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

Yes, costs can be difficult to estimate. In addition to the expense ratio, there are other real-world implementation costs (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 recent webcast about factor-based investing.

 

Not all equity factor-driven products are cheap

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 industry-level cash-flow trends, 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

 

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.

 

More and more investors are learning that keeping costs low is an important way to help improve the odds of beating the market with active approaches, whether the search involves traditional active or factor-driven products. As you consider factor products for your clients’ portfolios, don’t forget about the elephant in the room. Be sure your due diligence includes an all-in cost assessment. At the end of the day, you need to be sure you’re getting what you pay for.

 

I would like to thank my colleague Ryan O’Hanlon for his contributions to this blog.

 

1 There is no consensus industry definition for smart beta. Some consider it a catchall marketing term for any index strategy that does not track a market-capitalization-weighted benchmark. I use the term in this blog simply because some advisors use it interchangeably with factor products, as their results are often driven by factor exposures. For our view, see https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/article/IWE_InvResEvaluationOfSmartBeta

2 James J. Rowley Jr., David J. Walker, and Sarinie Yating Ning, 2018. The case for low-cost index-fund investing. Valley Forge, Pa.: The Vanguard Group. Daniel W. Wallick, Brian R. Wimmer, and James J. Balsamo, 2015. Shopping for alpha: You get what you don’t pay for. (Research note). Valley Forge, Pa.: The Vanguard Group.

 

Note:

Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from the stock market. Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.