The Financial Industry Regulatory Authority issued a warning on smart-beta or alternative index-based exchange traded funds as the recent growth and rising popularity attract many new investors.
Many investors have become acquainted with traditional beta index-based ETFs that passively track large benchmarks, like the S&P 500 or Nasdaq Composite, which weight holdings based on market capitalization – the largest companies have the largest weights.
However, a growing group of smart-beta index ETFs track customized indices that select and weight component stocks based on specific factors. Consequently, these alternative index or smart-beta ETFs come with different risks that ETF investors may not think about.
An ETF may track an ETF, but it does not mean that the index is plain vanilla, writes Chris Dieterich for Barron’s.
“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,” according to FINRA. “Products that track these indices may be complex or unfamiliar for individual investors. They may also have higher expenses.”
The bottom line: smart-beta ETFs are not like traditional market-cap-weighted ETFs. Consequently, investors should do their due diligence and look under the hood to better understand that type of investment they are getting themselves into.
“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,” FINRA said.
Before diving into a smart-beta ETF, FINRA proposed six points investors should consider first:
- What is the strategy? Investors can take a look at a fund’s prospectus or talk with an investment professional to better understand the strategy and how the ETF may fit with one’s investment objectives. People can also take a look at the fund provider’s website to learn more about an ETF.
- Costs? Smart-beta strategies typically cost more than traditional beta-index funds since they rebalance holdings more frequently, but the strategies may still be cheaper than actively managed funds.
- Advantages? Different smart-beta ETFs promise to track varying strategies, so the ETFs may be advantageous in certain market conditions. For instance, some track low-volatility stocks, which may outperform the broader market during periods of high volatility, but the strategy may underperform during periods of high growth. Potential investors should weigh the benefits with potential risks.
- Risks? A fund’s prospectus may list potential risks, and different funds come with varying risks. Investors may also see if a smart-beta ETF is overweight specific sectors, categories or companies to get a better handle on concentration risk.
- Liquidity? Since many smart-beta ETFs are relatively new, the funds may be small with sparse activity and trade at wide bid/ask spreads. Additionally, investors should determine whether or not the underlying assets are liquid, which can affect the overall liquidity of the product tracking the smart-beta index.
- Back-tested performances? While back-tested data may provide a sense of how a smart-beta index performed in previous market conditions, it does not predict future performance nor perfectly replicates previous performance.
“Be smart when evaluating smart beta products,” FINRA added. “Such products are by no means guaranteed to outperform more traditional index products. And as with all securities products, they carry risks and costs.”
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.