US and European regulators are beginning to scrutinize smart beta products, as the sector continues to gain popularity.
The European Securities and Markets Authority (ESMA) has voiced concerns of unintended biases or problems being created within such products, according to Reuters.
“It remains an open question how [smart beta] will behave in different market environments going forward.” —FINRAPatrick Armstrong, senior officer, financial innovation at ESMA, said the regulator had “concerns around the level of transparency and risk disclosures” in products focusing on alternative sources of beta.
“Alternative index strategies may introduce potential factor biases or concentration risk in a portfolio that an investor may not be fully aware of,” he told Reuters.
In the US, the Financial Industry Regulatory Authority (FINRA) said it intended to review “alternatively-weighted strategies” in its 2015 Regulatory and Examination Priorities Letter, published in January.
“Exchange-traded products tracking these indices may be thinly traded and have wide bid-ask spreads, making these funds more costly to trade, in addition to their generally higher expenses,” FINRA said.
The authority warned that some alternative indices “may have significantly higher turnover” than cap-weighted indices, which could lead to higher transaction costs. These are generally not included in product expense ratios.
“While back-tested results and some academic research have highlighted the potential efficacy and attractiveness of alternatively weighted indices,” FINRA added, “it remains an open question how the indices and products tracking them will behave in different market environments going forward.”
Industry estimates of assets currently held in smart beta strategies vary from $400 billion in exchange-traded funds (Morningstar) to $1 trillion when segregated mandates and other structures are taken into account (Lyxor).
Laurence Wormald, head of buy-side risk research at financial software provider Sungard, told Reuters that “crowding and herding” into some smart beta strategies could erode their main characteristics.
“The illusion of being able to permanently depress the risk on equities through smart-beta or minimum-variance strategies has been very, very appealing, and a lot of money has piled in, but that delusion cannot be kept up because it’s based on a strategy that doesn’t work when the crowd arrives,” he said.
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