A Brief History of Powershares
First, a little history on the Powershares operation: The firm, which was purchased by Invesco in early 2006, was started in the US by Bruce Bond in 2002. Bond is a former sales and marketing executive from Chicago
-based Nuveen Investment Management, and the Powershares lineup to some extent reflects his background. Its US offerings are laden with narrowly targeted funds that have a "ripped from the headlines" ring: Powershares Lux Nanotech and Powershares Global Clean Energy are but two examples.
The firm's key differentiator for some of its funds is an indexing methodology that blurs the line between active and passive management. Many of its ETFs, including the Dynamic US Market fund launched today, track indexes that are rebalanced quarterly using a quantitative stock selection algorithm. (This is akin to the models some active quant fund managers would employ.) The indexes, run by the American Stock Exchange (AMEX), thus don't simply try to replicate the market or a slice thereof, but actively attempt to add alpha via rules-based stock selection.
Powershares US Dynamic Market: The Active Index Approach
The attempt to add value comes with certain risks. Consider the Dynamic US Market fund's US-listed version, for example, which has existed since May 2003. It tracks the AMEX Dynamic Market Intellidex (the same index followed by the new LSE-listed version of the fund) which uses a 25-factor quantitative model to select 100 stocks from the 2,000 largest U.S. companies listed on major U.S. exchanges. The factors employed include both technical (that is, price and volume trends) and fundamental (P/E ratios and growth rates) data points. The model follows rules to make sure its sector weightings stay close to those of its selection universe. It also caps position sizes and employs a stratified weighting scheme to keep large stocks from dominating the portfolio.
Those criteria have meant that, relative to popular indexes such as the S&P 500 and Russell 1000, the fund has had a persistent mid-cap tilt with an additional slant towards value securities. That worked well for it early on, and the fund's three-year return easily bests the S&P 500 . However, it will leave the fund vulnerable when growth-oriented fare and large-caps lead the US market. This hurt the fund in the second half of 2006 and has done so thus far in 2007, leaving it with a bottom quartile one-year return and 229 bps behind the S&P 500 for the same period.
Powershares FTSE RAFI 1000: Fundamental Indexing
Like its sibling, the FTSE RAFI 1000 ETF puts a new spin on indexing (RAFI stands for Research Affiliates Fundamental Index, in reference to the firm founded by Robert Arnott in 2002). Whereas traditional indexes weight companies according to their market capitalisations, the FTSE RAFI US 1000 weights companies according to their sales, book values, cash flows, and dividends. Each factor carries equal weight, and the index is rebalanced once a year. Proponents of the method argue that cap-weighting is essentially arbitrary and introduces volatile and possibly misleading stock prices into the equation, and that indexes should thus instead attempt to weight companies according to their fundamental strengths.
The outcome is much the same as with the US Dynamic Market ETF. Relative to the S&P 500, the index has a value tilt and ends up placing more emphasis on stocks with smaller market caps. When plotted in the Morningstar Style Box, the RAFI 1000 portfolio lands in the large-value square, not in large-blend like the S&P 500. The RAFI also parks more assets in mid-cap stocks and less in giant-caps. As with the US Dynamic Market offering, those biases have been a hindrance over the past year, and the US sold version of the fund lags the S&P 500 by 211 basis points over the 12 months ended 9 November.
Powershares Global Clean Energy: Too Narrow?
The goal of this fund holds a certain appeal--after all, who wouldn't want to invest in firms that promote clean energy? It tracks the unfortunately-named WilderHill New Energy Global Innovation Index, a modified equal-weighted index that follows companies that stand to benefit substantially from a transition toward the use of cleaner energy. However, the companies that are in the index tend to be quite small, and that fact, combined with the fund's relatively narrow emphasis, is likely to make it very volatile. We would use it only for a very small slice of a broad portfolio, if at all.
Costs on the High Side for ETFs
The above concerns aside, we're big fans of ETFs, as they have the potential to offer investors a simple, low-cost way to get diversified exposure to a given market. By the standard of UK funds, the new Powershares offerings are reasonably cheap, with total expense ratios of 0.75% per annum. However, we think they could do better. First, for the two broad US market offerings, the 0.75% TERs are nearly double the 0.40% charged by the LSE listed iShares S&P 500 ETF. For the Energy offering, it's slightly more expensive than the 0.65% charged by iShares S&P Global Clean Energy. It's also worth noting that the fees levied by the new Powershares ETFs are higher than those Powershares charges for the US sold versions of the funds, which clock in at 0.60% for Dynamic US Market and 0.70% for the FTSE RAFI 1000 offering (iShares is no saint in this regard--its Stateside S&P 500 ETF charges only 0.09%).
