From the June 2006 issue of Wealth Manager Web • Subscribe!

My So-Called Index

To say that investors are smitten with exchange-traded funds would be an understatement. Indeed, assets in ETFs have surged more than 200 percent since 2002 and now stand at more than $310 billion. While that amount pales in comparison to some $9 trillion invested in mutual funds, there's little doubt that plenty of money that used to find its way into open-end mutual funds is now finding a home in the more than 200 ETFs currently traded. Not surprisingly, the growth of ETFs--$54 billion alone was dumped into these investments in 2005--is drawing the eye of the mutual-fund industry. For example, mutual-fund giant AMVESCAP--home to the AIM funds--recently agreed to acquire PowerShares, one of the fastest-growing players in the ETF field.

What is especially interesting about the current land grab in the ETF world is that it is all based on what is, on the surface, a vanilla investment concept--index investing. While this reality is oftentimes lost on investors, the fact is that all ETFs are supposed to mirror an underlying index. Indeed, no actively managed ETF exists. When you buy an ETF, you are buying an investment vehicle that, in the words of more than one active fund manager, "a monkey could run."

One reason given for the lack of an actively-managed ETF is that active management would destroy one of the more important concepts underlying ETFs--transparency. According to their proponents, ETFs have no secrets. An investor always knows what he or she is buying with an ETF. The fact that ETFs are wedded to an underlying index ties their hands in terms of freelancing on the stock selection: Know the index; know the ETF.

Quite frankly--and this is heresy in the investment world--transparency is overrated. Or, at least, oversold. Yes, transparency can be a good thing. Being able to look underneath the hood of an investment to see exactly what it owns is useful when allocating portfolio assets. Transparency does play a role in limiting hanky-panky in the investment world. Still, the reality is that most retail and professional investors don't care all that much about transparency. The $9 trillion sitting in open-end mutual funds (hardly transparent investment vehicles) and another trillion or so in hedge funds (perhaps the most opaque of all investments) prove this point. Thus, it is only a matter of time before the transparency argument is pushed aside and regulators allow actively managed ETFs.

The irony is that some ETFs operate in a way that is neither completely transparent nor purely index. In fact, one could argue that actively managed ETFs already exist, albeit in a more tempered way than what we generally view as active management.

Read, for example, the following language from the prospectus of the PowerShares Zacks Small Cap Portfolio (PZJ). This ETF is based on the Zacks Small Cap Index:

The Fund generally will invest in all of the stocks comprising the Zacks Small Cap Index in proportion to their weightings in the Zacks Small Cap Index. However, under various circumstances, it may not be possible or practicable to purchase all of those stocks in those weightings...There may also be instances in which the Adviser may choose to overweight another stock in the Zacks Small Cap Index, purchase securities not in the Zacks Small Cap Index which the Adviser believes are appropriate to substitute for certain securities in the Zacks Small Cap Index or utilize various combinations of other available investment techniques, in seeking to track the Zacks Small Cap index.

And if that description of the ETF sounds anything but "locked in" to the underlying index, check out this description of the underlying index itself:

The Zacks Small Cap Index selects companies with potentially superior risk-return profiles as identified using a proprietary ranking methodology developed by Zacks. . . . The Zacks Rank, developed in 1978, is a proprietary quantitative stock-ranking model based on the pattern of analyst earnings estimate revisions. . .. Each company is ranked using a quantitative methodology and sorted from highest to lowest within the stock universe. The methodology optimizes the Zacks Rank and the constituent turnover relationship based on criteria quantified by Zacks. The 250 highest-ranking companies are chosen and receive a modified equal weighting. Constituents will be reviewed and are subject to elimination on a weekly basis in the event of material ranking declines.

To summarize:

The PowerShares Zacks Small Cap Portfolio is based on an underlying index that is created from a proprietary model based on a quantitative ranking system that looks at earnings estimate revisions and where index constituents could be added/deleted as often as weekly based on this proprietary model.

The PowerShares Zacks Small Cap Portfolio may or may not hold all of the components of the underlying index and may or may not hold those components in weightings similar to the index.

The PowerShares Zacks Small Cap Portfolio may or may not sell/buy components for the ETF prior to their removal/addition to the underlying index.

To be fair, since its launching February 16, 2006, the PowerShares Zacks Small Cap Portfolio has mirrored its underlying index. Still, the ETF seems to have given itself plenty of flexibility to stray from the index over time. Furthermore, one would have a difficult argument to make about the so-called transparency of the underlying index. That Zacks can swap out stocks in the index on a weekly basis is not exactly the type of transparency sold by ETF advocates. Oh sure, you can see what the ETF owns on a daily basis. But how many investors and advisors will take the time to check every day or every week to see what changes have been made to the underlying index or ETF. That's simply not practical.

I don't mean to pick on the PowerShares Zacks Small Cap Portfolio. In fact, the PowerShares stable of ETFs, for the most part, has put up good performance numbers for investors. Furthermore, I am a fan of the firm's niche strategy (the company offers ETFs in such diverse sectors as water, nanotechnology, and alternative energy). And I like that PowerShares employs an "intelligent index" approach that attempts to one-up the usual index construction by incorporating quantitative methods for stock selection. But I'm not a fan of PowerShares ETFs because they are particularly transparent. And PowerShares is not alone in this regard.

The iShares Dow Jones Select Dividend Index (DVY), benefiting from the huge interest in dividend investing in recent years, is one of the fastest-growing ETFs in history. The ETF invests in high-yielding stocks that have positive dividend growth for the past five years and dividend-payout ratios of 60 percent or less. Since being launched in November 2003, the ETF has grown to nearly $7 billion in assets. The reason the ETF has been so popular, however, has nothing to do with its transparency or how closely it mimics its underlying index. In fact, the ETF and underlying index are anything but identical twins.

The ETF, offered by Barclays Global Investors, is based on an index created by Dow Jones & Co. Interestingly, a side-by-side comparison (as shown in the table) shows some stark differences between the ETF and underlying index:

There are six stocks in the underlying index that are not in the ETF. Conversely, there are 20 stocks in the ETF that are not in the underlying index. This is a fairly sizable difference in components between the ETF and underlying index, given that the ETF has a total of only 114 stocks.

The top 10 largest holdings in the ETF account for about one-quarter of the total weighting of the ETF. In the underlying index, the top 10 largest stocks in terms of weighting account for 17 percent.

Six of the top 10 largest holdings in the ETF do not crack the top 10 largest holdings of the underlying index.

The largest stock in terms of weighting in both the ETF and underlying index is Altria. But Altria's weighting in the ETF is more than 60% greater than the underlying index (3.8 percent for the ETF versus 2.3 percent for the underlying index).

Why the discrepancies? In the prospectus, the advisor states, "The Fund uses a Representative Sampling strategy to try to track the Index." Sampling is a common strategy for index investing. Instead of buying exactly the same constituents in exactly the same weighting as the index, the ETF attempts to replicate the index's performance by sampling the index and including other investments. This ETF has done a good job of tracking the index, although tracking error--the performance of the ETF versus the performance of the underlying index--appears to have grown slightly in the last six months. This expansion of the tracking error, which may have to do partly with the divergence in components, certainly bears watching going forward.

Now this article may generate some hue and cry from ETF providers who say it's making a mountain out of a molehill. They'll argue that transparency does matter to investors, that ETF transparency is excellent. They'll say that whether an ETF perfectly mirrors the underlying indices' components is irrelevant; what matters is tracking error over time. However, given that many ETFs still haven't hit their third birthdays, it is way too early to say that such divergence between the ETF and underlying index, especially as assets continue to surge, won't be a bigger issue over time and won't have a bigger impact on tracking error.

And here's something else to consider: New ETFs, because they have no track record, are marketed based on the historical (and, in many cases, back-tested) returns of their underlying indices. Given that many ETF providers give themselves some leeway in managing their ETFs versus the underlying index, investors need to remember that past performance is no indicator of future results. If the ETF and the underlying index become untethered (and ETF providers seem to leave themselves plenty of flexibility to do this), those historical index returns won't necessarily be a useful guide as to expected future performance of the ETF.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (Harper Business). David Wright, CFA, provided research assistance for this article.

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