Smart Questions to Ask About Smart Beta Products: Part 2
There has been significant growth in the number of financial products—such as exchange-traded funds (ETFs)—that are linked to and seek to track the performance of alternatively weighted indices. Since these products are likely to stick around, it’s more important than ever for investors to know what to look for when evaluating these investments.
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
As we learned in Part 1 of our Smart Beta series, alternatively weighted 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 the more traditional measures of market-cap or price weighting.
If you’re 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. And using smart beta products as direct substitutes for products tracking better known, market-cap indices can expose investors to different, and sometimes additional, risks.
Here are six "smart" questions to ask before investing in a product linked to a smart beta index:
1. What is the product's strategy? Read the prospectus and talk to your investment professional to make sure you understand any smart beta product’s strategy and how it may fit 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.
2. What are the costs? Products that track smart beta strategies are usually less expensive than actively managed funds. On the other hand, they tend to be more costly than funds that track market-cap-weighted indices. This is partly because 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. FINRA’s Fund Analyzer can be a helpful tool when looking to analyze and compare the cost of owning different funds.
3. What are the potential advantages? Smart beta products vary, and so do the reasons to include or not include them as part of your 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.
4. What are the potential risks? A product's prospectus will outline risk factors, and those risk factors 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. Does it have a lot of exposure to small-cap stocks? Or to frontier countries? 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.
5. 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.
6. 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. They are by no means guaranteed to outperform more traditional index products. And, as with all securities products, they carry risks and costs.
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