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Custom-Built Index Funds: Are You the Right Customer?

By FINRA Staff - Sep 25, 2018 at 6:49AM

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These are not "set it and forget it" investments.

There are custom homes, custom cars and custom clothes. Now, there are even custom index funds.

Non-traditional index funds, or custom funds, can include mutual funds or exchange-traded funds (ETFs). These funds typically use more complex or targeted investing strategies than traditional index funds that track a particular market index. Rather than replicate an existing market index, these funds use custom-built indexes to select a fund's investments.

black custom hot rod car on a coastal road

Image source: Getty Images.

While custom funds might appear no different from traditional mutual funds or ETFs, that's not the case. These funds use very different investment strategies than traditional index funds, and may be complex and hard for investors to understand. Custom-built indexes might use criteria that an active fund manager would consider. For example, the index might include components based on companies' revenues or dividends. But custom funds are passively managed, meaning they do not use a fund manager's independent judgment to manage the fund's investments. Investors need to do some research to fully understand these products, as the SEC and FINRA recently cautioned in separate articles aimed at investors.

Why custom?

There are a few reasons why a fund would pursue a non-traditional index strategy. By tracking a custom-built index, a fund may seek to achieve better performance than a particular market or sector. Or, a fund may seek exposure to certain securities based on factors like financial strength or perhaps environmental, social, and governance concerns.

Here are a few examples of non-traditional index funds:

  • Smart beta funds are based on measures other than weighting by market capitalization -- the method used in most traditional index funds. For example, some smart beta strategies use an equal-weighted index in which all companies have an equal representation in the index regardless of market value, which typically results in smaller-cap companies being "overweighted" relative to large-cap companies. Other smart beta indexes may be linked to fundamentally weighted indexes with components chosen based on companies' revenues, dividends, or other corporate metrics. A low-volatility strategy is another example of a smart beta index weighting method.
  • Quant funds use numerical methods like quantitative analysis or algorithms to select the fund's investments.
  • Socially responsible funds use environmental, social, and governance factors to select a fund's investments (which is why they are sometimes called ESG Funds). As the SEC notes, these factors are subjective and could include concerns like avoiding the use of toxic chemicals (environmental) or achieving diversity on a board of directors (social).

Are you a "custom" customer?

Custom index funds have unique characteristics and may not be as easy to understand as a traditional index fund. Before going custom, make sure you understand the following features of a fund to help ensure the investment is right for you.

  • Returns. Custom funds may have active management features aiming to outperform the market. But there is no guarantee these funds will in fact outperform, or even perform comparably to, the market. Furthermore, these funds may have limited performance histories that make it hard to know how they will perform under different market conditions.
  • Risks. Read a fund's prospectus to understand its risk factors. For instance, look to see if the fund is more heavily weighted in a particular sector or country, or toward a particular size of company. For instance, is it more exposed to small-cap stocks? This is known as concentration risk. For more information, see FINRA's Concentrate on Concentration Risk.
  • Correlation to market. Non-traditional index funds may be less correlated to the market. For this reason, the SEC notes investors might want to consider "investing in them together with other types of funds." Depending on their characteristics, the other funds in your portfolio could help smooth out volatility and decrease the risk of owning a custom index fund.
  • Index construction. Do your best to understand how the fund's index was constructed, but this may be a challenge. As the SEC notes, an index based on quantitative analysis or algorithms may involve complicated mathematical calculations and economic concepts.
  • Index holdings. Look into the actual holdings of the fund. Different indexes might include the same securities or give more weight to certain securities than you might expect. Make sure your investments are as diversified as you want them to be.
  • Cost. These funds may be less expensive than actively managed funds because managers are not actively picking securities, so they do not need the services of research analysts and others that help pick securities. However, remember you are not buying into an actively managed fund, and custom funds typically have higher expenses than traditional index funds. You can compare costs using FINRA's Fund Analyzer.

Finally, ask yourself if the product fits into your overall investment goals and objectives. If not, a custom fund might not be a good fit for you.

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