ETF Expert Corner

Alpha Architect’s Jack Vogel Explains Closet Indexing, Highlights New ETF

May 9th, 2017 by ETF Store Staff

Jack Vogel, CFO & Co-Chief Investment Officer at Alpha Architect, discusses the problem of closet indexing and spotlights the recently launched Alpha Architect Value Momentum Trend ETF (VMOT).


You can listen to our interview with Jack Vogel by using the above media player or enjoy a full transcription of the interview below.

Nate: I'm now very pleased to welcome to the program Jack Vogel, CFO and Co-Chief Investment Officer at Alpha Architect. Alpha Architect currently offers five ETFs, including one they just launched last week, and they also do a tremendous job of helping to educate investors on a variety of important concepts, including one which we'll focus on today - this concept of active share in your mutual funds and ETFs. Jack is joining us via phone from just outside Philadelphia. Jack, as always, a pleasure to have you on the program.

Jack: Thanks for inviting me – I enjoy the conversation.

Nate: Jack, before we dive into some of the topics I would like for us to cover today, I'm sure you saw the headlines last week where the managers of the FPA Capital Fund referred to ETFs as weapons of mass destruction. Conor and I spent some time on this in our first segment, but I'm just curious, any thoughts or response to this?

Jack: What I would say is ETFs definitely probably are having some impact. There's some new academic papers on the topic as research is trying to figure out what's going on here with ETFs. Some papers have shown that, basically, macro information becomes more important than firm-specific information, which probably is where that comment may have come from as smaller-type stocks it appears are having smaller earnings response coefficients than in the past as their ETF ownership increases. The other thing that researchers have found is that liquidity cost of trading may be slowly transferring from individual stocks to ETFs. While I'd say I don't think they're weapons of mass destruction, I think that there's some interesting impact that they're having, which is probably the genesis for that conversation.

Nate: When you look at the messengers of some of these comments, what we're seeing more and more are the messengers being actively managed mutual fund companies and I want to talk a little bit about some of the challenges they face. We know about the high fees and the underperformance, which obviously go hand-in-hand. I think an under-reported issue is something that's called closet indexing, and I know your firm has spent a lot of time researching this topic and digging into the data. I was hoping first, for investors who may be unfamiliar with this term, can you explain what closet indexing is?

Jack: Sure. Closet indexing is really just trying to determine... a manager may put a name on the fund and say they’re value, growth, momentum, profitability, whatever factor they want to claim that they're trying to achieve. But really, one way to assess whether or not and how different said fund manager is from the market could be to compute what's called their active share. Active share is a calculation where it can range from zero percent to 100 percent, and whereas if you are 100 percent active share, that means that the rates of the stocks in your portfolio deviate a hundred percent from the index. If you are zero percent, that means you are basically just the market cap weighted index. One way to mathematically calculate and see how closet indexy a fund may be, would be to examine the mathematical active share calculations. A lot of smart beta ETFs are somewhere in the 30 to 40 percent active share percentage, meaning that 70 percent of the fund is simply market cap weighted attribution, and the other 30 percent is truly active.

Nate: So Jack, to sort of crystallize this, if an active fund or smart beta ETF is basically closet indexing but still charging a higher fee, investors are almost guaranteed to underperform, correct?

Jack: Yeah, well I think what investors and what we're trying to help out by providing some free tools on our website- one thing that an investor should look at is what is the true fee they are paying for active management? Let me just walk through an example here. Let's pretend you have a fund that is charging 30 basis points, right? This is your typical smart beta ETF, they're in that 30 to 50 basis point range, but they're really very closet indexy and they're only 30 percent active. One way to compute the accuracy is - and we'll assume that you can get beta for zero basis points - you take the fee which you're paying, the active fee. So in this case 30 bps, and divide it by the active share. So in this case, 30 percent and what you see is, you're really paying 1 percent for active management. For some funds, it's actually over 1 percent so I agree some when investors can kind of get duped at some level by seeing a lower expense ratio, but not understanding they're paying a high management fee for the active part - which, over the long-term, will probably lead to underperformance.

Nate: Jack, you mentioned some tools that you have on your website to help investors better determine the active share in their funds, can you maybe talk a little bit about those tools? And, are there other tools available that investors can use to find out the active share in their mutual funds or ETFs?

Jack: Yeah, that's a great question. Active share and active fee are really cool ideas proposed by researcher Martijn Cremers – he has a couple papers on it. However, it's mathematical, so a math calculation. And the old saying, "A picture is worth a thousand words". And so, what we developed was a new tool that we call our visual active share. What visual active share will allow you to do... you can pick any ETF, so currently it's just available for ETFs, mutual funds possibly in the future, but you can take any ETF and it will plot the individual securities that are held within that ETF. Now, let me walk you through even though we are on radio here. So, on the X and Y axis, you can pick what you want them to be. So you can make your X axis market capitalization and your Y axis book to market ratio. And when you pick your ETF, it will plot where all the underlyings hold on a percentile rank basis, relative to the universe. So what this will allow an investor to do is you can say, "Okay. I like said value fund. Let me view the holdings of this ETF". And so you type in whatever your favorite value ETF is, and once you do that, all the holdings will show up. Then what you can do is compare this to another ETF. So you might want to say, "Hey, let's see how my value fund compares to SPY, the S&P 500". In theory, if you're paying for a value exposure, you should see very little overlap, because you should see a very high concentration of high book to market ratio firms, and your value funds should provide some diversification. What a lot of people may see is for some ETFs, there's a ton of overlap, which means your value fund is really not giving you anything different than pure beta.

Nate: Jack, what's the motivation for active fund managers or smart beta ETFs to closet index? Why do it?

Jack: One of the big parts that you kind of don't see in the statistics is the tracking error. So, if you look at the academic anomalies for value, momentum, profitability, right... those are formed based on picking the top ten percent of firms on some ratio or some price path of past securities. And the returns are great. That's why they're called anomalies, why there's factor based funds in the marketplace. However, if you run a portfolio like it is proposed in the literature, where you're buying let's say value firms... and why do you buy them? You buy them because people are possibly overreacting to fundamentals. Well, if you run this, while over the long run it was a good bet, in the short run, you can have a very high tracking error relative to the market cap weighted index. And, if you're a manager and let's say, 1995 to 1999 happens as a value manager, you are probably going to get fired and lose all of your assets. So, one thing that managers do to stay close to the index, is closet index and make their fund have a lower active share and more like index.

Nate: What about smart beta ETFs where you don't have necessarily an active manager, you have a rules based approach? What's the motivation there? Is it just having a fund they can scale?

Jack: It's twofold. One is, there clearly are scale issues. If you say, "Hey, I want to run the pure academic anomaly, here's a hundred... or let's say a trillion dollars”. Well, I'd say "You can't do that”. So, there's pros and cons. Some fund managers in rules based strategies such as smart beta, they can do that for scale, as well as to keep their strategy close to the index. And, I think all advisors and allocators should be aware of this when allocating to certain funds. Just to make sure their clients and everyone's educated on potential tracking error that can occur.

Nate: Alright, before we move on because I want to touch on your new ETF, do you have any sense as to how many active mutual funds or smart beta ETFs are really just closet index funds? How prevalent is this issue?

Jack: What I'd say is, to say what percentage, you'd probably have to pick some random active share number and then say "Well, 50 or 80 percent are closet indexing." What I'd say is I think it is pretty prevalent due to the fact that a lot of strategies are built for scale, which is a good idea if you can get scale. I think that the tools on our website will probably, hopefully, allow allocators to decide on their own whether or not a fund is active enough for them, for the portfolio, and for the goals that they are trying to achieve.

Nate: Our guest today is Jack Vogel, CFO and Co-Chief Investment Officer at Alpha Architect. Jack, I know one of the key tenets of your firm is to not offer closet index funds. Alpha Architect currently offers five, what I would call, very high conviction ETFs, including a new ETF launched just last week - the Alpha Architect Value Momentum Trend ETF, ticker symbol VMOT. Tell us more about this ETF. I know your firm is a big believer in both value and momentum, what is this ETF designed to do?

Jack: Yeah, so as you mentioned, we are fans of value and momentum, so what VMOT does is basically from the long ... from the stock selection side, it will essentially invest in around 100 value securities right now. So, 50 US and 50 international. And same for the momentum side. Top 50 US and international momentum stocks. We do that by holding our four other ETFs in the portfolio. So, VMOT is a fund of funds ETF that will hold our four other ETFs. Now, the third component - so the first two are value and momentum - the third component is trend. We're fans of using long-term trend signals. Basically, it’s a form of market timing which is heresy to some people, but some people may like it. What this fund will do is, if long-term moving averages or time series momentum in the US or international, if those rules are broken, we will essentially hedge the beta in the portfolio for the US and international portion. So, this kind of combines the three factors that we like, which is value, momentum and trend all in one ETF.

Nate: And Jack, where does this ETF fit in a portfolio? Is this sort of a one-stop shop for equity exposure?

Jack: So, yeah, and again, it depends on the client and the goals, but for those people that are fans of value investing, fans of momentum, fans of trend investing, yes this is kind of a one-stop shop. For those advisors or allocators that are looking for maybe some alternative exposures, this could be a good out, possibly a good allocation for them -when equity markets are trending, which you want to hold beta, that may be helpful. But, if equity markets are, you know, going negative, the portfolio will be hedged. So, I think it depends on the goals, but, for some people it's a one-stop shop and for some people it's part of the alternative bucket.

Nate: Well Jack, we appreciate you joining us today. Congratulations on the launch of the new ETF. We certainly wish you all the success moving forward and hope to visit again soon. Thank you.

Jack: Yes, thank you very much for having me on.

Nate: That was Jack Vogel, CFO and Co-Chief Investment Officer at Alpha Architect. You can learn more about their ETF lineup by visiting and they also have all of the tools that we mentioned, the active share tools, at as well.