Vanguard Begins Updating Its Investing Philosophy
Founder Jack Bogle isn’t crazy about smart-beta and factor-based products, but the firm will offer them anyway.
Bloomberg, December 4, 2017
As if it hasn’t done enough this year, Vanguard Inc. is shaking up the world of factor investing and smart beta by introducing six new exchange-traded funds and one mutual fund that rely on those strategies. This represents a major expansion of the offerings by the fund company that all but invented low-cost passive index investing.
Before going further, two quick definitions are called for. First, factor-based investing involves assembling portfolios based on specific quantifiable characteristics such as valuation, capitalization size, earnings quality, momentum and so on. Academic research suggests these attributes can potentially generate above-market returns. Second, smart beta is a way to assemble an index by means other than the traditional weighting by market capitalization, again with the goal of outperforming the market As we have previously discussed, it has attracted lots of capital, even as some have dismissed it as a mere marketing gimmick.
Vanguard has been offering funds that are variants of smart beta and/or factor for a while. For example, the Vanguard Dividend Appreciation exchange-traded fund, with about $27 billion in assets, is made up of large capitalization companies selected based upon their history of increasing dividends; the $35 billion Vanguard Value ETF is based on a classic value factor screen. Both are passively managed and tied to an index, and both have been around for more than a decade. The firm has other similar funds as well.
What makes the new factor and smart-beta offerings from Vanguard different is that they are actively managed, using a rules-based approach to factors. As of now, about a quarter of Vanguard’s funds are actively managed, but most of its earlier offerings that were factor or smart-beta based were passively tied to an index.
Perhaps it was inevitable that the capital flows into smart beta and factor would attract the company’s attention. Senior management has been debating a more aggressive approach for a while. Chief Executive Officer Bill McNabb hinted at this in our last conversation in 2016, saying the company was “looking carefully at the space.”
This internal debate has been described as an identity crisis, at odds with founder Jack Bogle’s philosophy. I don’t believe it is. How can we reconcile what looks like a deviation from Bogle’s investment philosophy with these new products? I would argue it is consistent with the core philosophy 1 as espoused by Bogle since the formation of Vanguard more than 40 years ago. 2
If you reduce the Bogle philosophy to its key elements, you end up with a list that looks like this:
- Put the interests of clients first
- Focus on keeping costs low
- Diversify holdings
- Maintain a long-term investment horizon
- Keep it simple
- Rely on rational analysis and decision making
Some of Bogle’s other investment precepts don’t necessarily align with those six principles. As we discussed, Bogle isn’t a big fan of ETFs; nor does he believe fund buyers in the U.S. should invest overseas due to currency risk; he is unsure of the advantages of the small-cap stock premium; lastly, he was never a fan of smart beta.
However, that Bogle has derided smart beta as bogus doesn’t matter, so long as the firm can provide a simple, low-cost, high-quality version of it. Think of it in the same way the firm has embraced ETFs or overseas holdings despite Bogle’s views. Management at Vanguard disagreed with the founder’s dislike of those niches, yet managed to stay true to his philosophy.
And yet anytime a company moves into a new area, there will be some risks involved. But as I see it, they appear to be minor. The company has had a proverbial toe in the water for a while; this looks like a circumspect expansion rather than a headlong dive.
For an example of Vanguard’s measured approach, consider its entry into the market for robo-advisers, the online-only algorithmically driven asset allocators. Vanguard watched the market closely for years. It studied robo firms such as Betterment LLC and Wealthfront Inc. as they scaled up over the course of the past decade to billions of dollars in assets under management. It observed pricey — at least by Vanguard standards — acquisitions by BlackRock Inc. (FutureAdvisor), Aviva (Wealthify), Invesco (Jemstep), TIAA-CREF (MyVest) and others.
After all that, it came to the conclusion that building its own robo-adviser and converting an existing online-only brokerage site made the most sense. Two years ago, it introduced Vanguard Personal Advisors with a modest $8 billion in assets under management; it now has about $100 billion. The firm makes no bones about believing this could be a $1 trillion business someday. No other robo-adviser is remotely close in terms of assets managed this way. When it comes to robos, there is Vanguard, and then there’s everyone else.
Expect Vanguard’s push into smart beta to follow a similar path, relying on organic building rather than acquisitions. Look also for the so-called Vanguard effect, in which its low-cost approach drives down fees throughout the market.
Vanguard’s entry should certainly give those currently profiting from the smart-beta trend some pause. But the upshot is likely to be a win for investors.
2. I recently discussed this philosophy in a few weeks ago in “Understanding What Makes Vanguard So Successful.”