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| The Basics | A dynamic new twist on ETFs
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Sophisticated portfolio construction means these funds are no longer limited to investing in entire indexes, warts and all.
By Harry Domash
Exchange-traded funds, although getting more popular every day, have been limited to investing in indexes. Buy an ETF with a particular focus -- technology stocks, for instance -- and you get the full index of stocks, dogs and all.
PowerShares Capital Management is changing that paradigm, chipping away at one of the big advantages traditional mutual funds have over the cheaper, more tax-efficient ETFs.
Before I get into the details, a little background on ETFs.
Exchange-traded funds are similar to conventional mutual funds, but they trade like regular stocks. Unlike conventional funds, which frown on rapid trading, you can buy and sell ETFs as often as youd like, even in the same day.
Sector hopping
ETFs are useful if you want to hop into a hot market sector without going through the time and effort required to research and analyze individual stocks. If you think energy stocks are merely taking a breather before they take off again, you have a choice of at least four ETFs focusing on that sector.
But because of the way ETFs are constructed -- the very factors that make it possible for investors to trade them like stocks -- most of them simply emulate a fixed group of stocks, either an existing index or one designed specifically for that fund.
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The downside of index investing is that not all stocks making up an index are equal in terms of short-term price-appreciation potential.
PowerShares has overcome that shortcoming by limiting its portfolios to the stocks within each sector that have the best short-term return prospects, and then rebalancing each portfolio every three months.
PowerShares doesnt employ squads of analysts to ferret out the best stocks in each index. Instead, it uses quantitative selection strategies.
What are those? Instead of scrutinizing analyst reports and financial statements, quantitative investors, or quants, crunch reams of historical data to figure out what counts most for pinpointing future stock winners. Then they rev up their computers and search out stocks that currently match those specifications.
Triumph of the quants
Quant strategies, in many cases, work. - One of the simplest, James P. OShaughnessys Cornerstone Growth strategy uses only three screening parameters to build stock portfolios that have consistently beaten the market year-after-year.
- The top-rated Bridgeway Micro-Cap Limited (BRMCX) and Bridgeway Ultra-Small Company (BRUSX) mutual funds have recorded three-year average annual returns of 30% and 37%, respectively, selecting stocks using quant formulas devised by Bridgeway founder John Montgomery.
- Santa Monica, Calif.-based Dimensional Fund Advisors manages $82 billion for institutional investors using quantitative strategies devised by its founders at the University of Chicago.
Unfortunately, because most require buying 50 to 100 stocks, its difficult for individual investors to implement quant strategies. That brings us back to PowerShares.
PowerShares ETFs, on the surface, look like every other ETF. For instance, PowerShares launched its Powershare Dynamic OTC (PWO, news, msgs) fund to compete with the Nasdaq 100 Trust (QQQQ, news, msgs), better known as the Qs. The Qs emulate the Nasdaq 100 Index ($NDX.X), which contains the 100 largest stocks by market capitalization, excluding financial services, listed on the Nasdaq.
However, when you look under the hood, about the only similarity between the Dynamic OTC and the Qs is that they both hold Nasdaq stocks.
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Fund data provided by Morningstar, Inc. © 2008. All rights reserved.Quotes supplied by Interactive DataMSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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