ETFs

Vanguard Group hires a smart beta expert from pioneer Research Affiliates

Index investing giant has challenged the marketing of smart beta funds. Now it's turning to someone whose research has helped those funds grow.

The Vanguard Group Inc., which has for years voiced skepticism about the fast rise of exotic index-investing strategies, has hired a top researcher away from one of the best-known promoters of smart beta, Research Affiliates.
Valley Forge, Pa.-based Vanguard, the largest mutual fund firm and the second-largest ETF manager, is bringing Research Affiliates analyst Denis B. Chaves to its quantitative equity group, according to the leader of that group, John Ameriks.
Mr. Chaves, who holds a doctorate in finance from the University of Chicago’s Booth School of Business, has contributed to the design of Research Affiliates’ famous RAFI Fundamental Index. The award-winning researcher has also been a regular co-author of academic papers with Robert D. Arnott and Jason Hsu, co-founders of Research Affiliates and among the intellectual forefathers of what’s now commonly called smart beta, rules-based investment strategies that are not tied to traditional market-capitalization-based indexes.
“It’s an arms race for gray matter,” said Ben Johnson, Morningstar Inc.’s director of global ETF research. “When you look at these various factors that have been discovered and developed and tested inside academia, they’ve been tested in this frictionless vacuum that is not reflective of investor reality, which more than anything is muddied by frictional costs — be they trading costs, be they fees, be they taxes.”
BlackRock in June announced it was hiring Andrew Ang, a Columbia Business School professor who specializes in factor investing, to help with its marketing and product-development efforts.
“You’re looking for people who can straddle that fence between theorists and practitioners,” said Mr. Johnson.
Roughly $174 billion in assets is managed using Research Affiliates’ version of smart beta. And over the last year, one in five dollars that has moved into U.S. mutual funds and ETFs has moved into Morningstar’s classification for alternative-index-tracking smart beta funds, which it calls strategic beta.
ACTIVE RESISTANCE
Vanguard, by contrast, has actively resisted the trend to make non-cap-weighted indexes out of such strategies. Unlike peers including BlackRock Inc.’s iShares, the firm has not built or licensed new indexes to capitalize on interest in smart beta. And its executives have engaged in pointed public debates with Mr. Arnott, arguing that smart beta funds should be considered “active management” because they take potentially losing bets against the market.
“The term enhanced indexing, which has morphed into ‘smart beta,’ is like finger nails on a blackboard to me,” former Vanguard chief investment officer Gus Sauter wrote last year. “What makes an enhanced index fund ‘enhanced?’ The real answer is probably a lot of marketing.”
A spokesman for Research Affiliates, Tucker Hewes, did not respond to a request for comment.
Vanguard’s Mr. Ameriks said that the firm’s thinking hasn’t changed. He said that they have no plans to launch smart beta ETFs. He said that he’s expanding his unit, which is responsible for $24 billion in assets and has existed since 1991, due to the growth of Vanguard’s actively managed strategies. In 2013, for instance, the firm brought out its Global Minimum Volatility Fund (VMVFX), which now manages more than $1 billion.
‘TERMINOLOGY ARGUMENT’
Some of those funds bear a likeness to approaches marketed as smart beta or factor investing.
“If you’re going to tilt the portfolio towards securities that you think have better fundamental value in the market, that’s an active strategy. There’s nothing to apologize for,” said Mr. Ameriks. “It’s active, and we think there are some advantages to running a strategy like that as a full-blown active proposition.
“The argument that we have with folks who try to talk about rules-based active strategies — it’s a terminology argument. It’s not indexing,” he said. “We think that does a disservice because indexing, in investors’ minds, when you present the idea of an index fund, investors think what they’re going to get is the market.”
Morningstar’s Mr. Johnson said Vanguard could be continuing to develop the sorts of “quant-driven light touch active management” strategies that have made firms like Dimensional Fund Advisors a darling of advisers.
Mr. Ameriks declined to comment on Mr. Chaves’ specific job functions.
Smart-beta indexes generally hold stocks, bonds or other securities in different proportion than traditional indexes. Stock indexes are usually cap-weighted, meaning that they hold stocks in proportion to their total market value. Mr. Arnott has argued that often requires index funds to buy too much of already overvalued stocks.
The fundamental indexes for which Newport Beach, Calif.-based Research Affiliates is most known use numbers drawn from company balance sheets when determining how much of a given stock to hold. They argue that the approach effectively sells popular overvalued stocks and buys less-popular undervalued stocks.
Research Affiliates’ strategy is the basis of funds by Invesco PowerShares and Pacific Investment Management Co.
Charles Schwab & Co. has also invested in Research Affiliates approach, which it calls fundamental indexing, producing a suite of index funds around the concept that are also widely used in the firm’s Intelligent Portfolios automated investment advisory service.
“Rebalancing helps the strategies that systematically trade against changes in price or valuation multiples and hurts strategies that chase momentum,” Messrs. Chaves and Arnott wrote in the Journal of Portfolio Management in 2012. “At a risk of rather drastically oversimplifying, it would seem that … the Fundamental Index approach is a better way to handle value investing.”