We examine a unique looking actively-managed product

Liquidity is typically seen as the investor’s friend. It represents the ease at which you can buy and sell shares quickly and easily, and without causing a drastic change in the price.

However, there is research which suggests less liquid investments can generate premium returns – in part as compensation for the lack of liquidity and the perception that these equities are riskier than more liquid shares.

Vanguard Global Liquidity Factor – sector breakdown

Financials – 30.9%

Industrials – 15.5%

Consumer services – 13.3%

Consumer goods – 10.6%

Oil & Gas – 8.8%

Basic Materials – 7.8%

Technology – 4.3%

Utilities – 4.1%
Source: Vanguard

Investors can tap into this theme via an exchange-traded fund from Vanguard. For an ongoing charge of 0.22%, Vanguard Global Liquidity Factor (VLIQ) tracks stocks which, when compared to others in the investment universe, have low trading volumes and other measures of trading liquidity, including lower trading share and dollar volumes, based on percentage turnover, and price impact.

What is the difference between active ETFs and smart beta?

The development of ETFs in the last decade has seen the emergence of products which rather than tracking a simple index like the FTSE 100 will seek to filter stocks based on different criteria including levels of volatility or dividend yield.

These are known as smart-beta ETFs. Vanguard’s factor products don’t track an index at all, instead the firm’s quantitative analyst team actively manage the portfolio of the product.

As Vanguard’s Fitzgerald explains: ‘Our quants team effectively check and test portfolio holdings on a daily basis. If you have a benchmark it will rebalance every six months and this means your exposure to the factor will decay. We take an active approach to tweak and keep it on course.’

If a stock doesn’t fit the relevant criteria it can be removed immediately rather
than sitting in the ETF for months until the underlying index is updated.

VOLATILE STRATEGY

In 2016 and 2017 the ETF achieved returns of 16.7% and 20.1% respectively but in 2018, a tough year for equities in general, it turned in a negative performance of -15.9% which shows that the strategy isn’t a guaranteed winner.

Mark Fitzgerald, Vanguard’s head of ETF product development in Europe, says the product stands out in the way it is constructed as it seeks to capture the so-called ‘illiquidity premium’ without the unintended bias towards small cap stocks.

‘In this space it is a struggle to find an appropriate competitor product. Most of the development around this area tends to be around small caps.

‘People traditionally have focused on small cap positioning with an understanding of what that means and the premium to be had – that is that shares are less liquid and are not traded as efficiently.’

Fitzgerald explains that at the same time as delivering the factor-based exposure, there is a focus on maintaining diversification. ‘The philosophy here is very much in line with John C Bogle’s maxim of not looking for the needle in the haystack and just buying
the haystack.’

The factor-based ETF can choose from a large list of global stocks and will often have thousands of holdings, aiming for around a third of the available universe.

Fitzgerald adds that while capturing lower liquidity stocks, Vanguard looks to avoid a situation where that might compromise the liquidity of the overall portfolio.

PART OF A BROADER PRODUCT SUITE

Vanguard Global Liquidity Factor is part of a quartet of ETFs, launched in 2015, which track global stocks based on different ‘factors’ which are defined as underlying investment drivers that explain the performance of markets – see table.

The roster comprises actively managed ETFs focused on value, liquidity, momentum and minimum volatility. All four have an ongoing charge of 0.22%.

The minimum volatility ETF uses a model which is designed to measure stocks’ exposure to a variety of factors that drive volatility such as sector, liquidity, size, value and growth. The model also assesses the interaction between these factors and their impact on the overall volatility of the portfolio.

The momentum-based instrument looks for stocks which have performed relatively strongly on a six-month and 12-month basis.

The value-focused product uses metrics including price-to-book or price-to-earnings ratio, estimated future earnings, and operating cash flow to filter stocks.

Fitzgerald explains Vanguard can keep the costs on these products low thanks to its scale, which means cheaper commissions on trading, and because the cost of employing quant analysts is cheaper than paying the licence fee on an index.

There is also an aim to strike a balance between tweaking the portfolio to ensure it remains in line with the relevant factor and trading too frequently.

Vanguard Factor ETFs

Vanguard Global Liquidity Factor (VLIQ)

Vanguard Global Minimum Volatility Factor (VMVL)

Vanguard Global Momentum Factor (VMOM)

Vanguard Global Value Factor (VVAL)

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