Has Vanguard Been Seduced by the Dark Side?

The Vanguard Group has a reputation for offering passive index-tracking mutual funds and exchange-traded funds at the lowest possible cost. It hasn't hesitated to criticize more expensive ETF providers for taking more of their investors' money than they should, and it has pulled in trillions of dollars of assets from investors who like its shareholder-owned fund structures and cheap fund offerings. A whole generation of Vanguard investors has adopted what they see as the fund manager's corporate philosophy that active investing is a waste of money.

Yet earlier in February, Vanguard appeared to move in a completely new direction with a set of new ETF offerings. The company released six new funds that seek to jump onto an industry trend known as factor investing, featuring stocks that share certain attractive traits that investors want to focus on in their portfolios. Most factor ETFs are actively managed, leaving some to wonder whether Vanguard has abandoned its long-held emphasis on passive index investing.

So, has Vanguard lost its way? Or should investors see the new ETFs as merely another way in which the fund giant has sought to give its shareholders more choices? Let's look more closely at these new Vanguard factor ETFs to see what's underneath the hood.

Data source: Vanguard.

What is a factor ETF?

Vanguard notes that despite the recent introduction of the factor ETF concept to the exchange-traded fund market, there's nothing new about looking for stocks that share common attractive characteristics. What the new ETFs do is allow investors to concentrate on certain areas. In choosing its factors, Vanguard has noted that on the whole, the following statements tend to be true:

• Cheap stocks earn higher returns than expensive stocks.
• Stocks that have done well lately earn higher returns going forward than those that have done poorly recently.
• Stocks with better company fundamentals outperform those with weaker fundamentals.
• Stocks with less trading liquidity have done better than those with more liquidity.

Moreover, Vanguard recognizes that some investors will want to protect against episodes of market volatility by choosing stocks that tend to move less abruptly during market downturns, even at the cost of giving up higher returns during bull markets.

Image source: Vanguard Group.

A better alternative to true active management

Vanguard's factor ETFs are the first actively managed ETFs that the fund manager has offered to the U.S. market. But the fund company still emphasizes that most of the value in investing doesn't come from active management. The factor ETFs distill the key areas in which Vanguard believes active managers can add the most value.

The factor ETFs use a rules-based approach that's somewhat similar to the strict index-tracking investment objectives of true passive ETFs. Yet Vanguard sees its offerings as better than most factor ETFs because its active management allows it to make changes immediately when a stock no longer fits a given factor. That can be crucial in areas like momentum investing, where a reversal in upward momentum can be a huge impediment in a fund that only rebalances on a quarterly or less frequent basis.

Vanguard's initial materials on factor ETFs emphasize applications in which investors can substitute them in place of high-cost fully actively managed mutual funds and ETFs that often carry annual costs of 1% or more. With expenses of 0.13% to 0.18%, Vanguard's factor ETFs aren't its cheapest offerings, but the costs are relatively low compared to other actively managed options.

Adapting to investor needs

In offering factor ETFs, Vanguard appears to be responding to the need among professional advisors to have products that meet clients' desires for a more active approach toward portfolio management. Some of Vanguard's marketing materials take positions that strongly suggest that Vanguard still believes that a passive approach is best, but that products like factor ETFs are necessary to give clients what they think they want. That's a balancing act that recognizes the realities of the money management world.

Vanguard hasn't gone to the dark side with its factor ETFs, but it will be interesting to see how the products perform compared to the asset manager's popular index ETFs. If factor ETFs truly produce consistent outperformance, then they could fundamentally change the way that Vanguard shareholders look at how they should invest.