Vanguard: should you take the middle way?

Has Vanguard finally moved into 'smart beta' investing? Mischa Frankl-Duval looks at the American fund giant's latest products.

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Get active or go passive? There is another option

American fund giant Vanguard is best known for its very low-cost "cap-weighted" passive funds (in other words, funds where the amount invested in each stock is in proportion to their market value). So the news that it's launched four "factor-weighted" exchange-traded funds (ETF) on the London Stock Exchange has been seen as a change of direction.

Rather than tracking a traditional index, these ETFs invest in equities selected on the basis of certain criteria: value (cheap shares), low liquidity (lower-than-average trading volume), momentum (shares that have been rising strongly), or minimum volatility (shares that are less volatile). These criteria known as "factors" have historically delivered higher long-term returns than the wider market.

Factor investing also known as "smart beta" is a fast-growing part of the investment industry at present, and is generally presented as a halfway choice between passive investing (tracking an index) and active management (where the fund manager tries to beat the market).

However, Vanguard which was one of the pioneers of passive investing has tended to resist the concept of smart beta, taking the view that a fund is either truly passive or is actively managed, with no middle ground possible. That remains true even with these launches, which Vanguard describes as actively managed, even though most in the industry probably wouldn't. Yes, it's true that there are differences between Vanguard's new products and a typical smart-beta fund.

Rather than tracking a formally defined smart-beta index created by a third-party index provider, the ETFs select their constituents using Vanguard's own screening models. And Vanguard's fund managers have discretionary oversight, meaning that they can override the model if they choose. But overall, these are rules-based funds that look much more like smart beta than traditional active funds (including those active funds that Vanguard offers to American investors).

Most industry analysts were surprised by Vanguard's new direction, says Aime Williams on FT.com. The products may suggest that Vanguard is "missing out" on the smart-beta boom and needs to catch up, according to Francois Millet of rival ETF provider Lyxor. Nonetheless, they are "bold and innovative", says Hortense Bioy of fund research firm Morningstar. Whether they will prove popular is another matter. There are almost 200 smart-beta ETFs in Europe, with collective assets under management of around €30bn, according toMorningstar data. But actively managed ETFs remain a nascent market Europe has only 13 active ETFs, with assets of €5.8bn. So Vanguard's decision to market its products as active could help it stand out.

However, actively managed ETFs have not taken off as much as proponents hoped and the market is pretty tough. In the last six months, a number of actively managed ETFs have been wound up after struggling to attract investment. Swiss asset manager Julius Baer has closed its entire range of active ETFs and Deutsche Bank one of the biggest European ETF firms has shut its sole active offering, the db x-trackers SCM Multi Asset ETF.

Nonetheless, Vanguard's reputation and size should help attract investors. And the ETFs are cheap, with an ongoing charges figure (OCF) of 0.22%. Comparable smart-beta ETFs from iShares have an OCF of 0.3% and even Vanguard's own FTSE All-World ETF has slightly higher costs. Overall, they are an interesting new venture and could be worth a look if you're looking for a global equity ETF.

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