Despite all the talk about factor funds, there’s an elephant in the room that deserves more attention
Smart-beta or factor funds are getting plenty of press, due in no small part to investment industry professionals who see support from hypothetical back-tested returns data. But an expert from Vanguard notes that they fall short in one crucial aspect.
“Rarely … do they address the elephant in the room: costs,” wrote Doug Grim, senior investment strategist with Vanguard Investment Strategy Group. “When we talk to advisors, we hear that what they care about most are the returns their clients get to keep, including after the tax collector takes his portion.”
Acknowledging that costs can be difficult to estimate, Grim noted that real-world implementation costs, such as the bid-ask spreads, commissions, and market impact have to be factored in aside from the management expense ratio. But even the management expense ratio alone can be very informative.
“Reason assumes that smart beta costs are between cap-weighted indexing and traditional active. But that isn't always the case,” Grim said. Referring to a graph showing a distribution of traditional active and factor-driven funds, he pointed out that some active funds are not expensive, and some factor-based funds are actually not low-cost.
Because of the rules-based and transparent nature of many equity factor-driven products, he said, advisors should compare the costs of such funds with rules-based, transparent, broad-based cap-weighted index funds that charge a few basis points, as well as with any low-cost traditional active managers.
Grim also cited data derived from Morningstar figures, which showed US investors’ steady migration toward lower-cost equity factor funds. He suggested that investors are learning that containing costs is important to improve their odds of beating the market with active approaches.
“As you consider factor products for your clients' portfolios, don't forget about the elephant in the room,” he concluded. “Be sure your due diligence includes an all-in cost assessment.”
