FINRA reminds us that nobody knows the future; that no investment is guaranteed to outperform traditional index products....
Questions to Ask
...Be smart when evaluating smart beta products. Such products are by no means guaranteed to outperform more traditional index products. And as with all securities products, they carry risks and costs. The more you know about a given product, the more equipped you will be to make informed choices about whether smart beta investments should be part of your portfolio.
- 4- What are the potential risks? Risk factors are outlined in a product's prospectus and 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. For instance, is it more exposed to small-cap stocks? 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.
Personally, I will continue to exercise critical thought when reading posts touting the superiority of certain complex products over simple low-cost index funds.