From the June 2008 issue of Research Magazine • Subscribe!

June 1, 2008

Whiter ETFs?

During the mid-1990s, the first generation of ETFs arose to track key benchmark indexes, like the S&P 500, Dow Jones Industrial Average and Nasdaq-100. Toward the tail end of the decade, more narrowly focused funds began to appear. In 1996, Barclays Global Investors launched a series of single-country ETFs, covering important capital markets like Germany (EWG), Japan (EWJ) and the United Kingdom (EWU). Others would follow.

While most investors could easily buy an S&P 500 index fund, investing in the S&P's industry sector parts wasn't a convenient choice. In 1998, that changed when State Street Global Advisors debuted the Select Sector SPDRs. From that point forward, there was a shift in the dynamics of index investing from what was known before. Instead of owning the entire index, investors could now pick and choose their desired percentage of exposure to each S&P industry sector. If you were bullish on technology you could overweight XLK or if you were bearish on industrials, you could underweight XLI, and so forth. Before ETFs, eliminating the parts of an index you didn't like wasn't easy.

Then, seemingly out of nowhere, another dramatic shift occurred in the ETF marketplace. A plethora of new funds based upon unfamiliar indexes and alternative indexing strategies emerged.

In 2003, Invesco PowerShares launched two index ETFs designed to outperform traditional benchmarks. The PowerShares Dynamic OTC Portfolio Fund (PWO) and PowerShares Dynamic Market Portfolio (PWC) were built around the Intellidex indexes constructed by the American Stock Exchange. Unlike previous indexes, these ones weren't passive and they weren't based upon market indexes.

PWC sifts through the 2,000 largest U.S. stocks to come up with a 100-stock index. The fund's goal is not to match the S&P 500's performance record, but to beat it. PWO follows a similar approach by selecting just 100 stocks chosen from the 1,000 largest companies listed on the Nasdaq Stock Market. The fund attempts to beat the Nasdaq-100.

The performance history of these funds still isn't long enough to discern whether these investment strategies will work over long periods of time. Through the end of March 2008, SPDRs S&P 500 (SPY) had a 3-year annualized return of 5.75 percent versus 5.17 percent for PWC. During the same time frame, PWO was ahead by just 0.31 percent versus 6.50 percent for PowerShares QQQ Trust (QQQQ), which is benchmarked to the Nasdaq-100.

"Today, new ETFs are following active investment strategies and are called 'indexes' just to satisfy the long-held SEC requirement that ETFs follow an index," explains Richard Ferri, CFA with Portfolio Solutions and author of The ETF Book (Wiley).

Other investment opportunities that ETFs have cracked open include commodities, currencies, leveraged long and leveraged short funds. In just 15 years, the ETF industry has introduced investment opportunities that the much more mature mutual fund industry never made possible. Is it any wonder why ETFs have been such a hit with financial advisors and their clients?

For example, before the streetTRACKS Gold Shares (GLD) was born in 2004, investing in gold meant buying jewelry, investing in gold futures, tinkering with coins or taking physical delivery of gold bars. With GLD, investors can now have exposure to gold, without the awkward burden of storage and insurance. For sure, the securitization of commodity assets like gold, along with oil (USO), natural gas (UNG) and others has been a boon to investors.

Changing LandscapeWhile the ETF industry is today dominated by index-based products, active investment management is just beginning to take root. In 30 years, it's very likely that active ETFs will outnumber index ETFs.

In April, PowerShares launched the Active AlphaQ, benchmarked against the Nasdaq-100 index (PQY); the Active Alpha Multi-Cap, benchmarked against the S&P 500 index (PQZ); the Active Mega-Cap, benchmarked against the Russell Top 200 index (PMA); and the Active Low-Duration, benchmarked against the Lehman Brothers 1-3 year U.S. Treasury index (PLK).

Stocks for Active Alpha ETFs are selected based on a quantitative selection methodology called "NOW" ranking, developed by AER Advisors, a New Hampshire-based researcher. The system combines aspects of stock money flow with traditional security analysis.

Even though active ETFs may be the latest thing, they aren't a complete panacea.

Some have argued that today's active ETFs aren't really as active as their labeling. True these first-generation active ETFs are not tied to a particular index, but they are still a far cry from active investment management as we know it. Where are the famous portfolio managers? Where's the freedom of managers to buy and sell holdings at will? And what about proven historical track records? There are none.

Then too, a closer look at today's active ETFs reveals that the quantitative strategies being used carry a striking resemblance to index ETFs already using similar strategies. Because of these limitations, the appeal of active ETFs could be hampered.

What comes to your mind when you hear the words "active ETF"?

"I think of the Magellan Fund [FMAGX] trading on a stock exchange with tight spreads and the portfolio not [being] disrupted," states Jim Ross, senior managing director, State Street Global Advisors. "That's nirvana, but we're not quite there."

Others agree that today's version of active ETFs may not resemble what we see in 30 years. "The big picture for ETFs long-term is going to be very different than how it will look over the next six months to 2 years," says Gary Gastineau of New Jersey-based ETF Consultants.

What about ETF share classes of existing mutual funds?

Gastineau says there's a conflict of interest between the two sets of shareholders.

An ETF shareholder pays all the cost of entering and exiting the fund whereas conventional mutual fund shareholders don't. It's not a fair arrangement. Other complexities arise too. For example, ETF portfolio managers don't need cash balances to meet redemptions because the underlying shares are redeemed in kind. Mutual fund managers will typically reserve a small portion of capital to meet the demands of exiting shareholders.

Gastineau envisions a world where actively managed ETFs merge with mutual funds and become the surviving funds because mutual funds can't survive. He adds, "We need an ETF structure that accommodates broad active strategies."

But how many different investment strategies can you put into an ETF?

"The ETF is an efficient packaging mechanism for a range of investment objectives and I expect there to be no shortage of ideas or investment theory, thus the commercialization of those theories to investors will continue to remain strong," says Lisa Dallmer, senior vice president for exchange-traded funds and indexes at NYSE Euronext.

The number of potential active strategies seems to be, roughly speaking, infinite.

Russell Wild, a financial advisor and author of Exchange-Traded Funds for Dummies (Wiley), observes that the number of ETFs over the past two years has jumped by roughly 87 percent. He jokes, "At that rate, in 30 years there will be 100,079,755,598 ETFs!"

Wild believes that exchange-traded portfolios (which encompass ETFs along with exchange-traded notes or ETNs) will likely surpass mutual funds as America's most popular investments in the next few years.

But with success, comes failure. How can ETFs assure themselves the former?

"I believe fund families will have to earn the right to call their products ETFs in the future," contends Dan Dolan, director of wealth management strategies at Select Sector SPDRs. He adds, "These products will have to carry low costs, be totally transparent, tax efficient and offer real liquidity."

So maybe investing in 30 years from now won't be all that different from today.

Dolan says, "The real change in the future will be how we buy stocks. Investors will prefer 'basket securities' or ETFs to single stock exposure in order to minimize risk."

Sounds like my kind of future.

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Ron DeLegge is editor of www.etfguide.com

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