ETFs: Index Funds Are Still a Good Idea

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The three actively managed equity ETFs that Invesco PowerShares launched this past April only use market capitalization to determine the master list of 3,000 stocks from which each fund picks the 50 stocks with the highest rankings based on earnings, cash flow, and low valuation. In the Active AlphaQ Fund (PQY) and the Active Alpha Multi-Cap Fund (PQZ), the 50 stocks start out equal-weighted, and any stocks that grow to over 2% of the portfolio's total asset value are cut back to 2% each Friday, says David O'Leary, chief investment officer at AER Advisors, which sub-advises the two funds. The funds also dispose of any names whose rankings have fallen due to negative earnings surprises.

"We don't want one stock to dominate and the next day it blows up. The reason for the equal weighting is you never know what's going to blow up," says O'Leary.

BAD STOCKS

To the extent that actively managed funds steer clear of the weakest parts of the market, he believes they can outperform the index, since stock prices tend to track earnings strength. The disadvantage of an index fund such as those based on the S&P 500, for example, is that they hold bad stocks that cannot be removed from the index until they have lost most of their value, he says. The stocks in his portfolios have annual earnings growth of more than 30% and trade at a p-e multiple of around 12.

O'Leary thinks most active fund managers waste a lot of time and energy trying to time the market, which hurts their returns, when they could focus on finding companies with high earnings growth and low valuations.

The four active Alpha ETFs offered by PowerShares have an expense ratio of 0.75%, triple the average fee of most index ETFs and two to three times higher than Wisdom Tree's U.S.-based active ETFs, but half the average fee of the typical actively managed mutual fund.

Lavine at Wisdom Tree believes choosing to be as active as you want using index-based tools is the winning concept. "You get more returns from being in the right asset class than from the stocks you choose within that asset class," he says. "If you chose commodities this year, you did well. If you chose financial stocks, you didn't do so well."

Many professionals, including Lavine, argue that the value you add to a portfolio by getting the asset allocation right far exceeds the differential you get from how active you are in selecting the stocks within that asset class. "ETFs are perfect for that world," he says. "You get a high level of diversification within one trade. They're fabulous tools for being smarter than market downturns."

Bogoslaw is a reporter for BusinessWeek's Investing channel.