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Why Vanguard Overweights Small Caps in Its Multifactor ETFs

Adam McCullough, CFA

Adam McCullough: Hello, I'm Adam McCullough; I'm here at the 30th annual Morning Star Investor Conference. Joining me is Antonio Picca, he's the head of factor strategies with Vanguard's Quantitative Equity Group. Antonio, thank you for joining me today.

Antonio Picca: Thank you, Adam.

McCullough: We're here to talk about some factor based strategies, equity factor strategies, and Vanguard is coming out with a handful of strategies in February of this year; and the approach there is a little different where you target factors across the entire market-cap spectrum in the US. 

Do you mind kind of walking me through why you chose that approach and the advantages and disadvantages of approaching factor investing in that manner?

Picca: We start from the Russell 2000 universe, we divide the universe in three sizebuckets. Large, mid, small caps. Within each bucket, we sort stocks based on an equally weighted average of the rankings generated on value, momentum, and quality.

McCullough: Okay, so all very well vetted factors.

Picca: Yes.

McCullough: But picking from different buckets based on the market-cap of the stocks.

Picca: Within each bucket we sort the stocks that are most attractive from a combination of value quality and momentum scores; and then we select the securities within each bucket and then give the same weight to each bucket. That means that you get a third in large, a third in mid, and a third in small caps. That is pretty substantial over weight to small caps.

McCullough:I was gonna say, that must skew you more towards smaller cap names because, you know, usually when you're market-cap weighting things you skew larger, so this must give you much more weighting to mid and small cap stocks in a traditional mulifactor strategy.

Picca: That's exactly the point. We do this deliberately because we believe that increases the chances of investment success for investors, because the factors have delivered the stronger premiums within small caps.

McCullough: The factors work better within smaller cap names than larger cap names?

Picca: Historically, that has been the case.

McCullough: Yes, in the research it has been.

McCullough: How far would you expect this funds performance to deviate from the Russell 3000 index, as like a base benchmark index for this?

Picca: Look, you are talking about a 3-5% tracking error with respect to the market every year. Some people like active shares, you're talking about an active share in the high-seventies, so you can expect a pretty significant deviation.

McCullough: That's pretty high.

Picca: It is pretty high, and we know that not every investor is willing to tolerate a higher level of tracking error; but you can always combine that with a broad market allocation in order to reduce the tracking error and still get a meaningful exposure to the underlying factors.

McCullough: But for investors that want a higher active exposure to factors, this could be a good fund for the to chose.

Picca: It really depends on what the investment goal is. If the investment goal is a outperformance, and you have high tolerance for a high tracking error, you can make a multifactor fund a core of your allocation. If you are not willing to tolerate such a high level of tracking error, you can always combine it with broad market allocation.

McCullough: This might tie in to the funds structure, but I just hit on really quick; the fund is structured as an active ETF, instead of an index tracking ETF, can you walk me through the thought process there of why you decided to go that route and work that out first?

Picca: I have to say, factor investing is a form of active investing. You are deviating from the market, you are making so many decisions along the way that are going to determine a difference in performance from the market year in and year out. 

We believe that the best way of implementing that active type of strategy, is through active implementation, because it allows us to maintain a consistent exposure to the underlying factor. It allows us to balance the trade off between maintaining the exposure and trading costs. We can spread turnover over time, so to reduce the cost per unit of turnover. 

And finally, a very simple example that advisors seem to understand and like, if you give us money today, we get inflows, we can invest money, put the capital to use at a signal that was generated today; as apposed to signal that are three, four, five months old, at that point it is pretty stale.

McCullough: More flexibility with the active approach in the ETF structure, and a broader market-cap spectrum of stocks that you're targeting, where these factors may outperform compared to the larger cap names.

Picca: We expect so, yes. Over long periods of time.

McCullough: Alright Antonio, thank you again for being here today. Great information.

Picca: Thank you Adam.

McCullough: With Morningstar, I'm Adam McCullough, here at the 30th annual Morningstar Investor Conference.

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