The Financial Industry Regulatory Authority (FINRA) issued Smart Beta – What You Need to Know, an investor alert aimed at educating stockholders about financial products. These products include mutual funds, but primarily focus on exchange-traded funds (ETFs).
ETFs are a form of marketable securities that monitor an index, commodity, bond, or a group of assets. Meyer Wilson has a great explanation of ETFs and how they work, which you can view here. They look at alternatives to weighted indices, called “smart beta” indices. A normal index looks at a company’s market capitalization to determine how much weight a particular stock has in an index. Alternatively, a smart beta looks at non-market-capitalization-based measures, which include earnings and volatility. Examples of known indices include S&P 500, NASDAQ 100, and Russell 2000.
By using smart beta indexes, investors both receive diversification when it comes to weighted market value, however, it can be a risky venture. Because it does not follow the traditional method of tracking indices, returns for smart beta indices can vary greatly from market-cap-weighted indices.
By issuing the new investor alert, FINRA seeks to give investors an overview of smart beta strategies. They recommend asking six questions to help better understand smart beta indices. Before considering a product linked to a smart beta index, ask the following:
- What is the product’s strategy?
- What are the costs?
- What are the potential advantages?
- What are the potential risks?
- How liquid is the product and its holdings?
- Are the performance figures back-tested?
By asking these question, investors can make a more informed decision on smart beta indexes. FINRA wants investors to understand how the financial product works, what does it mean fiscally to invest in such a venture, and what are the advantages and disadvantages of the index. With their new investor alert, FINRA hopes investors will proactively protect their investments and know exactly what they are participating in.