LONDON (Reuters) - Funds that mimic strategies used by active managers for a fraction of the cost could be forced to carry a health warning by regulators who are concerned they may pose greater risks than are being disclosed.
The so-called "smart-beta" funds use formulas to decide when to buy and sell stocks and bonds on a semi-regular basis as opposed to blindly tracking an underlying index or being more actively run on a daily basis.
Fund tracker Morningstar, which calls the funds 'strategic beta', estimates the industry has quadrupled assets to near $400 billion since 2010. Add private mandates and the total is nearly $1 trillion, money manager Lyxor estimates.
The reason is clear. "Smart" funds can charge between a quarter and half the fees of actively managed funds.
However, their popularity has now caught the eye of regulators in Europe and in the United States who are looking at the potential risks they pose, which could lead to new rules and greater disclosures.
The U.S. market watchdog said it would "review" the market this year to see how market volatility affects the funds' performance and regulators in the European Union flagged additional concerns with how the funds are constructed.
The funds shuffle holdings to capture the replicable parts of a strategy which don't involve a manager's particular skill or emotional bias, a kind of half-way house between a passive and actively managed fund.
That could mean, for example, buying high-dividend-yielding stocks, selling overvalued and buying undervalued stocks or re-creating the trades of certain hedge funds.
But such strategies could leave a fund unbalanced.
We "have concerns around the level of transparency and risk disclosures," said Patrick Armstrong, senior expert of financial innovation at the European Securities and Markets Authority.
"Alternative index strategies may introduce potential factor biases or concentration risk in a portfolio that an investor may not be fully aware of," he added.
Regulators are also concerned because large institutions such as pension funds are increasingly looking to such funds as a cheaper and relatively safe way to access the equity market and improve returns after the financial crisis led to a drop in bond yields.
One sought after strategy is 'minimum variance', which involves buying stocks with low volatility, said Laurence Wormald, head of buy-side risk research at Sungard, although as the assets become more popular, they can become volatile.
"Crowding and herding is the big problem with smart-beta," said Wormald.
"The illusion of being able to permanently depress the risk on equities through smart-beta or minimum-variance strategies has been very, very appealing, and a lot of money has piled in, but that delusion cannot be kept up because it's based on a strategy that doesn't work when the crowd arrives," he said.
Regulators worry the methodology used to create some funds, the testing used to show how they would fare at periods of market stress and the way risks are disclosed to investors is uneven.
Regulators are currently just looking at the plain vanilla end of smart-beta - which account for the bulk of industry assets - but demand is growing to create funds using more exotic formulas to copy strategies similar to hedge funds.
"It's very early days in applying that technology to create alternative strategies. It is growing fast but it's growing fast from a very small base," said Chris Brightman, chief investment officer at smart-beta fund provider Research Affiliates.
"Once you move away from a long-only, unlevered portfolio to using derivatives and leverage in a strategy, you are absolutely introducing additional risks that need to be managed," he said.
Goldman Sachs (GS.N), for example, in December sought the regulatory nod to launch 11 alternative beta funds, five of which sought to replicate hedge fund returns, while IndexIQ, whose funds aim to clone hedge fund gains, recorded a 46 percent jump in assets to $1.6 billion last year.
Academic research papers have identified more than 350 factors that can be used to create 'smart beta' funds, making such investments difficult to monitor for regulators and investors alike.
"It's a legitimate area for research and to invest, but some of these things are becoming more and more opaque," said Andrew Herberts, head of private investment management UK for Thomas Miller.
(Story refiles to amend headline)
Editing by Elaine Hardcastle