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Three years of active factor ETFs

04 January 2019 | Mark Fitzgerald

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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.

Important 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.

ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.

The fund(s) may invest in financial derivative instruments that could increase or reduce exposure to underlying assets and result in greater fluctuations of the fund's Net Asset Value. Some derivatives give rise to increased potential for loss where the fund's counterparty defaults in meeting its payment obligations.

Other important information:

For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). Not to be distributed to the public.

For Dutch Investors only. The fund(s) referred to in this document are listed in the AFM register as defined in section 1:107 Dutch Financial Supervision Act (Wet op het financieel toezicht).

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this document is general in nature and does not constitute legal, tax, or investment advice. Potential investors are urged to consult their professional advisers on the implications of making an investment in, holding or disposing of [units/shares] of, and the receipt of distribution from any investment.

Vanguard Funds plc has been authorised by the Central Bank of Ireland as a UCITS and has been registered for public distribution in certain EU countries. Prospective investors are referred to the Funds' prospectus for further information. Prospective investors are also urged to consult their own professional advisers on the implications of making an investment in, and holding or disposing shares of the Funds and the receipt of distributions with respect to such shares under the law of the countries in which they are liable to taxation.

The Manager of Vanguard Funds plc is Vanguard Group (Ireland) Limited. Vanguard Asset Management, Limited is a distributor for Vanguard Funds plc.

For further information on the fund’s investment policy, please refer to the Key Investor Information Document (KIID). The KIID and the Prospectus for this fund is available in local languages from Vanguard via our website https://global.vanguard.com/.

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

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

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