Why Vanguard’s Smart-Beta Bet May Unsettle Its Rivals

The indexing pioneer is expanding its reach in smart-beta funds — just as rival asset managers are betting big on the category.

Illustration by Pete Gamlen

Illustration by Pete Gamlen

If anything seemed like it could possibly pose a competitive threat to mutual fund juggernaut Vanguard Group — which in the past year has taken in more money from investors than its next nine largest competitors combined, according to Morningstar — it was the increasing popularity of smart-beta funds. But the news that the indexing pioneer is expanding its smart-beta effort is sure to rattle rival asset managers that are hoping these funds will appeal to investors dumping active strategies.

That’s because 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 its costs. It doesn’t have public shareholders or a parent to please.

Smart-beta funds, often called factor-based investments, provide investors with exposure to securities with certain characteristics, such as value or growth, that can outperform the market over time. Computer-based algorithms — some say robots — (cheaply) run the funds. With investors in the throes of a decade-long love affair with passive funds, asset managers have been scrambling to launch smart-beta funds, which look a lot like passive because they follow a transparent set of rules, but charge fees closer to those of active products. Fund companies are selling smart-beta funds as a premium version of market-capitalization-weighted index funds, with a premium price tag to match.

Still, smart beta is cheaper than traditional active, and investors have noticed, making it one of the fastest-growing fund categories. Vanguard, which has $1.1 trillion in active strategies and $4.7 trillion overall, doesn’t consider smart beta to be passive at all.

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

Vanguard’s popular Global Minimum Volatility Fund, launched in 2013, is one example. McNabb says the firm is likely to create more factor-based investments once it starts offering active exchange-traded funds. McNabb offers no details because the firm has not yet filed for specific products.

“If we do an active ETF, something factor-based would make a lot of sense for a firm like us,” he says. On October 4 the Securities and Exchange Commission granted the firm the ability to offer a standalone ETF.

Dana D’Auria, a member of the investment committee and head of research for $8.8 billion Symmetry Partners, which designs portfolios for advisers using factor-based investments, says Vanguard’s move into smart beta is inevitable — and good news for her firm. She expects to see the so-called Vanguard Effect, which has been well documented, play out in smart beta. When Vanguard enters an asset class or strategy, other providers lower their expenses in an effort to remain competitive with the low-cost giant.

D’Auria says it will be interesting to watch Vanguard’s move into smart beta and see whether investors will trade their market-cap-weighted funds for factor funds across the board. Vanguard investors might also trade their market-cap funds for factors, which she says offer distinct benefits supported by decades of academic research.

“Market-cap indexing is a really good option for investors, but is it the best option? It doesn’t take advantage of a lot of knowledge we have about what types of stocks tend to outperform,” she says.

Goldman Sachs Asset Management has been offering smart-beta ETFs with the same fees as market-cap index funds, hoping investors choose what the firm thinks is the premium version.

McNabb, who is stepping down as Vanguard’s CEO on January 1 but will remain board chair, is unapologetic when it comes to the price competition Vanguard will bring to the smart-beta world: “Price competition will come to all aspects of investment management. Not just indexing, but also active — and active in all its forms.”

McNabb isn’t worried about the competition, either. “If anybody is saying smart beta is a threat to us, I disagree,” he says. “It’s an opportunity.”