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September 25, 2006 9:50 pm

ETFs start to look beyond the index model

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A slew of new exchange-traded funds launched last week has reignited the debate over whether ETFs can be actively managed. They incorporate alternative weighting and quantitative strategies.

ETFs, baskets of securities that are designed to track indices and trade like stocks, have skyrocketed in popularity in recent years with nearly 90 new fund launches so far this year. But ETFs that take a different approach from the conventional index-based, market capitalisation-weighted model have set off a debate.

In one corner are the ETF traditionalists who claim that the funds ought to stay true to their index model – or else come with a buyer beware warning; and on the other side of the ring are the ETF revolutionaries who advocate quantitative innovation in spite of any added complication it might bring.

Tom Coyne, editor of Index Investor, an independent industry newsletter, is of the traditional camp. He says certain ETFs arriving on the market present themselves as regular index funds, when in fact they are based on a methodology that makes them “functionally indistinguishable” from actively managed mutual funds.

“These new ETF products typically track an index that includes securities selected on the basis of a model, such as an algorithm, designed to identify investments that will outperform a given benchmark,” he says. “As the model operates over time, the securities included in the so-called index also change. In my view, this is nothing more than a relatively low cost quantitative active management strategy cleverly placed in an index ‘wrapper’ to enhance its customer appeal.” Mr Coyne says this approach is most apparent in those ETFs that use something other than market capitalisation to determine index weights.

PowerShares, for instance, last week launched 10
ETFs based on the “fundamental indexing” methodology of Robert Arnott, chairman of Research Affiliates. One of these funds weights mid- and small-cap stocks based on revenues, book value, cash flow and dividends instead of by market
capitalisation. The other funds apply the same weighting scheme to stocks in sectors including basic materials, industrials, consumer goods and financials.

Also last week, Claymore Securities, the privately held financial services company, started trading five new ETFs, including one that selects stocks based on “insider sentiment and behaviour”. It uses the Sabrient Insider Sentiment Index to identify companies with favourable corporate insider buying trends and Wall Street analyst upgrades.

Another new Claymore ETF attempts to capture the so-called “neglected stock effect”. This ETF seeks to identify companies that are “flying under the radar screen” of Wall Street analysts but which display growth characteristics that give them the potential to outperform other small-cap benchmarks.

“These algorithms are straightforward, but are still designed to produce index returns that are higher than those on a comparable market capitalisation weighted index,” says Mr Coyne.

PowerShares and Claymore aren’t the only fund providers moving away from market-capitalisation indexes. WisdomTree recently introduced 20 ETFs that track dividend indexes – 18 of these US and international indexes are weighted based on the total cash dividends companies pay; two are based on dividend yield.

The First Trust IPOX-100 ETF, described as “a rules-based value-weighted index measuring the average performance of US IPOs during their first 1,000 trading days,” is another example of this approach. Shares are selected based on quantitative initial screens and range from large, mature companies and fast growing IPOs to IPOs that are underperforming the market.

Some find this profusion of options alarming. Mr Coyne says: “Not all investors are well-informed, and most – both amateur and professional – are not consistently skilled at forecasting and active management, particularly after expenses, trading costs and taxes are taken into account.”

Not everyone believes that alternatively weighted ETFs are actively managed, however. “Active management involves selecting securities in a way that’s not visible or replicable,” says Bruce Lavine, president of WisdomTree. “People could replicate what we’re doing.”

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