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Tangy or spicy? Evaluating factor fund styles

17 May 2018 | Portfolio construction

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Ground spices

Commentary by Doug Grim, senior investment strategist with Vanguard Investment Strategy Group.

I love to barbecue on my outdoor grill. It hardly matters whether I'm cooking steak, pork, chicken or ribs. But what does matter, for me, is the barbecue sauce. It has to taste distinctive. I like mine extra spicy.

Not all barbeque sauces are the same. Some are vinegar-based; others are made with tomato or mustard. Some have paprika; others use red pepper. How do you pick the one you want? There's no benchmark or standard. You read the ingredients, and then you choose what you like. (Vanguard Global Chief Economist Joe Davis, a barbecue aficionado, always picks the right one.)

The same could be said for factor-based products. When you pick them for a portfolio, you're likely adding to an existing portfolio. You're looking for a tilt on value, for instance, or to add an element of momentum.

But as with barbecue sauce, there can be a lot of differences and similarities between them. In order to know what you're getting, read the bottle carefully.

When shopping for factors

How factor strategies are constructed and implemented can lead to markedly different results. It might be logical to think that because some are characterised as "indices," factor strategies should perform similarly to one another. However, factor indices can vary greatly, even those that have similar names and/or investment strategies. For example, there is no standard definition of value, even if a low price-to-earnings ratio is a commonly used metric.

Numerous important active decisions are made in an attempt to target a particular factor exposure. For most factor funds, these decisions are made by the index provider as part of its construction methodology. The asset manager's responsibility is to manage the portfolio to seek to track the index. As a result, even though a fund can technically be an index fund, the index itself is an active strategy.

Understand the factor recipe

Once you determine a certain factor is worth pursuing, how do you select the investment vehicle to gain exposure to that factor?

Here are four key questions to ask:

1. What metrics are used to represent the factor?

Let's continue with the value example. Is the best metric price-to-book? Price-to-earnings? Both? Something else? What is the supporting evidence to suggest that the chosen metrics are a sensible way to access the style factor?

2. What is the weighting scheme (i.e. the construction methodology)?

What is the eligible universe? Is it weighted based on each security's exposure to the factor? Is the target factor exposure consistent? How is rebalancing handled? How diversified or concentrated is the strategy?

3. How is the factor strategy implemented?

Is it actively managed or does it seek to track an index? Does the asset manager have significant experience effectively executing factor-oriented strategies? Is there trading flexibility? What is the expected turnover?

4. What are the expected all-in costs?

What are the ongoing costs, such as the expense ratio? What are the transaction costs, such as bid-ask spreads, entry or exit fees, and premiums/discounts?

The bottom line is: Before selecting which factor product to buy out of all the available choices, do your homework. Choosing a factor product is like selecting any other type of strategy. Extensive due diligence is necessary, even if the product tracks an index.

You are the cook. Be sure you are seasoning your portfolio with the right sauce.

I would like to thank my colleague Kelly Farley for her contributions to this blog.

Doug GrimDoug Grim
Senior investment strategist, Vanguard Investment Strategy Group

Investment risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

Other important information:

This information is directed at professional investors and should not be distributed to, or relied upon by retail investors.

This article is designed for use by, and is directed only at, persons resident in the UK.

The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

This article was produced by The Vanguard Group, Inc. It is not a recommendation or solicitation to buy or sell investments.

The opinions expressed in this article are those of the individual author and may not be representative of Vanguard Asset Management, Limited.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

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