Designing factor portfolios for your clients

February 19, 2019

Fran Kinniry

Fran Kinniry
Global Head of
Portfolio Construction
Vanguard Investment Strategy Group

Knowing how to deploy Vanguard U.S. Factor ETFs in a portfolio means knowing your clients’ goals and understanding their appetite for risk.

I always tell everyone there is no optimal portfolio for every client and/or every practice, since the optimal portfolio is fully dependent on the goals and objectives of each client and each practice, and that's true for factor-based investing as well.

Advisors have definitely begun adopting our factor funds, and plenty more want to know how to implement thoughtful factor-based exposure. That can be a hard question to answer in more ways than one. But Vanguard, as a partner and advocate for the advisory community, stands committed to producing research, tools, and strategies to help answer such challenging implementation questions.

For example, you could assemble the same factor-focused portfolio in countless ways, ranging from traditional bottom-up active management to a size and style "nine-box" approach to using next generation products such as our highly targeted, low-cost active factor ETFs. Also, different clients and advisory practices may want different factor exposures, which would render as many factor portfolios as there are client preferences.

At Vanguard, we have a suite of products that includes market-cap-weighted index strategies, traditional bottom-up active funds, size and style funds that employ factor tilts inside of an overall cap-weighted approach, and actively managed factor-based ETFs that dispense with cap weighting. Again, the right choice depends on client and/or advisory practice objectives, as well as the client's willingness to accept risks.

Embarking on a factors-finding mission

When you’re trying to figure out what factor exposure makes sense for your clients, you have to:
(1) Start with asset allocation.
(2) Then determine what level, if any, of active exposure makes sense for their long-term plans.

Let's say you set out to assemble a hypothetical 60% stocks/40% bonds broad-market global portfolio for a client who is looking for outperformance. Given the outperformance objective, you have to determine the appropriate active approach. Are you going to use bottom-up fundamental managers, or are you interested in a factor-based investment?1

Attributes of primary types of factor products*

Attributes Style index products Factor funds and ETFs Traditional active products
Examples of products offering
value factor exposure:
Vanguard Value Index Fund and ETF Vanguard U.S. Value Factor ETF Vanguard Windsor™ Fund
Weighting Market capitalization Rules-based (varies) Proprietary
Transparency High Moderate-high Low-moderate
Consistency of factor exposure Moderate High Low-high
Degree of factor exposure Moderate High Low-moderate
Tracking error
(versus broad-market index)
Moderate Moderate-high Low-high
Opportunity for alpha
(through unique manager stock selection and/or market-timing)
No No Yes
Manager risk Low Low Low-high
Cost Low Low-moderate Low-high
Level of portfolio manager discretion Low Moderate High

* Long positions only.

Source: Vanguard, as of December 31, 2017.

Let’s also say that you wanted about a third of your client's equity allocation to be active and that you decided you would obtain the active exposure using factor ETFs.

To keep your client's portfolio well diversified, you decide to devote 40% of the equity allocation to international stocks. You then divide the 60% of the U.S. equity allocation in half, investing 30 percentage points in a total market index strategy and the other 30 percentage points in a factor-based ETF.

Hypothetical equity allocation to factor ETF

Hypothetical equity allocation to factor ETF

Determining the allocation is all about aligning with your client's objectives and, more important, understanding what the client can stick to during all market cycles. It also is highly dependent on your beliefs as the advisor, along with your preferences and the value proposition of your practice.

Mustering single-factor fortitude

While factor investing has existed at least since Benjamin Graham and David Dodd published their classic book in 1934, Security analysis,2 it was largely limited to market-cap-weighted design or traditional pure style managers. But factor-based investing now has become much more targeted and explicit given the launch of active factor ETFs.

Our factor ETFs are untethered from the market-cap weighting of earlier factor funds, and their expense ratios are about a third of the expense ratio of the average manager of a traditional bottom-up active fund.3 Also, the level of factor exposure is especially important to an understanding of how our single-factor ETFs can potentially enhance returns or dampen volatility, depending on the choice and client goals.

From a behavioral coaching standpoint, you have to make sure that your clients understand that the tracking error of these factor funds is much larger than that of a market-cap-weighted factor fund. In other words, their returns can look very different from a total market cap-weighted index fund because the weighting of securities differs from that of cap-weighted funds in ways that increase the degree of factor exposure.

That tracking error also means that investors who believe in factors must be extremely patient.4 Factors can go through long periods of underperformance before the tide turns and, as research has shown, begin outperforming.5 That said, if one believes in the factor he or she is investing in, the greater the degree of exposure to that factor provides the highest capture of the factor. That represents an improvement because of the more pure exposure to the factor

Understanding the smoother multifactor ride

If your clients or your practice does not have a strong conviction in an individual or select few factors you wish to overweight, a multifactor fund is a great place to start. The Vanguard strategy seeks to provide long-term capital appreciation by investing in U.S. stocks that target three factors, value, momentum, and quality, after an initial volatility screen.

Such a strategy offers potential diversification benefits that can help reduce the active risk associated with exposure to a single factor.

Harnessing high-octane exposure with single factors

But for those who believe that now's the time for, say, momentum or value, our single-factor ETFs are about a third less costly than a bottom-up active approach3 and are designed to deliver much more concentrated factor exposure than a market-cap-weighted style factor fund from the size and style universe.

We designed our factor ETFs to provide strong and consistent factor exposure that investors can get in a transparent, broadly diversified, and long-only solution. Our active implementation, which includes reviewing portfolios daily and rebalancing them when necessary, helps maximize their factor concentrations.6

Active equity factor implementation can maintain more consistent exposure

Active equity factor implementation can maintain more consistent exposure

Source: Vanguard.

Notes: Figure is hypothetical and stylized and is for purposes of illustration only. Factor-weighted indexes, by design, require more trading than market-cap-weighted indexes, increasing the risk of front-running. For more about factor index front-running, see Joop Huij and Georgi Kyosev, 2016. Price response to factor index additions and deletions. Available at

That might mean that a client who had, say, half of his or her equity allocation in a style-box value fund could potentially get the same level of value exposure with a smaller position in our value factor-based ETF. Again, that’s because with our factor-based ETF, the client would get a more targeted exposure to factors without the diluting effect of market-cap-weighting methodology.

Assessing the future of factor ETFs

In assessing the future of factor-based investing, it’s important to remember that there are still substantial assets invested in higher-cost active funds that happen to carry a lot of factor exposure.

Given that we’ve been in one of the longest bull markets in history, many advisors and investors are stuck with large capital gains in these high-cost funds. We believe that if the market falls and the cost basis of some of these high-cost active funds falls below their market value, factor funds will represent great value and opportunity for advisors.

High-cost vs. low-cost funds

High-cost vs. low-cost funds

Source: Vanguard calculations using data from Morningstar as of December 31, 2017.

Advisors could potentially replace these higher-cost active funds with factor ETFs, which are about a third of the cost, while not incurring any capital gains.3 The chart above shows the differences between average Vanguard expense ratios and average industry expense ratios for different strategies, including traditional actively managed mutual funds.

In other words, we believe that many of the highest-cost active funds of today are most likely not going to be around 20 years from now.

In this context, we believe our factor ETFs are innovative and disruptive in that they may be less expensive and more targeted versions of high-cost active. As you take measure of how to achieve targeted factor exposures in client portfolios, our ETFs loom as vehicles that can potentially deliver a whole variety of exposures in a high-octane, low-cost, and tradable ETF wrapper.

1 Vanguard considers any deviation from broad-market, market-cap-weighted indexing to be active management—even non-cap-weighted strategies in rules-based indexes.

2 Benjamin Graham and David L. Dodd, 1934. Security analysis. New York: Whittlesey House, McGraw-Hill Book Company Inc.

3 Vanguard calculations, using data from Morningstar, Inc., as of December 31, 2017.

4 Douglas M. Grim, 2018, at (Blog post.)

5 Douglas M. Grim, Scott N. Pappas, Ravi G. Tolani, and Savas Kesidis, 2017. Equity factor investing: A practitioner's guide. Valley Forge, Pa.: The Vanguard Group.

6 Vanguard, 2018. Vanguard factor ETFs: Harness low-cost, transparent exposure to factors. Valley Forge, Pa.: The Vanguard Group.

For more information about Vanguard factor ETFs, please check out The Factor Center.

Check out the next article in the winter 2019 issue of ETF Perspectives.

Nate Geraci

The best portfolio is the one your clients stick to

Advisor and ETF evangelist Nate Geraci, who is president of The ETF Store, outlines the importance of due diligence in the selection of ETFs.


  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Diversification does not ensure a profit or protect against a loss.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
  • Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from the stock market. Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.


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