Non-traditional indexes can provide investors with an expanded set of investment opportunities — but they can also create additional complexities and risks.
Funds that track market indexes have historically offered investors a cost-effective and efficient way to gain exposure to the performance of a market benchmark or index. “Traditional” market indexes such as the S&P 500 or Dow Jones Industrial Average provide investors with exposure to a broad basket of securities and, as a result, generally offer less risk as compared to investing in individual securities. Increasingly, opportunities are also available to invest in alternative investments and strategies through funds that track “non-traditional” indexes.
Funds tracking non-traditional indexes can provide investors with an expanded set of investment opportunities beyond those offered by traditional indexes. But they can also create additional complexities and risks to consider.
The Basics of Non-Traditional Indexes
Traditional indexes are generally designed with rules governing investment selection that seek to match the performance of a specific market. These parameters may relate to price, market capitalization, industry or sector, growth or value orientation, and more. Indexes can be broad-based (such as the S&P 500) or narrow (such as an index focused on gold miner stocks).
In comparison, some non-traditional indexes can be more customized according to specific goals or needs. For example, a non-traditional index might track risk tolerance or exposure to specific investment themes.
Non-traditional indexes can be tracked by a variety of products, including mutual funds or exchange-traded products (ETPs), as well as other instruments like structured notes. These investment vehicles can use more complex or targeted investing strategies than traditional indexes that provide direct exposure only to a particular market or sector. Some non-traditional indexes may be based on academic research and focus on factors other than market capitalization (such as dividends), while others can be rules-based versions of strategies that investment professionals have developed for their customers and can create more personalized investment exposures.
A Closer Look at Non-Traditional Index Funds
Non-traditional indexes might include some criteria that an active fund manager would consider, such as choosing components based on valuation, earnings growth and other factors. But funds tracking these indexes are passively managed, meaning they don't use a fund manager's independent judgment to manage investments day-to-day. Such funds that include active characteristics but are passively managed are sometimes referred to as being “quasi-active.”
There are a variety of reasons why a fund would track a non-traditional index, including performance and preference considerations such as:
- seeking to outperform a particular market, sector or benchmark index;
- seeking improved diversification;
- seeking performance that's uncorrelated to the broader market; and
- seeking exposure to or avoidance of certain securities as determined by customers.
Examples of non-traditional index funds that might be available include:
- Smart Beta Index Funds: Unlike most traditional indexes, which are weighted by market capitalization, smart beta funds screen and weight securities using other rules-based factors. Some of these funds track an equal-weighted index in which all companies have an equal representation regardless of market value. Others can be linked to company financial metrics or focus on stocks with relatively low-volatility.
- Quantitative Index Funds: These funds often use sophisticated, computer-based models including quantitative analysis, algorithms or variants of machine learning to select the index fund's components.
Other products, such as structured retail products and leveraged or inverse funds, often referred to as “geared” ETPs, can track the performance of non-traditional indexes as well.
Non-Traditional Index Fund Features
Non-traditional indexes have unique characteristics and risks. Make sure you understand the following features of a fund (or other product) that tracks a non-traditional index as you evaluate whether the investment is right for you:
- Returns: Non-traditional index funds might have active management features aiming to outperform the broader market. There's no guarantee, however, that these funds will outperform — or that they'll even perform comparably to — the broader market. Furthermore, because these funds track indexes that might be relatively new, they might have limited “live” performance histories that could make it hard to understand how they'll respond under different market conditions.
- Risks: Read a fund's prospectus to understand its risk factors. For example, a non-traditional index fund might intentionally create concentration risk through its selection and weighting of its underlying investments.
- Market Correlation: Non-traditional index funds might be less correlated to the broader market, which can be an attractive feature for investors seeking reduced volatility. However, consider how much exposure you want to these indexes in your overall portfolio and assess whether other investments in your portfolio could help smooth out volatility instead.
- Index Construction and Holdings: Do your best to understand how an index was constructed and what the non-traditional index fund hopes to achieve as compared to more traditional index funds. This can be challenging given the complexity of some funds. At the very least, you should be able to understand how the index is designed to respond to various investment scenarios. Be wary of index funds that are too complex to explain in plain language. Also, look into the actual holdings of the index fund to ensure that the exposure and weightings match your investment and diversification goals.
- Cost: Funds tracking non-traditional indexes might be less expensive than actively managed funds because analysts and active managers aren't required. But these funds can have higher expenses than traditional index funds. Some non-traditional index funds might have embedded costs or fees that can be hard to assess or understand. You can compare costs using FINRA's Fund Analyzer.
Ask yourself whether funds or other products tracking non-traditional indexes fit with your overall investment goals and objectives. Given their complexity and risks, consider discussing these products with an investment professional.
