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Recent articles by Harry Domash: • How to spot trouble in earnings reports, 10/23/2005 • Inflation-proof your portfolio, 10/9/2005 • Pipe oilfield profits into your pocket, 9/25/2005 More... |
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| 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. Related news and commentary on MSN Money
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.
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 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. The American Stock Exchange, which constructs the index for PowerShares, ranks the 1,000 largest market-cap Nasdaq stocks based on company fundamentals, stock valuations, risk measures and how a company's stock-price has behaved. The details are secret, of course, but the process sounds similar in concept to MSNs StockScouter rating system. Power performance Based on the ratings, AMEX selects stocks from each of nine economic sectors, following a procedure whereby it ends up with around 30 large-cap stocks and 70 small- and mid-caps. AMEX repeats the process every three months, and PowerShares rebalances its portfolios accordingly. Is all that fuss worth the effort? PowerShares only started the fund about two years ago, so it doesnt have a long enough track record to draw any hard conclusions. But initial results are encouraging. From its Oct. 7, 2003, launch date through Nov. 15, 2005, the Dynamic OTC fund has produced a 28.6% total return, beating the Nasdaq 100's 17.3%. On the same day that the Dynamic OTC started trading, PowerShares also introduced its Dynamic Market Fund Rather than simply replicating the S&P 500, PowerShares starts with 2,000 large-cap stocks and, using a process similar to the one described for the Dynamic OTC fund, whittles that list down to what it hopes are the 100 best stocks. As is the case with all of its Dynamic funds, PowerShares repeats the process every three months. Again, the Dynamic Market Fund has only been trading a short time, but so far, its results look good. According to my calculations, the fund returned 41.8% from its Oct. 7, 2003, start date through Nov. 15, 2005, soundly beating the S&P Depositary Receipts Trusts 22.8% return for the same period. (All of the returns quoted here include dividends received.) PowerShares has 22 ETFs that use the AMEX dynamic portfolio-building strategy. These include both growth and value, small-, mid- and large-company funds and 14 industry-specific funds. Except for the two funds that I described, all the PowerShares funds were launched this year, so theyre too new to evaluate. In addition to the AMEX-constructed portfolios, PowerShares has one more ETF, Zacks Micro Cap In theory, PowerShares has raised the bar in terms of ETF portfolio construction from simple indexing to sophisticated, quantitative selection strategies. But everything hinges on how well those strategies work. While initial results look good, only time will tell. Harry Domash does not own or control positions in any of the ETFs mentioned in this article. | |||||||||||||
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