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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.

Many indexes promote the use of academic research in the methodology, citing the work of leading economists and other academics. It’s important to have an academically sound foundation for index design, but the index must also accurately apply that research in its methodology.

One way to ensure this is happening is to determine whether the index simply “name-checks” a famous economist, without truly integrating the research into the index design (“citation distortion”). Advisors should also determine if the economist played a lead role in developing the index methodology, and whether the index is endorsed by the academic.

Step 2: Review the Index Components

The first generation of smart beta indexes is allocated between a large-cap U.S. equity index like the S&P 500, a bond index and cash. As Wall Street forecasts expect lower returns for U.S. large-cap benchmarks and bonds, there is a greater need for indexes to outperform using valuation, momentum or another academically proven method.

Advisors should confirm that the global indexes in a prospective FIA include a variety of international equity, bond, and alternative asset classes like commodities. Non-correlated asset classes may provide alternative growth opportunities in changing markets while also reducing the overall volatility of the index.

Step 3: Analyze the Back-Test

When it comes to exploring an index back-test, timing is everything. The index must have a statically significant and available back-testing period of greater than 10 years that allows advisors to see how it would have performed throughout multiple market cycles.

One thing for advisors to look out for are back-tests that begin at the bottom of a trough and therefore benefit from a marketwide recovery. We spend a tremendous amount of time “extending” back-tests by substituting proxy asset classes with longer histories to ensure that the back-test isn’t cherry-picked to artificially increase the annualized return. First-generation smart-beta methodologies can be back-tested to the 1950s or earlier and still show remarkably consistent long-term returns. Essentially, advisors should be wary of indexes that only show strong performance during a historically long bull market.

Step 4: Establish a Forecasting Mindset

There is no debating the fact that we are living in unprecedented times. Bond yields have been declining for nearly four decades, and the U.S. equity market has returned to the pace of the longest bull run in history. This combination has distorted some of the traditional tools used to evaluate financial products, including product illustrations and index back-tests. Should we assume that U.S. equities will continue to return over 13% per year as they did from 2009 to 2019? Does it seem reasonable to expect bonds to return almost 4% annually — even when interest rates today are below 1%?

Wall Street firms create long-term forecasts based on level economic growth, valuation and inflation that have historically provided a reliable measure of future performance. These forecasts project a very different decade ahead, with international equities significantly outperforming U.S. equities and bonds yielding just 1.90% annually.

Many firms publish their asset class forecasts as capital market assumptions. These are useful in projecting the go-forward performance of dynamic indexes by looking at the asset classes available and their historical allocations. A weighted average of the forecast performance is a good start, and if advisors see bonds contributed historically to 40%-60% of the returns, they should know this is unlikely to continue going forward.

No amount of due diligence will definitively show you how an index will perform going forward. To help set reasonable expectations with clients, advisors should take the time to analyze the index using the above framework — evaluate the methodology, review the index components, analyze the back-test, and establish a forecasting model.

Once advisors have tackled these steps, they should help clients understand that illustrations — and back-tests — may not be a complete reflection of how the index will perform going forward.


Tom Haines is senior vice president of Capital Markets and Index Solutions at Annexus, a leading retirement product design company. Tom plays an integral role in determining which indices to embed within future product designs, working with investment banks and asset managers across the United States to assess and ensure index integrity.