For investment funds, smart beta is purported to be an innovative leap. But are marketers steering it into choppy retail waters?

Smart beta was the hot product development topic for investment funds last year, and has started strongly in 2015. Products using smart beta seek to offer passive, alternative index investing that aims to be better tuned to the needs of investors. By way of example, rather the tracking the FTSE 100, a provider may identify certain stocks with a lower liquidity that are a drag on performance and screen those out of the replication of the index. So far, so normal, as these types of bespoke investment strategies have been the stock in trade of active managers for years. Many of the products themselves are an active attempt to beat the market (which, in fact, is actually 'alpha' not 'beta'). However, outside of sophisticated investor circles, it is not clear that investors know or understand what they are buying.

Over the past two years the fund and asset management industry has watched the push for product innovation in general, and smart beta in particular, with great interest. Most of the large product providers now have smart beta offerings. However are they correctly articulating how the products work, and are so-called smart offerings storing up problems for the future in non-institutional channels? The investment thesis may be sound. But some query whether product providers are paying enough attention to the build-up of liability risks, as the press and marketing teams hype up smart beta products.

The Financial Conduct Authority (FCA) has set out detailed guidance in its Conduct of Business Sourcebook (COBS) on the business standards to be applied to the promotion of financial products. Is the use of, and now reliance on, the term 'smart' promising clients an unrealistic outcome?

In 2006, the FCA outlined six outcomes expected to flow from treating customers fairly. Outcome five stated: 'Consumers are provided with products that perform as firms have led them to expect, and the associated service is of an acceptable standard and as they have been led to expect'. Where does that leave consumers that buy smart products when they are a great idea in the prevailing market, but later turn out to be market laggards? COBS 4.2.5 provides that a communication or financial promotion should not describe a feature of a product or service as 'guaranteed', 'protected' or 'secure', or use a similar term unless:

  • that term is capable of being a fair, clear and not misleading description of it;


  • the firm communicates all of the information necessary, and presents that information with sufficient clarity and prominence, to make the use of that term fair, clear and not misleading.

In a business context, the term 'smart' is often interpreted as astute, clever or operating with a level of intelligence. The fundamental issue with smart beta products is that the outcome, no matter how well constructed, is no more certain that that of a vanilla products. If a consumer buys a smart S&P 500 exposure, their automatic expectation may be that it will outperform the S&P 500 Index. If so, there is real risk of misselling unless such assumptions are challenged.

The idea of adjusting the weightings or other exposures in search of better or more stable performance is nothing new. Unfortunately, the way smart beta is being marketed under a hyped umbrella brand is. The legal documentation may hold up to scrutiny, but much of the marketing noise around smart beta may be overly bullish. In the context of passive product design, smart does not mean better. It means different, and failure to recognise and explain this should be a cause of concern. Providers need to better explain how smart beta operates in the context of different product types. For products designed to operate with lower volatility, the risks or opportunity cost of following this type of strategy should be clear. Use of a term of art such as smart beta risks considerable confusion amongst investors, with so many products trying to achieve different outcomes across different asset classes.

To insulate from the risk of misselling, many providers have sensibly sought to keep the product push around the term smart to institutional channels. However, the term is now so widely used that it has started to leak into the mainstream retail press channels. There is evidence that, as a result, terminology is moving away from smart beta to 'advanced beta' or 'beta plus'. But the hurdles for selling to retail investors remain. Use of revised nomenclature is not a suit of armour in a retail context – all attention inevitably returns to fair, clear and not misleading.

The challenges for providers are twofold. First, they should ensure that usage of the term 'smart' is restricted in retail channels. Second, they must correctly identify and describe the nature of the risk involved with bespoke indices. Every opportunity to outperform or seek lower volatility has a risk of material underperformance. There is risk, especially in these days of heighted sensitivity to financial misselling, that a so-called smart product on a vanilla index may fail to perform, leading to a misrepresentation claim. If a product turned out not to be as smart as designed – or has a materially worse outcome than the benchmark it is based on – clearly there a risk the 'smart' description could be deemed materially inaccurate. Also, in pursuing a claim for misrepresentation it may be easier, when presented with two closely related products, to claim one relied on the words smart as the positive differentiator. Whether caveat emptor acts as a shield would surely depend on the sophistication of the investor making the claim.

The desire to build products designed to seek better investment outcomes, such as low volatility, is sound. The risk of it being sold as a risk free wonder strategy is not. Product providers would do well to ensure the method of distribution and marketing strategies for smart products do not back providers into a dumb corner.

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This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.