Vanguard sounds warning on ‘rules-based’ ETFs

Vanguard, seen as the pioneer of the low cost passive investment strategy now manages over $4bn in bond and equity funds. Rodney Comegys, head of investments at Vanguard says, “Indexing is hot. Target date funds are hot. Exchange-traded funds just keep growing.” Vanguard is now the largest bond fund investor in the world and it’s partly a reflection of the dissatisfaction investors have with active managers’ performances and fees. However, parts of the passive investment community have sought ways to become wring more out of their passive returns. Starting in 2006, ETF providers such as Wisdom Tree launched one of the first alternatively weighted ETFs, calling them “fundamentally weighted.” Describing the ETFs as rules-based and offering representative exposure to an asset class, the new style of index ETF had “alternative weighting methods” and a high correlation to established benchmarks. This style became known as “smart beta”, which The Economist later defined as an approach that tries to enhance the return from tracking an asset class by deviating from the traditional “cap-weighted” approach, with “deviation” produced by employing screens and filters over the benchmark index. However, Vanguard and Comegys are wary. “It’s neither smart nor beta…we are talking a rules-based active strategy. It’s going to perform like active. It’s going to outperform, underperform, it’s going to have transaction costs and there are taxes that have to be paid.”