FINRA Alert: Smart Beta

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longinvest
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FINRA Alert: Smart Beta

Post by longinvest »

https://www.finra.org/investors/alerts/smart-beta
...
Questions to Ask
...
  • 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.
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.
FINRA reminds us that nobody knows the future; that no investment is guaranteed to outperform traditional index products.

Personally, I will continue to exercise critical thought when reading posts touting the superiority of certain complex products over simple low-cost index funds.
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Re: FINRA Alert: Smart Beta

Post by VictoriaF »

longinvest wrote:Personally, I will continue to exercise critical thought when reading posts touting the superiority of certain complex products over simple low-cost index funds.
I agree with your conclusion, but I am critical of FINRA's recommendation "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."

On the surface, it seems prudent to learn, analyze, and make informed decisions. In practice, when you read about a complex product without a long experience and strong expertise in the matter, you start accepting the premises and the logic of those promoting the product without the independent ability to analyze it. The more effort you put into learning about a complex financial product, the more likely you are to buy into it, literally and figuratively.

Victoria
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Re: FINRA Alert: Smart Beta

Post by longinvest »

VictoriaF wrote:On the surface, it seems prudent to learn, analyze, and make informed decisions. In practice, when you read about a complex product without a long experience and strong expertise in the matter, you start accepting the premises and the logic of those promoting the product without the independent ability to analyze it. The more effort you put into learning about a complex financial product, the more likely you are to buy into it, literally and figuratively.
I often forget that behavior is one of the most important aspects of investing. Tuning out the noise is important. Unfortunately, this also means that I will have to be more selective when choosing which forum threads to read. :annoyed
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Re: FINRA Alert: Smart Beta

Post by sgr000 »

VictoriaF wrote:
longinvest wrote:Personally, I will continue to exercise critical thought when reading posts touting the superiority of certain complex products over simple low-cost index funds.
I agree with your conclusion, but I am critical of FINRA's recommendation "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."

On the surface, it seems prudent to learn, analyze, and make informed decisions. In practice, when you read about a complex product without a long experience and strong expertise in the matter, you start accepting the premises and the logic of those promoting the product without the independent ability to analyze it. The more effort you put into learning about a complex financial product, the more likely you are to buy into it, literally and figuratively.
This sounds like an example of the Outside View heuristic, where more detailed information leads to less accurate predictions.
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Re: FINRA Alert: Smart Beta

Post by VictoriaF »

sgr000 wrote:
VictoriaF wrote:
longinvest wrote:Personally, I will continue to exercise critical thought when reading posts touting the superiority of certain complex products over simple low-cost index funds.
I agree with your conclusion, but I am critical of FINRA's recommendation "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."

On the surface, it seems prudent to learn, analyze, and make informed decisions. In practice, when you read about a complex product without a long experience and strong expertise in the matter, you start accepting the premises and the logic of those promoting the product without the independent ability to analyze it. The more effort you put into learning about a complex financial product, the more likely you are to buy into it, literally and figuratively.
This sounds like an example of the Outside View heuristic, where more detailed information leads to less accurate predictions.
Inside View is a problem, Outside View is a solution.

But once you get wrapped up in the Inside View, it becomes devilishly difficult to consider the Outside View or to comply with its findings.

Daniel Kahneman provides an excellent example of Inside-Outside Views in Thinking, Fast and Slow based on his own error of judgement. Kahneman was leading a team of academics evaluating a new psychology curriculum. After the team has made some progress, Kahneman held a meeting to assess the remaining duration. The team estimated that it would take about 2 more years. Kahneman then asked one of the participants about his extensive experience with similar projects. The participant was taken aback and then admitted that only 40% of similar projects have been completed, and the average duration from their project's state was 8 years. Kahneman asked how their project rated in comparison to others, and the expert responded that it was weaker. To summarize:
- The inside view: 2 years to complete
- The outside view: 40% completion rate, 8 years for the completed projects that were in a better state than this one.

The logical solution would be to trust the outside view and drop the project. However Kahneman, the top expert in the field, went ahead with it. The project had the fate of others represented in the outside view, it lingered for 8 more years and then was dropped.

Victoria
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Re: FINRA Alert: Smart Beta

Post by RunningRad »

"A little learning is a dangerous thing"--Alexander Pope
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Re: FINRA Alert: Smart Beta

Post by Fallible »

VictoriaF wrote:
sgr000 wrote:
VictoriaF wrote:
longinvest wrote:Personally, I will continue to exercise critical thought when reading posts touting the superiority of certain complex products over simple low-cost index funds.
I agree with your conclusion, but I am critical of FINRA's recommendation "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."

On the surface, it seems prudent to learn, analyze, and make informed decisions. In practice, when you read about a complex product without a long experience and strong expertise in the matter, you start accepting the premises and the logic of those promoting the product without the independent ability to analyze it. The more effort you put into learning about a complex financial product, the more likely you are to buy into it, literally and figuratively.
This sounds like an example of the Outside View heuristic, where more detailed information leads to less accurate predictions.
Inside View is a problem, Outside View is a solution.

But once you get wrapped up in the Inside View, it becomes devilishly difficult to consider the Outside View or to comply with its findings.

Daniel Kahneman provides an excellent example of Inside-Outside Views in Thinking, Fast and Slow based on his own error of judgement. Kahneman was leading a team of academics evaluating a new psychology curriculum. After the team has made some progress, Kahneman held a meeting to assess the remaining duration. The team estimated that it would take about 2 more years. Kahneman then asked one of the participants about his extensive experience with similar projects. The participant was taken aback and then admitted that only 40% of similar projects have been completed, and the average duration from their project's state was 8 years. Kahneman asked how their project rated in comparison to others, and the expert responded that it was weaker. To summarize:
- The inside view: 2 years to complete
- The outside view: 40% completion rate, 8 years for the completed projects that were in a better state than this one.

The logical solution would be to trust the outside view and drop the project. However Kahneman, the top expert in the field, went ahead with it. The project had the fate of others represented in the outside view, it lingered for 8 more years and then was dropped.
Victoria
Hi Victoria,

Good to see this as I remember reading it in the book and thinking it was, ironically, a case of overconfidence by Kahneman and the group, i.e., overconfidence in their abilities to finish the book, abilities they considered greater than those in the other groups. Maybe there was just a little bit to that, since they did at least produce a book - which apparently was then ignored. One of the lessons Kahneman says he learned from this "embarrassing" episode was that "we gave up rationality rather than give up the enterprise." Well, as he has always said, we are all both rational and irrational.

Fallible
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Re: FINRA Alert: Smart Beta

Post by VictoriaF »

Fallible wrote:
VictoriaF wrote:The project had the fate of others represented in the outside view, it lingered for 8 more years and then was dropped.
Hi Victoria,

Good to see this as I remember reading it in the book and thinking it was, ironically, a case of overconfidence by Kahneman and the group, i.e., overconfidence in their abilities to finish the book, abilities they considered greater than those in the other groups. Maybe there was just a little bit to that, since they did at least produce a book - which apparently was then ignored. One of the lessons Kahneman says he learned from this "embarrassing" episode was that "we gave up rationality rather than give up the enterprise." Well, as he has always said, we are all both rational and irrational.

Fallible
Hi Fallible,

You are right, the book was completed but not published.

As I was reading Thinking, Fast and Slow, I was identifying various situations in which I was ignoring the base rate and making decisions based on my internal knowledge. The problem is that even when I know that I am engaging in wishful thinking, I have difficulty quitting a project in which I have already invested time and emotion. In most cases, the best approach is to stay away from imprudent projects instead of checking them out. And if I find myself in the midst of a losing project unable to let go of the sunk cost, I should devise some mind tricks to take my attention away.

Victoria
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Re: FINRA Alert: Smart Beta

Post by nisiprius »

FINRA is a self-regulating creation of the investment industry, and it is not inclined to be alarmist. "Alert" is their slightly low-key word for "warning."

I think it is very significant that FINRA would issue an alert about "Smart Beta" and is a clear indication that "Smart Beta" products are being aggressively oversold in situations where investors, if not being lied to in the literal sense of the word, are allowed to make incorrect inferences that work to the benefit of the seller.

What I think is extremely interesting is their definition of "smart beta," whose definition has rather eluded me before:
A smart beta index is essentially any index that is based on measures other than weighting by market capitalization. Such indices might carry names like Strategic, Alternative, Advanced, Enhanced, or Scientific—labels meant to convey that something more than passive tracking of a market-weighted index is involved.
I guess they left out "Fundamental."
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Re: FINRA Alert: Smart Beta

Post by lack_ey »

They have a different alert (pointed out by nisiprius elsewhere) for alternatives funds:
https://www.finra.org/investors/alerts/ ... tual-funds

"Smart beta" almost always refers to long-only stock with some manner of tilts and as such are usually understood to be in a different category as alternatives, which is really a very broad catchall kind of category for "everything else" and may involve a number of different underlying asset classes and strategies. After all, it doesn't make much sense to call it smart beta unless it's got beta in it, so I don't think you'd apply that label to a hedged long/short fund.

The end result isn't much different from overweighting cap-weighted funds that represent slices of the total market (say a sector, or growth stocks), and the risks are much the same too. The cost is usually higher because of novelty, and depending on the construction methodology the tax cost might be higher as well. It really depends.
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Re: FINRA Alert: Smart Beta

Post by JoMoney »

...
[*]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.
Liquidity is one of those funny things people seem to overlook as a concern. There's been cases with other exchange traded products where it's been suggested their existence made problems even worse.
The buyers for some security disappear, the spreads on the underlying security rise, some ETP holding that security also starts having liquidity issues and divergences appear between what the ETP is being sold at and what the underlying quoted NAV is reported as selling for. Arbitrageurs step in to by the ETP at a discount and attempt to redeem and sell the holdings which just dumps further pressure on assets that may not be finding buyers to begin with.
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Re: FINRA Alert: Smart Beta

Post by grok87 »

What about leverage?
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Re: FINRA Alert: Smart Beta

Post by VictoriaF »

grok87 wrote:What about leverage?
The FINRA alert does not explicitly mention leverage but it contains a general suggestion:
FINRA wrote:1. What is the product's strategy? Read the prospectus ...
which covers leverage implicitly.

Victoria
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Re: FINRA Alert: Smart Beta

Post by Fallible »

VictoriaF wrote:[...
As I was reading Thinking, Fast and Slow, I was identifying various situations in which I was ignoring the base rate and making decisions based on my internal knowledge. The problem is that even when I know that I am engaging in wishful thinking, I have difficulty quitting a project in which I have already invested time and emotion. In most cases, the best approach is to stay away from imprudent projects instead of checking them out. And if I find myself in the midst of a losing project unable to let go of the sunk cost, I should devise some mind tricks to take my attention away.

Victoria
What I thought puzzling about Kahneman's handling of the outside view is that after learning of it, he did not do what seems obvious and easiest: contact other groups to see why they failed. So the outside view was incomplete and should have led him to begin gathering more outside views. Instead, his inside view prevailed (system 1?). In your case, if you learned that others had failed at a similar project, wouldn't you then ask why? And if it was pertinent to your situation, it could be incentive for you to quit. I'm almost certain I would ask for more of that outside view, but if up against a stronger (irrational) inside view, maybe not.
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Re: FINRA Alert: Smart Beta

Post by VictoriaF »

Fallible wrote:
VictoriaF wrote:[...
As I was reading Thinking, Fast and Slow, I was identifying various situations in which I was ignoring the base rate and making decisions based on my internal knowledge. The problem is that even when I know that I am engaging in wishful thinking, I have difficulty quitting a project in which I have already invested time and emotion. In most cases, the best approach is to stay away from imprudent projects instead of checking them out. And if I find myself in the midst of a losing project unable to let go of the sunk cost, I should devise some mind tricks to take my attention away.

Victoria
What I thought puzzling about Kahneman's handling of the outside view is that after learning of it, he did not do what seems obvious and easiest: contact other groups to see why they failed. So the outside view was incomplete and should have led him to begin gathering more outside views. Instead, his inside view prevailed (system 1?). In your case, if you learned that others had failed at a similar project, wouldn't you then ask why? And if it was pertinent to your situation, it could be incentive for you to quit. I'm almost certain I would ask for more of that outside view, but if up against a stronger (irrational) inside view, maybe not.
I recall that Kahneman listed some reasons for project delays and failures, e.g., academics leaving on sabbaticals and dropping out due to health issues, divorces, and moving out of the area. As new people were coming aboard they had to come up to speed and be integrated into the team. Every such instance was an exceptional case, but every project had about the same number of exceptions and about the same delay.

I think that Kahneman has developed this line of reasoning not while he was leading the project but later, when he was contemplating the planning fallacy.

Victoria
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Re: FINRA Alert: Smart Beta

Post by nisiprius »

VictoriaF wrote:...I recall that Kahneman listed some reasons for project delays and failures, e.g., academics leaving on sabbaticals and dropping out due to health issues, divorces, and moving out of the area. As new people were coming aboard they had to come up to speed and be integrated into the team. Every such instance was an exceptional case, but every project had about the same number of exceptions and about the same delay...
Oh, that is so familiar to me, as a software engineer during the times I was at companies big enough to have planning meetings. They would ask for time estimates. People would say "six months," "nine months." Then I would say "two or three years." There would be a shocked hush and they'd ask me why I said that. I'd say "because that's how long it took the last time. This project is very similar to the D68 Cazador project and that took well over two years." And then everyone would say "Oh, well, the Cazador, everything went wrong on that. I should hope we'd do better than that. Why the lead engineer left halfway through and nobody worked on it for three months. And then Buncoflex said they'd buy thirty but only if we could guarantee a twenty meter cable, so we had to respin everything for differential SCSI and that needed a special chip with a six-month lead time..." And I'd say "It took over two years last time." And they'd say (effectively) "Shut up." And it took over two years. And Buncoflex didn't buy any.
Last edited by nisiprius on Thu Oct 01, 2015 2:05 pm, edited 5 times in total.
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Re: FINRA Alert: Smart Beta

Post by Fallible »

VictoriaF wrote:
Fallible wrote:
VictoriaF wrote:[...
As I was reading Thinking, Fast and Slow, I was identifying various situations in which I was ignoring the base rate and making decisions based on my internal knowledge. The problem is that even when I know that I am engaging in wishful thinking, I have difficulty quitting a project in which I have already invested time and emotion. In most cases, the best approach is to stay away from imprudent projects instead of checking them out. And if I find myself in the midst of a losing project unable to let go of the sunk cost, I should devise some mind tricks to take my attention away.

Victoria
What I thought puzzling about Kahneman's handling of the outside view is that after learning of it, he did not do what seems obvious and easiest: contact other groups to see why they failed. So the outside view was incomplete and should have led him to begin gathering more outside views. Instead, his inside view prevailed (system 1?). In your case, if you learned that others had failed at a similar project, wouldn't you then ask why? And if it was pertinent to your situation, it could be incentive for you to quit. I'm almost certain I would ask for more of that outside view, but if up against a stronger (irrational) inside view, maybe not.
I recall that Kahneman listed some reasons for project delays and failures, e.g., academics leaving on sabbaticals and dropping out due to health issues, divorces, and moving out of the area. As new people were coming aboard they had to come up to speed and be integrated into the team. Every such instance was an exceptional case, but every project had about the same number of exceptions and about the same delay.

I think that Kahneman has developed this line of reasoning not while he was leading the project but later, when he was contemplating the planning fallacy.
Victoria
Yes, at some point he did learn about these difficulties faced by the other groups, but it's not clear, at least to me, when or how he learned about them and the actual wording is confusing. Even more interesting, when he and Amos Tversky came up with "planning fallacy'," one of its two descriptions was that forecasts could be improved by "consulting the statistics of similar cases." In the group book case, it was not just statistics that were needed, but personal information that was available by simply talking to the other groups. But maybe it was too simple...
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Re: FINRA Alert: Smart Beta

Post by VictoriaF »

Fallible wrote:Even more interesting, when he and Amos Tversky came up with "planning fallacy'," one of its two descriptions was that forecasts could be improved by "consulting the statistics of similar cases." In the group book case, it was not just statistics that were needed, but personal information that was available by simply talking to the other groups. But maybe it was too simple...
Planning fallacy as one of my examples of Behavioral Economics of el Camino. I estimated my duration by reading a guidebook(*) with the suggested daily stages and added a 50% margin, i.e., I allowed myself 34 x 1.5 = 51 days. Eventually, I finished it in 42 days. That was an External View. Other pilgrims applied their Internal Views, e.g: 5 km/hr, 800km, 160 hours, 20-25 days. However, finishing in 25 days is difficult due to external factors such as blisters, ankle/shin/knee problems, weather, terrain, and slowing down to be with friends.

Victoria

(*) The guidebook is very popular and reflects a typical average speed that's been observed in thousands of pilgrims over many years.
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Re: FINRA Alert: Smart Beta

Post by Leeraar »

Ah, yes. The mythical man-month.

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Re: FINRA Alert: Smart Beta

Post by 691175002 »

I've actually been pretty displeased with most smart beta, for a very specific reason. Nowadays most smart beta managers just try hundreds or thousands of strategies until they find one that works well (but not too well or people get suspicious) then launch an ETF tracking a back-filled index.


Firms are not allowed to market hypothetical performance. This is a pretty obvious rule - people should not be allowed to make up performance history for this funds. They should not be allowed to market their products based on fabricated returns.

I've started to see some pretty nefarious behavior catch on recently. You might not be able to publish fabricated fund returns, but you can backfill and publish fabricated index returns instead. If you are clever you might realize the legal issues can be sidestepped by publishing a fabricated index then selling a "passive" ETF that tracks it, effectively creating 15+ years of back-tested history for a brand new product.

http://www.blackrock.com/ca/individual/ ... -en-ca.pdf
https://www.msci.com/documents/10199/c8 ... 162f138690

In many cases the webpages and marketing material will direct you to documentation on the index and not the etf producing a near impenetrable illusion that you are investing in an established product with a 15 years of actual history.

I find it hard to fully express how unethical and disgusting this is.
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Re: FINRA Alert: Smart Beta

Post by grok87 »

691175002 wrote:I've actually been pretty displeased with most smart beta, for a very specific reason. Nowadays most smart beta managers just try hundreds or thousands of strategies until they find one that works well (but not too well or people get suspicious) then launch an ETF tracking a back-filled index.


Firms are not allowed to market hypothetical performance. This is a pretty obvious rule - people should not be allowed to make up performance history for this funds. They should not be allowed to market their products based on fabricated returns.

I've started to see some pretty nefarious behavior catch on recently. You might not be able to publish fabricated fund returns, but you can backfill and publish fabricated index returns instead. If you are clever you might realize the legal issues can be sidestepped by publishing a fabricated index then selling a "passive" ETF that tracks it, effectively creating 15+ years of back-tested history for a brand new product.

http://www.blackrock.com/ca/individual/ ... -en-ca.pdf
https://www.msci.com/documents/10199/c8 ... 162f138690

In many cases the webpages and marketing material will direct you to documentation on the index and not the etf producing a near impenetrable illusion that you are investing in an established product with a 15 years of actual history.

I find it hard to fully express how unethical and disgusting this is.
+1
RIP Mr. Bogle.
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