Smart Beta—What You Need to Know
Many investors are familiar with index funds, which are mutual funds and exchange-traded funds (ETFs) that seek to track the performance of a particular benchmark index. A few of the oldest and best-known indices that these funds track, such as the Dow Jones Industrial Average, are price weighted. In other words, the higher the stock price of Company X, the more weight Company X has in determining the value of the index.
Most other widely known indices, including the S&P 500, NASDAQ 100 and Russell 2000, use a company's market capitalization to determine how much weight that particular stock will have in the index. Market cap is the company's share price multiplied by number of shares outstanding. So with a market-cap-weighted index, stocks with a higher market cap value account for a greater share of the overall value of the index.
Recently, there has been significant growth in the number of financial products, primarily ETFs, which are linked to and seek to track the performance of alternatively weighted indices. These indices are commonly referred to as "smart beta" indices. They are constructed using methodologies that rely on, for example, equal weighting of underlying component stocks, or measures such as volatility or earnings, rather than market-cap weighting.
FINRA is issuing this investor alert to help investors better understand smart beta products. While there are potential advantages, including diversification through exposure to nonmarket-cap weighted indexes, products tracking smart beta indices can also carry investment risks, and returns for these products may be very different from investments that track market-cap-weighted indices. As FINRA noted in its 2015 Exam Priorities Letter, products that track these indices may be complex or unfamiliar for individual investors. They may also have higher expenses.
Smart Beta 101
A smart beta index is essentially any index that is based on measures other than weighting by market capitalization. Such indices might carry names like Strategic, Alternative, Advanced, Enhanced, or Scientific—labels meant to convey that something more than passive tracking of a market-weighted index is involved.
Some smart beta strategies are relatively straightforward. For example, the companies in an equal-weighted index all have an equal representation in the index, regardless of market value (which typically results in smaller-cap companies being overweighted and larger-cap companies being underweighted relative to a market-cap-weighted index).
Other smart beta indices can be based on more complex methodologies. For example, there are products linked to fundamentally weighted indices, in which the index components are determined based on companies' revenues, dividends or other corporate metrics.
A low-volatility strategy is another example of a smart beta index weighting method. For instance, a low volatility index strategy might measure the performance of the 100 least-volatile stocks in the S&P 500. In this scenario, the index components might be weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights.
Still other offerings may be combinations of factors or exposures.
Questions to Ask
If you are considering a product linked to a smart beta index, or have been contacted about purchasing such a product, it's important to understand how the index the product tracks is constructed, what factors are claimed to be captured, and whether it helps meet your overall investment objectives.
Products tracking smart beta indices can in some cases be more difficult to analyze because their methodologies for attempting to achieve returns may not be straightforward. Using smart beta products as direct substitutes for products tracking more well-known, market-cap indices can be risky, as exposure offered by a smart beta product could differ significantly from that provided by product tracking a market-cap-weighted index.
Here are six "smart" questions to ask before investing in a product linked to a smart beta index:
- What is the product's strategy? Read the prospectus, and talk to your investment professional to make sure you understand the strategy and how it fits with your investment objectives. It's also a good idea to visit the index provider's website to learn more about the index’s methodology.
- What are the costs? Products that track smart beta strategies are usually less expensive than actively-managed funds, but tend to be more costly than funds that track market-cap-weighted indices. This is due in part to the fact that smart beta indices rebalance their holdings—selling and buying securities to stay within the boundaries of their strategies—more frequently than market-cap-weighted indices. This turnover can increase investor costs.
- What are the potential advantages? Smart beta products vary, and so do the reasons to include or not include them as part of an overall investment strategy. For example, some indices use factors such as company growth rate, income or other criteria for stock selection, which may or may not be useful to your overall investment strategies and goals. Visit the index provider's website for information on potential advantages, and weigh them against any potential risks.
- What are the potential risks? Risk factors are outlined in a product's prospectus and will vary by product. In particular, look to see if the fund is more heavily weighted in a particular sector or country, or toward a particular size of company. For instance, is it more exposed to small-cap stocks? Because of their unique methodologies, smart beta strategies can be less diversified than other investment strategies. This is known as concentration risk. For more information, see FINRA's Concentrate on Concentration Risk.
- How liquid is the product and its holdings? Because many of the exchange-traded products tracking smart beta indices are relatively new, the ETPs themselves may be thinly traded and have wide bid/ask spreads, which can increase both the cost and risk of investing. Consider these issues and examine the underlying holdings to determine whether they are broadly traded or are themselves subject to illiquidity. The liquidity of these underlying holdings can affect the liquidity of the product tracking the smart beta index.
- Are the performance figures back-tested? Many alternatively weighted index strategists claim their approaches beat the market based on historical back-testing. To support this claim, the strategists generate hypothetical performance results by applying a mathematical model to historical market data. While back-testing is helpful, it neither predicts future performance nor perfectly replicates previous performance. Some back-tested results and academic research on these products have highlighted the potential attractiveness of smart beta indices. However, it remains an open question how the indices and products tracking them will behave in different market environments going forward.
Be smart when evaluating smart beta products. Such products are by no means guaranteed to outperform more traditional index products. And as with all securities products, they carry risks and costs. The more you know about a given product, the more equipped you will be to make informed choices about whether smart beta investments should be part of your portfolio.
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