Proponents of passive investing have tended to emphasise the simplicity and transparency of their approach to markets.
That was always a contentious claim, but such an argument became even more difficult to make with the approval in early May of quadruple-leveraged ETFs in the US.
As well as the risk inherent in the leverage, investors must also assess the counterparty exposure and understand that only the index's daily returns rather than longer-term performance are leveraged, a mechanism that mathematically means it can take longer to recover from losses.
These are obviously extreme examples, but reflect a trend towards complexity in the passive industry. Even an established area like factor-based investing is not as straightforward as some suggest: investors must grapple with everything from how an index is constructed to whether the historical performance is robust or the result of data mining.
A forthcoming essay in the Journal of Corporation Law by Anita Krug, of the University of Washington School of Law, addresses the inadequacies of the current regulatory regimes governing such complex products. The paper focuses on liquid-alternative funds, but has clear implications for the proliferation of smart-beta funds too.
Krug is by no means opposed to the development of new investment products and indeed welcomes it. ‘By giving retail investors access to investment strategies to which only sophisticated investors previously had access, the new investment products enable retail investors to diversify their portfolios in a way that only sophisticated investors previously could,’ she says.
Investors who want to own low-volatility stocks no longer need to pay active fees for the privilege, for instance, and also now have a convenient way to hold commodities. But should they do so without knowing how an index provider defines volatility or the meaning of contango and backwardation?
One industry riposte has been that all the relevant information is available in a fund’s prospectus. Krug is not convinced.
Such disclosures, she argues, ‘serve little purpose – and, indeed, harm those whom they are supposed to benefit – if investors take advantage of them without an adequate understanding of why an investment in any one of them is appropriate or how that investment might serve a diversification function within their overall portfolios’.
Prevailing regulatory attitudes are therefore insufficient. ‘The [current] driving principle is that these goals are best served not by regulators’ passing judgment on the merits of any particular investment product – for how could regulators competently do that? – but, instead, by their ensuring that would-be investors are informed of the risks associated with the product,’ Krug continues. ‘The complementary principle is that investors will be able to become informed about an investment product if they are given disclosure documents that set forth specified facts about it.’
Yet, for Krug, ‘although a fund’s prospectus could impart to investors any information they might wish to know about a fund, in fact, it typically tells them nothing’.
So what does Krug prescribe? She applauds the move to higher fiduciary standards around the world, but cautions against viewing this as a panacea.
‘Fiduciary obligations may be expected to benefit investors only to the extent that the person who is subject to them has a thorough understanding of both portfolio diversification principles and the wide range of investment products available to retail investors,’ Krug explains.
Krug suggests that regular competency exams could therefore place greater weight on subjects such as fund selection and portfolio allocation. She acknowledges, however, that these are imperfect disciplines.
‘The driving thrust of improving investor decision-making should not be immediately to achieve a gold standard of investment advice whereby all investors are able to obtain the best or most thorough advice that may be had about an investment or their portfolio composition,’ Krug insists. Instead, she prioritises a more gradual progression towards appropriately diversified portfolios guided by clearer product information.
The challenge will be ensuring standards and education keep pace with, but do not stymie, product innovation.
‘Better decisions in this context cannot mean decisions that ultimately prove profitable,’ Krug concludes.
‘Rather, it means decisions based on an actual understanding of an investment’s possible risks and anticipated rewards and the diversification function that the investment might serve in the investor’s overall portfolio. Much is occurring, and has occurred, in the financial industry that rightly causes worry. Increasing investment opportunities for investors that, for so long, have been excluded from so many of them – and doing so in a prudent and thoughtful manner – should not be among them.’