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A smarter breed of ETFs
PowerShares' funds use intelligent indexing to emphasize the best stocks in an index, which should mean higher returns. What more could you want? A track record.
By Timothy Middleton
Buying index funds makes a lot of sense, because matching the market is like shooting par in golf -- only the best are able to do it.
But indexing isnt perfect, particularly in difficult market environments. Then, stock picking really pays off. The technology-heavy Nasdaq Composite Index ($COMPX) rose only 1.4% last year, while the average high-tech mutual fund -- nearly all actively rather than passively managed -- spurted 5.6%.
The problem is that indices are created to identify and quantify economic trends in broad securities markets or in specific industries, like semiconductors. Its a worthy endeavor, but one that has only a glancing relationship with investing. An economist has only an academic interest in an index -- to study market patterns or build computer models to create forecasts, for example -- whereas an investor's interest is more personal.
So Im hoping the recent surge of interest in so-called intelligent indexing will allow investors to reap some actual dollars from an appealing theory. PowerShares Capital Management launched 32 of the 51 exchange-traded funds that debuted last year. PowerShares specializes in intelligent indexing.
Not so passive
A market index includes securities regardless of their investment merit," says Bruce Bond, PowerShares chief executive. "With PowerShares, we want to give you market-like exposure, yet at the same time make sure the stocks youre investing in have investment merit."
There's already some evidence that points to the approachs success. Between its inception on May 1, 2003, and Feb. 15 of this year, PowerShares Dynamic (PWC, news, msgs) shot up 76.1%, compared with the 39.7% advance of the S&P 500 Index, ($INX).
Related news and commentary on MSN Money
In the same period, PowerShares Dynamic OTC Portfolio (PWO, news, msgs) jumped 77.7%, half again the 54.6% gain of the Nasdaq.
Im not entirely sold on the PowerShares approach, but I think its on the right track. My model portfolio of ETFs uses conventional index funds. But, since my goal is to beat the market with less risk, Im open to the idea of substituting portfolios representing better-designed indexes. Here are the pros and cons Im weighing now.
The PowerShares approach is to examine the same universe of stocks as a given index, and then replicate its most important characteristics, such as sector and industry weightings. After that, though, the idea is to include stocks that appear to be attractive investments, not merely representative of the groups top players.
In PowerShares Dynamic Market Portfolio, Computer Sciences (CSC, news, msgs) is allocated 2.3% of the funds assets. In the S&P 500, this stocks weighting is 0.08%. Meanwhile, such S&P heavyweights as Cisco Systems (CSCO, news, msgs), Intel (INTC, news, msgs), Dell (DELL, news, msgs) and Microsoft (MSFT, news, msgs) are entirely absent. (Microsoft is the publisher of MSN Money.)
Computer Sciences is included because, primarily from a valuation and risk standpoint, it scored very highly, says John Southard, the firms director of research.
In PowerShares Dynamic OTC Portfolio, such holdings as Microsoft and Qualcomm (QCOM, news, msgs) have a smaller allocation than in the Nasdaq Composite, and Cisco isnt owned at all. One of the largest holdings of the ETF is a mid-size company called Nvidia (NVDA, news, msgs), a semiconductor manufacturer.
Nvidia "doesnt score well on valuation or risk, but from the point of view of fundamental growth and timeliness, it does score well, Southard says.
PowerSharess 25-point checklist of attributes broadly divides into four categories -- valuations, risk, growth characteristics and timeliness (or relative strength). The investment matrix was developed in consultation with the American Stock Exchange, which oversees the indexes and rebalances them quarterly.
Frequent rebalancing -- adding to or subtracting from stock holdings to create the desired mix -- creates heavy turnover. The S&P 500 has annual turnover of 2%. Bond estimates Dynamic Markets turnover is 150%. Ordinarily, that would create a tax burden for shareholders, but ETFs can escape capital-gains distributions. Indeed, last year none of PowerShares 37 funds made a cap-gains distribution.
ETFs are created and destroyed through the exchange of shares in the constituent index between a cooperating institution and PowerShares, not by the purchase or sale of shares, which is what triggers taxes on gains.
Risk, rewarded
So it isnt taxes that concern me about PowerShares -- it is risk. Any investment capable of going up more than average is capable of going down more, as well. (A hedge fund called Long Term Capital Management went spectacularly bankrupt in the 1990s by ignoring this reality.)
Between mid-January and mid-May of 2004, when the Nasdaq corrected 10%, Dynamic OTC plunged 15%. Admittedly, Dynamic OTC had gained more than the Nasdaq in 2003, so they both ended up in a tie by May, but volatility is unsettling by itself. Most people who owned an investment that had done 50% worse than they thought it would do would sell, fearing it was on the verge of doing worse still.
Also, PowerShares are extremely expensive by indexing standards. S&P Depositary Receipts (SPY, news, msgs), or Spiders, an ETF that tracks the S&P 500, have an expense ratio of 0.11%, or $11 annually on a $10,000 investment. Dynamic Market Portfolios ratio is 0.6%, or $60.
Thats even higher than the 0.53% ratio of Dodge & Cox Stock (DODGX), an actively managed no-load mutual fund that did vastly better than the S&P during the bear market. Because its indexes are proprietary, PowerShares can reap profits on its monopoly. But that doesnt mean I have to like it.
These issues aside, the PowerShares slate bears careful watching. In December, the company launched PowerShares FTSE RAFI US 1000 Portfolio (PRF, news, msgs), which employs an intelligent big-cap stock index designed by Rob Arnott, chairman of Research Affiliates.
He argues capitalization-weighted benchmarks like the S&P 500 implicitly give more assets to stocks that are overvalued than those that are cheap, the opposite of how the most successful investors behave. His index is based on fundamental factors like sales, earnings and cash flow, rather than market cap.
And PowerShares is launching new funds in a steady stream. In February, it brought out PowerShares Zacks Small Cap Portfolio (PZJ, news, msgs), a turbocharged benchmark of small-company stocks. In theory, small stocks have the potential to deliver the markets greatest returns.
With such a limited track record, PowerShares has to rely more on theory than proof to woo investors. But intelligent indexes have proved very successful at Dimensional Fund Advisors. Ive called those portfolios the best funds you cant buy, because they are largely restricted to the wealthy through hand-picked financial advisers.
PowerShares will be doing us a favor if it brings something equivalent to the hoi polloi.
At the time of publication Timothy Middleton owned the following securities mentioned in this article: Dodge & Cox Stock Fund.
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