The CFA Institute Research and Policy Center has developed a new investment classification framework and issued recommendations for firms to improve transparency, communication, and investor comprehension associated with smart-beta, direct indexing, and index-based investment products.
The institute pointed out that investing has traditionally been divided into active and passive management strategies.
For many years, it said that index investing involved replicating market-capitalisation-weighted benchmarks without actively selecting investments or deviating from market-cap weights.
In contrast, newer index-based strategies such as smart beta ETFs and direct indexing introduce active decision-making in portfolio construction, challenging traditional distinctions.
To address this complexity, CFA offers investment firms a tool to better communicate index-based products to clients by describing index-based strategies according to their level of active decision-making.
CFA’s recent research proposes a framework of indexing along a spectrum of strategies beyond traditional market capitalisation weighting. The framework is based upon three dimensions of strategy, sources of returns, and level of discretion, with the goal of increasing transparency among index-based investment products.
CFA has also set out a number of recommendations for investment firms grounded in the principles of improved disclosures for clients, including:
- educate and inform investors of the active decisions made throughout the investment process for index-based investments;
- communicate to investors about the decision-making processes involved in index fund creation, including security selection and weighting methodologies used in the creation of the investment product or strategy;
- provide prospective clients with access to more detailed information on index product features as part of the pre-sale product literature.
Rhodri Preece, senior head of research at CFA Institute, said the notion of a simple bifurcation between active and passive investment products is “outdated”.
“Index-based strategies are varied in their design features and involve different layers of active decision-making, dispelling the historical distinction between active and passive management,” he said.
“As index-based products have proliferated, incorporating more complex features than market capitalisation weighting, there is a need for greater transparency and improved investor comprehension of these strategies,” Preece noted.
He added that this new framework intends to support investment advisers and end-investors through clearer disclosure and communication of the key features of index-based products.
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