June 27, 2005

Family Portrait: PowerShares Capital Management LLC

Going Off the Straight and Narrow

PowerShares Capital Management LLC 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, is set to introduce eight more 'intelligent' ETFs this week, expanding its roster to nineteen 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.

Exchange-traded funds 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.

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 included cash flow, a stock's historical trading range, analysts' consensus estimates, and earnings growth, said 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%-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.

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, 2005, both have beaten their respective benchmarks by a wide margin: Dynamic Market Portfolio rose 16.1%, versus 7.4% for the S&P 500. Dynamic OTC Portfolio rose 20.6%, versus 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 who founded PowerShares, said assets under management have grown to about $1 billion. Some 80% of that is from individual investors, with the rest coming from institutions. To be sure, competition in the ETF space is not letting up with behemoth Barclays Global Investors and its iShares family of ETFs, holding over $100 billion in assets, and State Street Global Advisors, another sizeable early entrant. Fidelity Investments, Vanguard, and others, have joined the fray.

Management fees, a component of overall expenses, are currently capped at 0.60% on all of PowerShares' funds except PowerShares High Yield Dividend Achievers (PEY), which imposes a fee of 0.50%. By comparison, iShares S&P 500 Index Trust (IVV) carries a total expense ratio of 0.09%. Typically, so called "enhanced" index funds, which aim to beat their benchmark's performance by overweighting exposure to certain stocks in the index or by using futures or options, have carried higher expenses.

Bond said, 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 is a more appropriate comparison to make," he added. Although expenses for PowerShares' ETFs are higher than those of its ETF competitors, they are not the highest compared to the average actively managed mutual fund. Expenses for PowerShares' ETFs may decrease as thier assets increase, Bond said.

Kirk Kinder, a financial planner in Palm Harbor, Fla., said he does not use PowerShares ETFs in his clients' portfolios because of their turnover and costs. But Steven Blankenship, a planner in Grapevine, Texas, said he thinks management fees for PowerShares' ETFs are "fairly reasonable," compared to those for actively managed funds.

However, Blankenship said he has reservations about using PowerShares ETFs because they lack long track records of performance. Still, he said 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 the fund. He said 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 said of PowerShares' exchange-traded funds. "PowerShares' strategy and their theory is quite interesting. It's just a matter of seeing if the reality will 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 is 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 Capital Management LLC Exchange-Traded Funds

ETF Inception Date One-Year Return Through 5/31/05 (%) Expense Ratio (%)
PowerShares Dynamic Market Portfolio (PWC) 5/1/03 +16.1 0.60
PowerShares Dynamic OTC Portfolio (PWO) 5/1/03 +20.6 0.60
PowerShares Dynamic Small Cap Growth Portfolio (PWT) 3/3/05 NA 0.60
PowerShares Dynamic Mid Cap Growth Portfolio (PWJ) 3/3/05 NA 0.60
PowerShares Dynamic Large Cap Growth Portfolio (PWB) 3/3/05 NA 0.60
PowerShares Dynamic Small Cap Value Portfolio (PWY) 3/3/05 NA 0.60
PowerShares Dynamic Mid Cap Value Portfolio (PWP) 3/3/05 NA 0.60
PowerShares Dynamic Large Cap Value Portfolio (PWV) 3/3/05 NA 0.60
PowerShares High Yield Equity Dividend Achievers Portfolio (PEY) 12/9/04 NA 0.50
PowerShares Golden Dragon Halter USX China Portfolio (PGJ) 12/9/04 NA 0.60
PowerShares WilderHill Clean Energy Portfolio (PBW) (PBW) 3/4/05 NA 0.60

SOURCE: Standard & Poor's and PowerShares Capital Management LLC. Return data as of 5/31/05.

Contact Bob Keane with questions or comments at: .

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