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The popularity of dynamic, or "smart beta," indexes in fixed indexed annuities (FIAs) has rapidly increased in recent years. Interest has exploded, and for good reason: These indexes systematically navigate in and out of various asset classes to generate stronger returns while reducing the potential for large drawdowns, offering the opportunity to secure more consistent long-term returns.
Just five years ago, only a handful of FIAs included access to these smart beta indexes. Now, there are over 90 different such indexes available — and more seem to launch each month.
With so many options, it's easy for advisors to feel overwhelmed and experience "choice paralysis." This is why many advisors stick to a few familiar indexes or only focus on back-tested performance, participation rates and product illustrations. However, shortcuts like these may lead to performance that does not align with clients' expectations going forward.
There's a better way.
Having worked with most of the major investment banks and asset managers on Wall Street, my team and I have evaluated a wide array of dynamic indexes over the years. We have developed a system that can help advisors navigate the broad range of available indexes and identify the options that make the most sense for their clients.
This system is based on our rigorous quantitative finance due diligence process, which we use to determine the integrity of different index designs as we assess future partners. We have broken this process down into four steps that will empower advisors to feel more confident that their chosen indexes will help clients meet their goals.
Step 1: Evaluate the Methodology
Dynamic indexes have long-term back-tests that are designed with the benefit of hindsight — they apply the index methodology to historical financial data as far back as the underlying components existed to give a sense of how the index would have performed in the past if it had been live during that time period. However, when evaluating these indexes, it's important to ask: How did the index achieve that performance?
It helps to take a step back and look at the methodology used in developing the index. If an asset manager has designed a given index strategy, it's valuable to know whether that asset manager is using the same, or similar, strategy with their clients, to whom they have a legal fiduciary responsibility. If the asset manager isn't using the strategy with their clients, you need to ask: why not?
Alternatively, if an investment bank sponsors the index, it's likely that there is a structured note using the index — and a prospectus that outlines in detail the risks in the index. It is critical to understand who is designing or sponsoring the index, and to secure all relevant information on how that index is being developed.
