The ‘Vanguard Effect’ Comes to Smart Beta

The Vanguard Group’s new factor-based funds get one step closer to launch.

Bill McNabb, Vanguard Group (Qilai Shen/Bloomberg)

Bill McNabb, Vanguard Group

(Qilai Shen/Bloomberg)

Vanguard Group has filed with the Securities and Exchange Commission to launch six new low-cost, factor-based exchange-traded funds, as well as a mutual fund.

The firm’s move into smart beta is likely to shake up a category that is among the fastest growing product areas for asset managers. The exchange-traded funds will be the first actively managed ETFs in the U.S. for the fund giant, which has $4.8 trillion in assets. Vanguard expects the new funds to begin trading in the first quarter of next year.

[II Deep Dive: Why Vanguard’s Smart Beta Bet May Unsettle Its Rivals]

Smart beta funds have been a bright spot amid overall gloom for the asset management industry. Investors have bought into the concept of factor-based funds as a cheaper alternative to more expensive and less predictable actively managed investments.

Factor-based funds, often called smart beta or strategic beta by asset managers, provide investors with exposure to securities adhering to certain characteristics, such as value or growth, that can outperform the market over time. Similarly to how a human value investor picks stocks, asset management firms can develop algorithms that identify companies exhibiting the value characteristic.

Although many asset managers view factor-based funds as a way to piggy back on the popularity of passive investing, Vanguard considers factor-based funds to be actively managed. For the passive giant, smart beta is about placing an active bet, whether it’s on low volatility or momentum stocks.

“It’s a form of active investing,” William McNabb, chair and CEO of Vanguard, told II earlier this month. “We already have some factor-based products. We don’t put them under that rubric, but we could.”

The industry’s exuberance over the potential of smart beta strategies in both stocks and bonds will likely be tempered by Vanguard’s entry. Vanguard, which is owned by its fund shareholders, can keep prices lower than competitors, as it only has to earn enough on products to cover costs. It doesn’t have public shareholders or a parent company to please. Dubbed the ‘Vanguard Effect,’ Vanguard’s entry into a market pushes competitors to lower their own prices.

And Vanguard’s new factor-based funds will be cheap. The indexing pioneer estimates that the five ETFs will have an expense ratio of 13 basis points, or .13 percent. The mutual fund, which will take a multi-factor approach, will have a slightly higher expense ratio of 18 basis points, or .18 percent.

But Vanguard will have competition on the price front. Goldman Sachs Asset Management has deliberately kept prices for its smart beta products low. The firm hopes that investors will see smart beta as a better option than plain-vanilla market-capitalization weighted index funds.

Market cap-weighted index funds typically have expense ratios of only a few basis points. According to Moody’s, most smart-beta products charge fees between 24 and 39 basis points, or 0.24 and 0.39 percent, which is still about half the fee charged by the average actively managed equity mutual fund.