Should You Recommend Smart Beta Indexes To Your Clients?
Investors understand the underlying reasons for investing in products that track passive market capitalization indexes as well as products that are actively managed. If smart beta takes positive features from both types of investing, it makes sense to investigate smart beta as another tool in an investing toolkit. But while the vast range of strategies that fall under the term smart beta may seem overwhelming, parsing through the information to uncover potential products should be a process similar to making other investment decisions. When considering the objectives and goals of clients, many advisors will find that various smart beta funds can be used as a core holding, a complement to existing holdings, to replace market cap or active managers, or as a tool for risk reduction. To find the smart beta fund that fits a specific objective, advisors need to contemplate the expense and tax considerations, an expected holding period and how a product would perform in different market cycles—the same diligence expected for an active investment or market cap fund. The decision to invest in smart beta products is as much an implementation decision as the investment decision.
How To Decide To Use Specific Smart Beta Products?
Once you have decided a smart beta product works well for your client, the deciding factor in choosing a specific product hinges on an understanding of the fund’s underlying index methodology, specifically how it works and its precise exposure. A transparent index methodology from a trusted independent index administrator should provide more information to make that assessment than what would be typically provided by an active manager. An advisor should focus on investigating several areas of the underlying index, such as:
-
How reliable is the underlying price data from the underlying securities?
-
How often is the underlying price data provided?
-
Are the prices from a regulated trading venue?
-
How was the back test created?
-
How transparent is the back test?
-
Does the back tested data cover multiple market cycles?
-
Does the index seem to be over-engineered to create a specific outcome?
-
Does there seem to be some economic rational to the index?
-
Does the index add or reduce risks to the existing portfolio?
-
Does the cost/ benefit tradeoff compared to market cap and active management seem worth it?
-
Does the outperformance come purely from increased risk (Sharpe ratio) ?
-
Does the index come from an independent administrator?
While there is still no universally accepted definition for smart beta, advisors should note that the separation and independence of the product provider and index administrator should provide an extra level of comfort in making the decision to invest in strategic beta products.
Richard Redding is the CEO of the Index Industry Association (IIA), becoming its first CEO in 2012. In addition to his role of promoting education for market participants, he has been working with IIA’s members on global advocacy issues including the IOSCO Principles for Benchmarks and the forthcoming EU Benchmark Regulation. Redding spent most of his career in senior leadership roles with The CME Group (CME), a leading provider of benchmark futures and options products and an innovator in futures trading.