10 March 2015 | Indexing

The financial industry is known for introducing new terminology to its already hefty dictionary and new funds to its already crowded shelves. Investing strategies called smart beta, fundamental indexing and liquid alternatives are recent additions to both the lexicon and the fund lineup.

These strategies have been gaining in popularity behind a combination of strong results at times, shrewd marketing and investors’ desire to beat the market indexes. They certainly sound exotic and might appear attractive to investors searching for different options. But exactly what are these strategies? Are they new ideas, or old ones with a new marketing spin? And what’s their potential role in an investment portfolio?

First and foremost, all are forms of actively managed investing. Traditional index strategies, including those Vanguard uses, are passively managed; they seek to replicate an index of a given market segment by weighting securities based on the size, or market capitalization, of companies in the index.

We sat down with Joel M. Dickson, The Vanguard Group, Inc.’s global head of research and development and a principal in The Vanguard Group, Inc. Investment Strategy Group, to talk about alternative strategies and what investors should know about them.

Let’s start with smart beta and fundamental indexing. Can you tell us more about these terms, which seem to be used interchangeably?

Fundamental indexing, alternative weighted indexing, smart betain many ways, these strategies in and of themselves are not new. They have been used in institutional asset management for decades.

They’ve been known by names like enhanced indexing, quantitative investing and so forth; Morningstar has started calling them strategic beta. But what’s common among them is a little more emphasis on different risk factors. They focus more on the risk characteristics of, for example, value or small-cap securities, or the volatility characteristics of a group of securities, as opposed to individual security selection.

How do they differ from what we think of as traditional index strategies?

Certainly indexes have been created out of them, and a lot of funds may be seeking to track these indexes. But we think these indexes reflect actively managed strategies just put into a passive form. And this has really, in many ways, been a rebranding of active quantitative strategies.

What about liquid alternatives, which are often touted as a natural extension of private hedge funds and use nontraditional methods to try to generate returns and diversify against risk?

In many ways, these strategies have also been around. They’ve just tended to be around in more opaque, less available ways, such as through hedge funds or other alternative investments outside the traditional mutual fund or exchange-traded fund approach. There are many reasons for that. Typical alternative strategies may have holdings like very illiquid securities. What people are trying to do now, though, is to create a more liquid, transparent version of strategies that historically might have been in the hedge fund industry. There can be some fairly complex strategies that you might be able to replicate in a more liquid way and potentially put them into a mutual fund form.

Are such strategies going to be more accessible to individual investors than ever before?

It’s possible. In some ways, the current frontier of fund development is in these sorts of alternative strategies and this reframing of quantitative investing in the fundamental indexing approaches. They may become more available, but sometimes more tools aren’t necessarily better. If you already have the tools to put into your portfolio and they work well, it’s not clear that the shiny new tool actually does anything better for you.

How might these strategies fit into an investment portfolio?

When we talk about portfolio construction, we focus a lot on asset allocation. As soon as you start deviating and becoming more concentrated in a specific factor or strategy or segment of the market, the more your return might differ from that broader asset class return. You need to understand the risks you’re taking. How are you, as the investor, going to react to those differences?

Is there a danger that investors could mistake some of these strategies for traditional indexing?

I think a lot of timesand this is especially true with fundamental indexing or smart betathese approaches are being marketed as new and improved index funds. While many of these strategies may be technically offered as index funds because they seek to track an index, the index itself just represents an underlying active strategy.

What should investors consider when evaluating these strategies?

These strategies often involve some historical relationship of risk or return that is different from the broad asset class, or market exposure. Do you believe those risk/return characteristics will persist? Is this portfolio capturing that risk factor? Does the fund look the way you would expect it to? That’s very much how we talk about evaluating an active manager. Also, there may be lower-cost ways, through traditional market-capitalization-weighted index funds, to achieve some of the risk exposures being offered through these so-called smart beta approaches.

What are the broad considerations for Vanguard and the investor when it comes to strategy?

We’re constantly aiming to put investors in the best possible situation for the potential for outperformance. And that often comes down to cost. So it’s not active investing versus passive investing. Rather, it’s often an issue of: Do the fees outweigh the potential benefits of active management? And certainly at Vanguard, with low-cost active and passive funds, we think we give investorsthrough either type of strategythe best possible chance to meet their goals and objectives.

Important information:

The views expressed in this material are based on Joel Dickson’s assessment as of the first publication date (March 10, 2015), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc.  The individual strategists may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise.  Any forward-looking information contained in this material should be construed as general investment or market information and no representation is being made that any investor will, or is likely to achieve, returns similar to those mentioned in this material or anticipated in this material.

This material is for informational purposes only.  This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and thus, should not be used as the basis of any specific investment recommendation. Please consult your financial and/or tax advisor for financial and/or tax information applicable to your specific situation.

All investments, including those that seek to track indexes, are subject to risk, including the possible loss of principal.  Diversification does not ensure against a profit or protect against a loss in a declining market.  >While ETFs are designed to be as diversified as the original indexes they seek to track and can provide greater diversification than an individual investor may achieve independently, any given ETF may not be a diversified investment.

In this material, references to Vanguard are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc. and/or may include its affiliates, including Vanguard Investments Canada Inc.

Vanguard ETFs are managed by Vanguard Investments Canada Inc. an indirect wholly-owned subsidiary of The Vanguard Group, Inc. and are available across Canada through registered dealers.