It was the first of the Ps that caught everyone’s attention when both JP Morgan and Vanguard entered the factor fray in November. JP Morgan listed ETFs covering value, quality, momentum, minimum volatility and dividends; Vanguard confirmed that in the first quarter of 2018 it would launch the same range minus dividends but including the liquidity factor plus a multifactor ETF and mutual fund.
Each JP Morgan ETF will carry a net expense ratio of 0.12%, undercutting the equivalent fund suite from iShares, which costs 0.15%. Vanguard, despite registering its products later in the month, declined to go lower; its single-factor ETFs will have an estimated expense ratio of 0.13% while the multifactor funds will cost 0.18%.
However, there are two caveats to these JP Morgan charges. One is that the firm has arrived at the 0.12% net figure only by discounting the funds. JP Morgan is waiving 40 basis points of revenue on each ETF until at least November 2020.
Price before a fall
Without this offer, the JPM ETFs’ total annual operating expenses would be 0.52%, comprising a management fee of 0.23% and estimated other expenses – such as trading costs – of 0.29%.
That the ETFs’ price point of 0.12% will be lower than these estimated expenses suggests that JP Morgan is heavily subsidizing them and running them as a loss leader as it seeks a foothold in this space.
The group may well be successful in this endeavor, and has indeed highlighted that it achieved a top-10 place in flows across smart beta products in 2016.
But the second caveat to the headline 0.12% is that even with these fee reductions, JP Morgan will not be the cheapest provider of these funds. Charles Schwab and State Street both have US value ETFs at 0.04% and US dividend ETFs at 0.07%. State Street has US momentum and low-volatility ETFs at 0.12%.
Only in the quality factor, then, does JP Morgan have a market-beating price. Here, though, some buyers may opt for a US growth strategy instead – which can be accessed for as little as 0.04% from Charles Schwab – given the overlap of major positions such as Apple, Facebook and Berkshire Hathaway.
Somewhere between everything and nothing
Rich Powers, head of ETF product management in Vanguard’s portfolio review department, has meanwhile argued that ‘low cost isn’t everything; it’s one factor among many other important factors’, which helps explains why his firm may have conceded the pricing lead to other players.
‘Cost matters when you’re considering an 80 to 120-basis-point expense ratio investment versus a 12 to 25-basis-point investment,’ Powers elaborated. ‘In that case, the expense ratio should be at the top of your due diligence checklist. When the difference in expense ratios among competing products is only a few basis points, cost falls down the checklist.’
Instead, he proposed, investors should focus on the underlying indexation of ETFs, dealing fees, tracking difference, tax efficiency, and the provider’s reputation.
The second P may therefore ultimately prove to be the most important differentiator for Vanguard and JP Morgan, even though the latter firm’s marketing material seems to underplay this aspect.
Rather than licensing its indices from an external specialist – iShares draws on MSCI, Charles Schwab uses Dow Jones, and so on – JP Morgan will be tracking a proprietary index of between 200 and 400 stocks derived from the Russell 1000.
Under a rules-based approach, the portfolio will be managed by JP Morgan’s quantitative beta team, led by Yazann Romahi.
Specific details of the underlying methodologies have not been released, but JP Morgan has said that it will, for example, define quality with reference to a stock’s profitability, solvency and – circuitously – the quality of its earnings. Meanwhile, momentum will target stocks with ‘better recent performance compared to other securities,’ as well as minimum ‘historical volatility and correlation of the returns among sectors over the last three years.’
The dividend and minimum-volatility ETFs will manage their exposures at the sector level, while the momentum, quality, and value ETFs will match their sector weights to those of the Russell 1000.
The weighting game
In practice, one of the main consequences of all this is that the JP Morgan funds are taking considerably less stock-specific risk than their iShares rivals.
The iShares Edge MSCI USA Value Factor ETF has, for instance, 9.8% in its top holding, Apple. For the JP Morgan US Value Factor ETF, the largest allocation is 2.1% in Microsoft, and Apple is its fourth-largest investment at 2%.
Likewise, the iShares momentum product has three positions worth at least 5% of the portfolio; the biggest stock in its JP Morgan competitor represents just 2% of the fund. For quality, iShares has 6% in Altria, while no company is worth more than 2% of the equivalent JP Morgan ETF.
As well as building less-concentrated portfolios, JP Morgan’s proprietary process diverges markedly from MSCI in stock selection too.
For JP Morgan, Amazon is the top momentum name; for MSCI and iShares, Microsoft is at number one and Amazon doesn’t feature at all. Wells Fargo ranks third in JP Morgan’s value screen, but isn’t included in the iShares ETF. Pfizer is a top-10 quality stock for JP Morgan but is not among the 129 securities in the iShares fund.
It is too early to tell whether JP Morgan’s proprietary approach will add any value, but it is clear that definitions matter far more than price. The Schwab US Large Cap Value ETF and the SPDR Portfolio S&P 500 Value ETF both now have the same 0.04% expense ratio, for example, and yet in the three years to the end of October, the former returned an annualized 9.6%, and the latter 8.5%.
Vanguard: the active giant
Vanguard, on the other hand, has handed responsibility for its factor funds to its quantitative equity group of active managers who oversee nearly $35 billion in assets.
They are of course quantitative and rules based rather than stock pickers, but the funds will nevertheless rely more on human discretion than others that replicate an external passive index.
In this effort, results have been mixed. Vanguard’s quantitative equity group has been running global factor ETFs in the UK since December 2015, with the minimum volatility and value strategies outperforming but momentum lagging the MSCI versions.
In the year to the end of October 2017, the UK-listed Vanguard Global Minimum Volatility ETF returned 16.7% compared with 15.4% from the MSCI World Minimum Volatility index, both on a gross basis and in US dollars. Vanguard’s value fund generated 26.4% over the same period, again ahead of the 21.1% from the MSCI World Value index. But in momentum, the MSCI World Momentum index delivered 32.4% while the Vanguard ETF achieved only 25.8%.