All About Non-Traditional Index Funds

What are non-traditional index funds?

Traditional index funds track a market index - hence the name. That may be the S&P 500 or NASDAQ or a smaller segment of the market. Non-traditional index funds, on the other hands, track customized index in order to achieve greater performance than their traditional counterparts. Non-traditional funds may also use leverage, such that they return a multiple of one of these customized indexes, thus ratcheting up potential returns (and potential losses) to an even greater extent.

Similar to a managed fund, the customized indexes of non-traditional funds may use idiosyncratic criteria for tracking performance. The system resembles individual judgment in way that is analogous to an algorithm. However, these funds are definitely not "actively managed" and should not be viewed as such. 

Examples of Non-traditional Index Funds

Non-traditional funds can be hard to categorize since as stated above they tend to rely on idiosyncratic performance markers. The SEC has provided the following funds as good examples of common index funds that a retail investor might come across:

  • Smart Beta – The custom-built indexes for these funds often use “factors” to select the fund’s investments.
  • Quant Funds – The custom-built indexes for these funds use numerical methods like quantitative analysis or algorithms to select the fund’s investments.
  • Environmental, Social and Governance (ESG) Funds –The custom-built indexes for these funds use environmental, social and governance factors to select the fund’s investments.

What Makes Non-Traditional Funds Different from Traditional Index Funds?

Non-traditional funds can be exceedingly complex and difficult to understand, plus they involve a unique set of risks and rewards that come from their being different from traditional index funds.

Lack of Market Correlation. As stated above, non-traditional index funds differ from traditional funds in that they typically do not track a market index but instead track customized markers. Thus non-traditional funds may be useful for smoothing out volatility and enhancing risk-mitigation strategies.

Leverage. Some of these non-traditional funds will return a multiple of an index. This means that returns can be significantly higher than traditional funds; however, it also means losses can mount up rapidly.

Cost. While not as expensive as actively managed funds which are guided by an individual or group of individuals, non-traditional index funds are more expensive than traditional funds. The reasons for this may have to do with their specialization, greater risk, and greater complexity.

Are Non-Traditional Index Funds Right for You?

Securities industry rules and regulations stipulate that financial advisors must match investors with investments. This concept is called suitability. Suitability is an ongoing duty, thus if your investing preference or profile changes over time yet your investments stay the same, there may be a breach of the suitability principle. 

Complex and somewhat expensive investment products such non-traditional index funds are certainly not for everyone. They can provide a needed dosage of diversification for investors who would like to control for market volatility. They serve this purpose well since they do not track traditional index but rather customized markers that can be very idiosyncratic. 

In all likelihood, non-traditional index funds will be suitable for only a small number of investors; and equally likely they will only form a small portion of a responsible and well-balance portfolio.

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