategy at a low 18 basis points expense ratio. You are still within spitting distance of the lowest-cost market-cap-weighted total market stock funds out there. But you have a chance of earning higher returns by tilting toward stocks that have lower valuations, strong momentum, and higher-quality characteristics. I think, that's a very reasonable strategy. The hurdle was not that great, because the expense ratio is still low.

It's not for everyone. It's not always going to outperform. To benefit from these factor strategies, you really do have to have a long-term time horizon. If that describes you, if you are a patient investor, if you can stomach bouts of underperformance for the chance of earning higher returns over the long term, I think the multifactors fund is a really good alternative to a cap-weighted approach. Certainly, there's nothing wrong with sticking with a total market fund.

Benz: The single-factor ETFs, are those similarly cheap?

Bryan: They are. They are each charging 13 basis points.

Benz: Alex, always great to hear your insights. Thank you so much for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.