FINRA Issues Investor Alert On ‘Smart Beta’

While offering clear advantages, they also carry investment risk

September 24, 2015 — WASHINGTON–(BUSINESS WIRE)–The Financial Industry Regulatory Authority (FINRA) issued a new Investor Alert called Smart Beta—What You Need to Know. FINRA is publishing this alert to educate investors about financial products, primarily ETFs, which are linked to and seek to track the performance of alternatively weighted indices commonly referred to as “smart beta” indices.

Some widely known indices, including as the S&P 500, NASDAQ 100 and Russell 2000, use a company’s market capitalization to determine how much weight that particular stock will have in the index – others, like the Dow Jones Industrial Average, use price weighting. A smart beta index takes an alternative approach: weighting the index with a non-market-capitalization-based measure such as earnings or volatility or more.

“While products tracking smart beta indices can offer potential advantages, including diversification through exposure to non-market-cap-weighted indices, these products can also carry investment risks,” said Gerri Walsh, FINRA’s Senior Vice President for Investor Education. “Returns for smart beta products may be very different from investments that track market-cap-weighted indices.”

Smart Beta—What You Need to Know provides investors with an overview of smart beta strategies, which can range from products that track relatively straightforward equal-weighted indices to products linked to fundamentally weighted indices, in which the index components are determined based on companies’ revenues, dividends or other corporate metrics.

Six ‘Smart Questions’

The alert offers six “smart” questions for investors to ask before investing in a product linked to a smart beta index

1.What is the product’s strategy?
Read the prospectus and talk to your investment professional to make sure you understand the strategy and how it fits with your investment objectives. It’s also a good idea to visit the index provider’s website to learn more about the index’s methodology.

Returns for smart beta products may be very different from investments that track market-cap-weighted indices

2. What are the costs?
Products that track smart beta strategies are usually less expensive than actively managed funds, but tend to be more costly than funds that track market-cap-weighted indices.

3. What are the potential advantages?
Smart beta products vary, and so do the reasons to include or exclude them as part of an investor’s overall investment strategy.

4. What are the potential risks?
Risk factors are outlined in a product’s prospectus. Investors should look to see if the fund is more heavily weighted in a particular sector or country, and be aware that smart beta strategies can be less diversified than other investment strategies.

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.

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. It remains an open question how the indices and products tracking them will behave in different market environments going forward.

FINRA, the Financial Industry Regulatory Authority, is the largest independent regulator for all securities firms doing business in the United States. FINRA is dedicated to investor protection and market integrity through effective and efficient regulation and complementary compliance and technology-based services.

FINRA touches virtually every aspect of the securities business – from registering and educating all industry participants to examining securities firms, writing rules, enforcing those rules and the federal securities laws, and informing and educating the investing public. In addition, FINRA provides surveillance and other regulatory services for equities and options markets, as well as trade reporting and other industry utilities. FINRA also administers the largest dispute resolution forum for investors and firms. For more information, please visit