FINRA’s 6 “Smart” Questions for Smart Beta

On September 23, 2015, FINRA issued an investor alert about smart beta indexes, “essentially any index that is based on measures other than weighting by market capitalization.”  Unlike the most widely known indexes, such as S&P 500, which use a company’s market capitalization to establish an index, smart beta indexes rely on alternative methodologies, such as “equal weighting of underlying component stocks, or measures such as volatility or earnings, rather than market-cap weighting.”

FINRA’s alert outlines six “smart” questions that investors should ask their brokers and in turn brokers should be prepared to answer about smart data funds:

  1. What is the product’s strategy?
  2. What are the costs?
  3. What are the potential advantages?
  4. What are the potential risks?
  5. How liquid is the product and its holdings?
  6. Are the performance figures back-tested?

However, as stated by BloombergBusiness about smart beta: “Few can define it, and even fewer like it.”  The “viral term” is generally used to describe any exchange-traded fund (ETF) that purposely deviates from market return by orienting the portfolio toward a factor or strategy that has proven historical record of out-performance.  In simplest terms, smart beta funds “live in a space between actively managed funds and passive ones that just attempt to replicate broad market returns” because they utilize specific factors from an actively managed fund but at a lower cost.

The “likability factor” of smart beta, again as observed by BloombergBusiness, is up for debate because several firms have made a demonstrable investment in it.  For example, just this month Oppenheimer Funds agreed to acquire smart beta consulting firm VTL Associates and in January, Nasdaq announced its acquisition of Dorsey Wright & Associates to expand its diversity into smart beta indexes.  Additionally, based on data reported by BlackRock, smart beta has grown a nearly 40% annualized rate since 2012, which is consistent with the prediction that this year is on pace for a record influx of money in smart beta funds.

Goldman Sachs also launched its first smart beta ETF and is “actively” trying to relabel the smart beta type funds to “ActiveBeta.”   To add to the name confusion, MorningStar continues to call these funds “strategic” beta.

It’s all semantics but if there is inconsistency in the product type name, it may cause some confusion for investors and cause FINRA to reissue an “ActiveBeta” investor alert or another term that may rise to viral popularity.  Also provided the lack of knowledge about how smart data funds actually operate and their risks, query whether brokers will even satisfy answering the six questions proposed by investors.

Time to study up on smart beta or whatever you want to call it!

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