Three years of active factor ETFs
04 January 2019 | Mark Fitzgerald
Few investors think a portfolio can be a factor strategy, an actively managed portfolio and an exchange-traded fund (ETF). And yet combining all three does happen. It’s how we create factor portfolios at Vanguard.
Why factor investing is active investing
Factor-based investing has many labels. There’s smart beta, enhanced indexing and alternatively weighted strategies, just to name a few. But the common characteristics of these strategies are that they are rules-based. They aim to capture systematically the premiums associated with one or more factors.
At Vanguard, we believe the decision to target a factor or factors is an active decision. It’s an active investment strategy because it creates a portfolio that doesn’t represent the market consensus. That said, this kind of investing can track an index, albeit a factor index, which is maybe why there is debate around whether factor investing is active or passive.
How to actively implement a factor strategy
Taking a passive approach to factors is relatively straightforward; the portfolio tracks a factor index. And there are many indices available, covering a wide spectrum of factors. But there is a drawback with passive implementation – the potential for inconsistent factor exposure. After all, markets and stock prices are constantly changing. Depending on how frequently the index and the portfolio rebalh2ance, investors could find that their factor exposure drifts as markets move.
We take an active approach at Vanguard, using quantitative models to target the desired factor. These models are dynamic. They are not tied to a rebalancing schedule. Instead, they can respond to changing prices and opportunities in the market. And it means that the portfolio can maintain its factor exposure even as markets shift.
Three of our four factor ETFs – Value, Liquidity and Momentum – share the same active process. Portfolio managers use quantitative models to assess a share’s suitability, and build the portfolio. The models determine an equity’s factor characteristics. For example, when creating the value ETF, they look at a stock’s price-to-book ratio, forward price-earnings and cash flow. Equities in the available universe – which is a global universe – are then assigned a factor score based on these metrics.
Only the highest-scoring equities are included in the ETF, and their weight in the fund is determined by their factor score, subject to a given set of risk controls. These controls aim to create a globally diversified ETF and keep costs low.
Our fourth factor ETF aims to minimise volatility. Portfolio managers use an optimiser to create a global equity portfolio. They do not just rely on volatility, but instead they consider the interaction of multiple factors to reduce the portfolio’s overall volatility compared with the global market. The addition of prudent risk controls also ensures the portfolio is sufficiently diversified and liquid.
The optimiser identifies the most appropriate portfolio given these restrictions. Like our other three factor ETFs, the process is dynamic. Managers can change the portfolio to the prevailing market environment with the goal of minimising the absolute level of volatility.
Why ETFs make sense
Vanguard offers its active factor strategies as ETFs. Exchange-traded funds combine the benefits of collective investing with the trading flexibility of an individual security, which makes factor strategies accessible and low cost. So not only are Vanguard’s factor strategies active portfolios, they are also wrapped in an ETF. These three features are rarely considered together and yet we’re celebrating three years of success with this combination.
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