Index Funds with a Little Extra


By Richard Diennor PowerShares Capital Management is young, relatively small, and about to experience a growth spurt. The company, which debuted as a marketer of exchange-traded funds about two years ago, recently introduced eight more so-called intelligent ETFs, expanding its roster to 19 in all.

The latest offerings track sectors such as biotechnology, pharmaceuticals, semiconductors, and software, using a proprietary methodology that seeks to deliver higher returns from indexes based on those industries while lowering volatility.

ETFs track indexes of stocks. Unlike open-end index mutual funds, their shares can be bought and sold throughout the day, as well as typically sold short. ETFs also feature low turnover, which helps to maximize tax efficiency, and low expenses.

FACTORING THE EQUATION. PowerShares, however, has pushed the envelope by offering ETFs that attempt to beat market indexes instead of just track them. In what could be seen as a move towards eventual actively-managed ETFs, the firm's offerings attempt to replicate what it calls "Intellidex" indexes, which are designed to beat the benchmarks of traditional indexed ETFs through stock selection.

Companies are included or excluded from the indexes based on 25 factors. These include cash flow, a stock's historical trading range, analysts' consensus estimates, and earnings growth, says Bruce Bond, the company's president and chief executive officer. The indexes were developed by the American Stock Exchange, where the funds trade, with assistance from PowerShares.

The indexes' component companies change quarterly. As a result, the funds' portfolios can have "a good amount of turnover," ranging from 50% to 150% annually, according to Bond. That's higher than the average indexed ETF. The company notes, however, that its ETFs are structured to keep capital-gains taxes to a minimum, or avoid them altogether.

COMPETITIVE FIELD. Through late May, PowerShares' two oldest funds -- PowerShares Dynamic Market Portfolio (PWC) and PowerShares Dynamic OTC Portfolio (PWO) -- had both generated annualized average returns of more than 21% since their inception two years ago. For the one-year period ended May 31, both beat their respective benchmarks by wide margins: Dynamic Market Portfolio rose 16.1%, vs. 7.4% for the S&P 500. Dynamic OTC Portfolio rose 20.6%, vs. an advance of 4.1% for the Nasdaq composite. More meaningful performance comparisons are not available due to the short track records.

Bond, a former vice-president and managing director of Nuveen Investments before founding PowerShares, says assets under management have grown to about $1 billion. Some 80% of that is from individual investors, with the rest coming from institutions.

Still, competition in the ETF area is not letting up. Behemoth Barclays Global Investors and its iShares family of ETFs holds more than $100 billion in assets. State Street Global Advisors is another sizeable early entrant. Fidelity Investments, Vanguard, and others, have also joined the fray.

ACTIVE COMPARISON. So called "enhanced" index funds -- which aim to beat their benchmarks' performance by overweighting exposure to certain stocks in the index or by using futures or options -- typically carry higher expenses. Management fees, a component of overall expenses, are currently capped at 0.6% on all of PowerShares' funds except PowerShares High Yield Dividend Achievers (PEY), which imposes a fee of 0.5%. By comparison, iShares S&P 500 Index Trust (IVV) carries a total expense ratio of 0.09%.

Bond contends, however, that his company's ETFs should be judged against actively managed money if you want to evaluate their value and costs. "I think that's a more appropriate comparison," he says. Although expenses for PowerShares' ETFs are higher than those of its ETF competitors, they aren't the highest compared to the average actively managed mutual fund. Expenses for PowerShares' ETFs may decrease as their assets increase, Bond says.

Kirk Kinder, a financial planner in Palm Harbor, Fla., says he doesn't use PowerShares ETFs in his clients' portfolios because of their turnover and costs. Steven Blankenship, a planner in Grapevine, Tex., says he thinks management fees for PowerShares' ETFs are "fairly reasonable," vs. those for actively managed funds.

THEORY AND PRACTICE. However, Blankenship says he has reservations about using PowerShares ETFs because they lack long track records of performance. Still, he says he has been following the Dynamic Market ETF and will probably add it to one client's portfolio within the next few months, although he will keep a close eye on it. He says he would consider using more of the company's ETFs in the future.

"In theory, the logic behind these vehicles seems to be quite compelling," Blankenship says. "PowerShares' strategy and their theory is quite interesting. It's just a matter of seeing if the reality will be as good as the theory."

Whether or not PowerShares can successfully compete among established ETF players in the niche it has carved out remains to be seen. What's clear, however, is that ETFs are growing in numbers, and have more distinctive characteristics that Standard & Poor's will aim to clarify as the asset class evolves.

PowerShares ETFs

ETF

Inception Date

1-Year Return through 5/31/05 (%)

Expense Ratio (%)

PowerShares Dynamic Market Portfolio (PWC)

5/1/2003

16.1

0.6

PowerShares Dynamic OTC Portfolio (PWO)

5/1/2003

20.6

0.6

PowerShares Dynamic Small Cap Growth Portfolio (PWT)

3/3/2005

NA

0.6

PowerShares Dynamic Mid Cap Growth Portfolio (PWJ)

3/3/2005

NA

0.6

PowerShares Dynamic Large Cap Growth Portfolio (PWB)

3/3/2005

NA

0.6

PowerShares Dynamic Small Cap Value Portfolio (PWY)

3/3/2005

NA

0.6

PowerShares Dynamic Mid Cap Value Portfolio (PWP)

3/3/2005

NA

0.6

PowerShares Dynamic Large Cap Value Portfolio (PWV)

3/3/2005

NA

0.6

PowerShares High Yield Equity Dividend Achievers Portfolio (PEY)

12/9/2004

NA

0.5

PowerShares Golden Dragon Halter USX China Portfolio (PGJ)

12/9/2004

NA

0.6

PowerShares WilderHill Clean Energy Portfolio (PBW)

3/4/2005

NA

0.6

Diennor is a reporter for Standard & Poor's Fund Advisor


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