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Smart Beta Funds Can Be Costly
FINRA, the self-regulating body of the nation’s brokerages, recently published an investor alert, warning individual investors of the risks of what are broadly known as smart beta funds.
The warning came for two basic reasons: these funds can be complex and costly.
First, you may wonder what smart beta funds are. The term is frustratingly elastic, but generally smart beta exchange-traded funds, or ETFs, are investments that use rules or formulas other than market value to decide which stocks to own, and in what proportion.
For example, when you purchase a traditional S&P 500 index fund or ETF, you’re buying more of the larger-value companies like Apple, and less of the smaller companies in the index. But smart beta ETFs will use alternative formulas. For instance, the Guggenheim S&P 500 Equal Weight ETF will own the same proportion of Apple as the 499 or so other members of the S&P 500.
Other smart beta ETFs can be more esoteric. The First Trust Utilities AlphaDEX Fund, for example, skews its holdings toward utilities which demonstrated recent price appreciation and sales growth relative to others in the sector.
Costly Funds
More complicated ETFs will generally buy and sell more stocks within the funds, which in turn drive up costs. And even simpler, smart beta ETFs like the Guggenheim S&P 500 Equal Weight ETF, still require occasional rebalancing, which means buying some stocks and selling others once every three months. Compare these to ordinary market-weighted index funds and ETFs, which generally only need to buy and sell when there’s a change in the index they track.
This largely explains why the equal-weighted smart beta fund sports an expense ratio of 0.40 percent annually, four times the cost of market-weighted index funds. And First Trust Utilities AlphaDEX Fund costs investors 0.70 percent annually, a figure more in line with actively-managed funds that try to beat the index.
FINRA recommends investors ask “smart” questions about smart beta funds. Some, like what are the costs and risks of these funds, are questions investors should ask themselves about any investment. And if a financial adviser manages your investments, ask him or her if you own any smart beta funds. Two out of three advisers are using a smart beta ETF, according to a recent survey by market index provider FTSE Russell.
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