With the bevy of smart beta exchange-traded funds capturing greater investment dollars in 2017, regulators are not only focusing more on the risk associated with smart beta investments, but urging investors and their investment advisors to do the same.
In fact, the scrutiny of investor fees—and the onus on brokers and advisors to justify and disclose those fees to investors in case there are cheaper alternatives—is leading the regulatory agenda at both Finra and the Securities and Exchange Commission as 2017 draws to a close.
The sheer volume of investing in the smart beta space is also attracting attention from regulators. Investors pumped a record $6.42 billion into so-called "smart beta" equity ETFs and exchange-traded products (ETPs) in September 2017, according to Finra. And more than $53 billion has flowed into smart beta equity funds this year, according to ETF data provider ETFGI. Total assets invested in all smart beta equity ETFs and ETPs stood at $644 billion in the third quarter.
It’s true that smart beta ETFs are usually less expensive than actively managed funds, but “they tend to be more costly than funds that track market-cap-weighted indices,” Finra said in Part 2 of its new Alert investor series, “Smart Questions to Ask About Smart Beta Products.”
The report reads like a road map of issues brokers and advisors should be considering when selling smart beta products.
The higher costs stem in part from the fact that “smart beta indices rebalance their holdings—selling and buying securities to stay within the boundaries of their strategies—more frequently than market-cap-weighted indices. This turnover can increase investor costs,” said Finra, which refers investors to its Fund Tracker to check for less expensive options.
While many ETFs are lowering expense ratios, not all have jumped on the bandwagon. Over time, even slightly higher expenses can account for lower returns, Finra said.
What’s good advice for investors generally will be doubly smart for brokers and advisors, who may be called on to justify higher-priced investments.
The SEC, too, is looking at whether fees are being adequately disclosed, whether appropriate mutual fund share classes are being sold and whether sales are suitable for investors, said Stephanie Avakian, the agency’s co-director of enforcement, speaking to an audience of Finra and SEC examiners and attorneys earlier this month at the Practising Law Institute’s 49th Annual Institute on Securities Regulation.
Avakian said the SEC plans to be more strategic to harness data analytics and the resources of its new Retail Strategy Task Force to zero in on sales misconduct and ensure that salespeople not only focus on finding competitively priced products for investors but that they understand what they’re selling and whether it’s appropriate for the investor.