smart-beta

The Elephant In The Smart-Beta Room

Some of my industry peers make compelling cases for factor or smart-beta1 strategies. Their presentations showcase lots of data, often using hypothetical () returns. Rarely, however, do they address the elephant in the room: costs.

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Q2 hedge fund letters, conference, scoops etc

Yes, costs can be difficult to estimate. In addition to the expense ratio, there are other real-world (e.g., bid-ask spreads, commissions, market impact) when pursuing any investment strategy. But I worry that these presentations fail to serve our advisor audience. When we talk to advisors, we hear that what they care about most are the returns their clients get to keep, including after Uncle Sam takes his share in taxes. Not surprisingly, we received a number of questions about costs during a .

Not all equity factor-driven products are cheap

smart-beta

Source: Vanguard calculations, based on data from Morningstar, Inc.

Notes: The expense ratios for factor-driven products are based on conventional and exchange-traded equity funds from the strategic beta category of the Morningstar database. For a definition of what products Morningstar classifies as strategic beta, please see: https://corporate.morningstar.com/US/documents/Indexes/Strategic-Beta-FAQ.pdf. We excluded sector funds from both categories to focus the comparison on more diversified product options.

Maybe the elephant is so rarely mentioned because presenters presume that advisors know what it looks like. Reason assumes that smart-beta costs are between cap-weighted indexing and traditional active. But that isn’t always the case. The graph above shows quite clearly that not all traditional active funds are expensive and not all factor-driven products are low-cost.

Given that many equity factor-driven products are rules-based and transparent, advisors must carefully evaluate how much higher of an expense ratio is reasonable for their clients to pay versus what it costs to invest in a rules-based, transparent, low-cost, broad-based cap-weighted index fund (i.e., a total-market equity index fund), which can be purchased for a few basis points and low-cost traditional active managers they may be considering or using. This is particularly important now given the increased industry focus on costs and the investment research documenting that advisors cannot assume they will get more if they pay more.2

Similar to a theme observed in , investors have been directing more cash flow to lower-cost U.S. equity factor-driven products.

Investors are gravitating to lower-cost factor-driven products

smart-beta

Source: Vanguard calculations, based on data from Morningstar, Inc.

Notes: Factor-driven expense ratios of conventional and exchange-traded equity funds from the strategic beta category of the Morningstar database. Expense ratio quartiles were calculated annually. We excluded sector funds from both categories to focus the comparison on more diversified product options.

Read the full article by Doug Grim of Vanguard, Advisor Perspectives

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