It might be the fastest growing segment of the exchange-traded fund (ETF) market—but one U.S. regulators isn’t impressed by their performance. Last week, the Financial Industry Regulatory Authority (FINRA) expressed its concerns over smart beta ETFs and their ability to generate the outsized returns that some have promised to their investors.
Smart beta ETFs have pulled in US$115.8 million of new investor money since January 2013—to put it differently, 60 cents of every new dollar invested in ETFs in the U.S. has gone to smart beta product.
Investors like smart beta ETFs because they promise to set themselves apart from a broad index dominated by stocks with the biggest market capitalization. To do this, they rely on an algorithm that weeds out stocks based on certain characteristics and focuses instead on well-known factors such as value, size and momentum. Or it might hone in on companies with growing dividends or earnings.
The stock-picking possibilities of smart beta ETFs are endless—but are we still talking about passive investing?
Possibly not, according to a study for Reuters by ETF.com that shows some smart beta ETFs have turned over their portfolios two to three times a year. In doing so, many have lagged the performance of the index—the opposite of what the product promised to do.
FINRA’s focus on smart beta products in its latest compliance sweep will take a close look at whether these ETFs are living up to the marketing hype.
But it also raises a couple of important questions that, I think, will persist over the next year or two.
First, the continued blurring of the line between active and passive investing. Does an algorithm automatically mean that a product is passive—what is its role? And, based on that, how far can an ETF stray from an underlying index before it becomes actively managed? This is a question raised by Burton Malkiel most recently at Canadian Investment Review’s Risk Management Conference. Read our interview with him here.
Second, how much should investors pay for passive products? One of FINRA’s complaints is that these ETFs are also much more expensive than their plain vanilla counterparts—what is the value to investors of an algorithm versus a broad index?
No doubt, ETF providers have a huge job on their hands when it comes to educating retail investors about the benefits of passive investing. For an investing public raised on mutual funds and active management it’s a big hurdle. Product innovation can be a huge help, but the industry should be careful that it doesn’t stray too far its initial (and very important) mission: keeping investing transparent and cost-effective for the average investor.