One Vanguard, Many DFAs (Part 2)

The mutual fund industry’s two indexing leaders have left different legacies.

John Rekenthaler 28.04.2016
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In part 1 of this article, we looked at the “broad” and “narrow” approach that Vanguard and DFA took. In part 2 of this article, we will explore the business logic of these two indexing leaders.

DFA did not--and has not--used the language of strategic beta to describe its approach, but that is what it does. In DFA's words, academic research has identified “dimensions of higher expected returns in the global capital markets. Portfolios can be structured around those dimensions, which are sensible, backed by data, and cost-effective to capture.” Whether these additional returns from exposure to these factors (or betas) are fully paid by the price of additional risk is unclear. The main point is that DFA--as with fund companies that talk about the intelligence of their betas--promises that, by neglecting portions of the marketplace, its funds will outperform the naive, broad indexing strategy.

For Vanguard, this notion sounds suspiciously like those espoused by active managers. Strategic-beta investors think they can identify a pool of higher-returning stocks. So do active managers. Strategic-beta investors also believe that, no matter how cheaply a broad-index fund is priced, they can outgain that fund by applying insight. So, too, do active managers.

Indeed, writes Vanguard in a white paper on the subject, strategic-beta funds may be structured as indexes, but they are not passive investments. They are instead “active strategies, because their rules-based methodologies tend to generate meaningful security-level deviations, or tracking error, versus a broad market-cap index.” The paper finishes with a stiletto. “The debate regarding the long-term performance of active versus indexed strategies continues, but Vanguard believes that reweighting traditional market-cap-based indexes represents neither a ‘new paradigm’ of index investing nor a ‘smarter’ way to invest.”

Business Logic
The investment merits of each side continue to be debated. From a business perspective, the outcome of the broad versus narrow tussle was inevitable.

The market only needs one broad indexer. The 15th flavor of an S&P 500 fund won’t taste any different from the other flavors, assuming that the fund provider keeps costs low and has competent management. Vanguard got there first, pressed its first-mover advantage with aggressive cost controls, and rolled the field. The invention of exchange-traded funds did open a door for BlackRock and State Street, but Vanguard is catching up there, as well.

In contrast, there are many possible interpretations of strategic beta. A marketer can’t credibly make the proposition “Buy my market-capitalization fund because it is different from and better than Vanguard’s.” But it certainly can claim to have different strategic-beta funds from DFA. There are other betas to discover and new definitions of existing betas (for example, defining “value” in a manner other than a low price/book ratio), or fresh combinations thereof. The landscape has been wide open for companies that wish to follow in DFA’s footsteps.

And follow they have. It took until the ETF-age for strategic-beta providers to emerge in earnest, because accepting the lower fees associated with that approach was not an easy step for asset managers. (It feels a lot better to them to raise prices than to lower them.) But now they are legion, coming from all corners of the investment-manager industry, including hedge fund company AQR.

One Vanguard, many DFAs. (Note: This comment applies to the investment debate only. For its entire business, DFA, like Vanguard, has a wide protective moat, thanks to its unique distribution strategy of selling through relatively few financial advisors, who pledge unusual loyalty to the company and who use only asset-based fees [as opposed to load charges].) It took a while, but it was bound to happen.

 

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John Rekenthaler  is vice president of research for Morningstar.

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