The elephant in the smart beta room
28 June 2018 | Portfolio construction
Commentary by Doug Grim, senior investment strategist with Vanguard Investment Strategy Group.
Some of my industry peers make compelling cases for factor or "smart beta"1 strategies. Their presentations showcase lots of data, often using hypothetical (back-tested) returns.
Rarely, however, do they address the elephant in the room: Cost.
Yes, costs can be difficult to estimate. In addition to the expense ratio, there are other real-world implementation costs (e.g. bid-ask spreads, commissions, market impact) when pursuing any investment strategy. But I worry that these presentations fail to serve our adviser audience. When we talk to advisers, we hear that what they care about most are the returns their clients get to keep, including after the government takes its portion.
Not all equity factor-driven products are cheap
Source: Vanguard calculations, based on data from Morningstar, Inc.
Notes: The expense ratios for factor-driven products are based on conventional and exchange-traded equity funds from the strategic beta category of the Morningstar database. For a definition of what products Morningstar classifies as strategic beta, see: https://corporate.morningstar.com/US/documents/Indexes/Strategic-Beta-FAQ.pdf. We excluded sector funds from both categories to focus the comparison on more diversified product options.
Maybe the elephant is so rarely mentioned because presenters presume that advisers know what it looks like. Reason assumes that smart beta costs are between capitalisation-weighted indexing and traditional active. But that isn't always the case. The graph above shows quite clearly that not all traditional active funds are expensive and not all factor-driven products are low-cost.
Given that many equity factor-driven products are rules-based and transparent, advisers must carefully evaluate how high an expense ratio is reasonable for their clients to pay. They should compare that against what it costs to invest in a rules-based, transparent, low-cost, broad-based cap-weighted index fund (e.g. a total-market equity index fund), which can be purchased for a few basis points, and also against any low-cost traditional active managers they may be considering or using. This is particularly important now given the increased industry focus on costs and the investment research documenting that advisers cannot assume they will get more if they pay more.2
Similar to a theme observed in industry-level cash-flow trends, research shows that investors in the United States have been directing more cash flow to lower-cost equity factor-driven products.
Investors are gravitating to lower-cost factor-driven products
Source: Vanguard calculations, based on data from Morningstar, Inc. Figures are in US dollars.
Notes: Factor-driven management expense ratios of conventional and exchange-traded equity funds from the strategic beta category of the Morningstar database. Expense ratio quartiles were calculated annually. We excluded sector funds from both categories to focus the comparison on more diversified product options.
More and more investors are learning that keeping costs low is an important way to help improve the odds of beating the market with active approaches, whether they are using traditional active or factor-driven products. As you consider factor products for your clients' portfolios, don't forget about the elephant in the room. Be sure your due diligence includes an all-in cost assessment.
At the end of the day, you need to be sure you're getting what you pay for.
I would like to thank my colleague Ryan O'Hanlon for his contributions to this blog.
1 There is no consensus industry definition for "smart beta." Some consider it a catch-all marketing term for any index strategy that does not track a market-capitalisation-weighted benchmark. I use the term here simply because some advisers use it interchangeably with factor products, as their results are often driven by factor exposures.
2 James J. Rowley Jr., David J. Walker and Sarinie Yating Ning, 2018. The case for low-cost index-fund investing; and Daniel W. Wallick, Brian R. Wimmer and James J. Balsamo, 2015. Shopping for alpha: You get what you don't pay for. Valley Forge, Pennsylvania: The Vanguard Group, Inc.
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