Can active equity managers be replicated using factor funds?

November 10, 2020 | Vanguard Perspective

Can active equity managers be replicated using factor funds?

If an active equity manager is found to have generated returns that could have been more or less mimicked by factor strategies, you may be able to produce a similar style profile for your clients with greater transparency, more risk control, and lower costs, thereby raising the bar for some active managers.

By assessing the "clonability" of the traditional active equity managers in your clients' portfolios, you may find that a manager hired to generate positive alpha has merely been providing a fairly consistent tilt toward one or more well-known factors.

A step-by-step guide for assessing the factor profile of an active manager

This box chart shows steps one through five from left to right. Step 1 says select an active manager to test, Step 2 says select factor candidates, Step 3 says select investable proxies for each factor, Step 4 says conduct returns-based style analysis, and Step 5 says assess goodness of fit, factor stability, and alpha.

In cases where traditional active equity managers are not adding unique value or are charging too much, use this step-by-step approach to see if replacing them with a factor strategy provides an opportunity to generate excess return, with greater transparency, more risk control, and lower implementation costs.

Notes:

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  • All investing is subject to risk, including the possible loss of principal. 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.
  • The Factor Funds are subject to investment style risk, which is the chance that returns from the types of stocks in which a Factor Fund invests will trail returns from U.S. stock markets. The Factor Funds are also subject to manager risk, which is the chance that poor security selection will cause a Factor Fund to underperform its relevant benchmark or other funds with a similar investment objective, and sector risk, which is the chance that significant problems will affect a particular sector in which a Factor Fund invests, or that returns from that sector will trail returns from the overall stock market.