ETF companies have been rushing to introduce portfolios that weight holdings in unconventional ways. Popular choices give each stock equal weight in the fund, or they adjust the size of each holding based on some other variable, such as a stock's relative performance compared to similar ones or by its volatility. But in its annual priorities letter released today, the Financial Industry Regulatory Authority says it will be keeping a close eye on these so-called “smart beta” strategies.
“Some alternatively weighted indices may have significantly higher turnover than more traditional indices, leading to greater transaction costs for ETPs that track them,” FINRA said. “While back-tested results and some academic research have highlighted the potential efficacy and attractiveness of alternatively weighted indices, it remains an open question how the indices and products tracking them will behave in different market environments going forward.”
These strategies may also be unfamiliar to investors, thinly traded, and more expensive.
The problem, says Rick Ferri, founder of Portfolio Solutions, is that these strategies are being marketed as having higher risk-adjusted returns. But the managers are only measuring performance over a small period of time, when these strategies performed very well. The name, “smart beta,” can also be a bit of a misnomer.
“If the investors are buying these things because they think these are smarter ways to invest, that’s a marketing problem,” Ferri said. “That’s a misrepresentation of what’s going on. What’s going on is you’re taking very specific risks within the markets that have historically in the past—if you measure it over certain periods of time—produced superior returns, although sometimes there are long periods of time—over a decade or more—when they don’t produce superior returns. So that’s not getting out there.”
Smart beta managers can collect higher fees because people will pay for the hope of a higher return, Ferri said.
These strategies can also have high turnover, as FINRA points out. The S&P 500 index, in contrast, has a turnover of about 5 percent because it’s capitalization weighted, Ferri said. But when an index is equal-weighted, there is a lot of turnover of individual shares because the portfolio has to be rebalanced frequently.
“You’ve got energy stocks down 20 percent, and healthcare stocks up 20 percent; now your portfolio is out of whack.”
But in an ETF structure, that doesn’t really reduce the fund’s net asset value.
“The real risk to the public and why FINRA is going to be interested is the risk of chasing the hot dot,” Ferri said. “Investors are highly into this stuff without really understanding what it is only to pile out of it after it doesn’t perform well for a period of years, and therefore not even getting the return of the market.”
Another area of focus for FINRA in 2015 is alternative mutual funds. The regulator is concerned with bundling these strategies together in one category, when they may behave very differently. Other concerns include how firms communicate how the products work and clients’ misunderstanding how the funds will respond in different market conditions.
Other areas of focus for the coming year include variable annuities and their compensation structure, non-traded REITs, structured retail products, and floating-rate bank loan funds.