The new etf generation

Exchange traded funds (ETFs) may have started as a mere speck on investors' horizons when the first three ETFs appeared in the US in 1993 – but they have proven to be far more than a blip on the screen. With assets under management ballooning from US$ 0.81 bn to more than US$ 746 bn over the past 14 years, ETFs have become a fixture of the investment industry. And not only their popularity continues to increase: never before have ETF investors been able to choose from such a wide range - from “plain vanilla” funds based on broad market indices to sophisticated funds striving to combine the best of passive and active investment management by using “intelligent indices.” As so often, a trend that started in the United States is now also gaining hold in Europe. While the US is still the world’s premier market with both the largest number of ETFs and assets under management, 533 ETFs and US$530 bn respectively, Europe has been catching up fast. When the first six European ETFs were launched by the London Stock Exchange and Deutsche Börse in 2000, the rest of the global business was already valued at US$74 bn. Seven years later, Europe already boasts over 390 ETFs worth around US$126 bn and has become the fastest growing region for ETF usage, outpacing even the US. And now a new generation of innovative ETFs is gaining a foothold in this healthy and rapidly growing market. One of the pioneers of those innovative ETFs is Invesco PowerShares, with more than 95 products already the second-largest provider of ETFs in the US. At the end of the third quarter of 2007, PowerShares’ ETF range held assets under management in excess of US$35 bn. As ETF investors have become more seasoned, Invesco PowerShares believes that investors are increasingly looking for a more innovative approach that seeks to produce extra benefits by adding value to investment strategies. The reasoning behind this approach is simple: While traditional ETFs offer investors compelling benefits such as simplicity, cost efficiency and transparency, they can also harbour risks that a diversified investment should not be exposed to – for the simple reason that these indices were not actually designed as indices to track for invest purposes but to track the performance of markets and market segments. For investors ETFs are an inexpensive and highly liquid means of accessing markets because ETFs, which are listed and traded on exchanges like ordinary stocks, can offer an efficient means of gaining exposure to national, regional or global stock markets as well as special sectors, fixed-income markets and even currency and commodities markets. Another benefit is the transparency as the composition of the portfolio is disclosed on a daily basis and net asset values determined several times a day during trading hours. Institutional investors with a longer-term investment horizon can also use ETFs for securities lending. Shortcomings of Traditional etfs Yet traditional ETFs also have some major shortcomings, which Invesco PowerShares’ intelligent ETFs address. The biggest of these shortcomings is that traditional ETFs are based on traditional stock indices like the S&P 500 whose constituents are determined by the capital weighting of each stock in the relevant stock universe. Since there is no fund manager who could take corrective action, ETFs based on traditional stock indices like the S&P 500 that are put together on the basis of market capitalisation will participate not only in the underlying index’s rallies, but also in its downturns. The fact that cap-weighted indices include stocks regardless of their investment merit thus produces an embedded valuation risk. As the weighting of a share increases or falls with its performance, already overvalued stocks may be overweighted, and undervalued stocks underweighted. This means that market speculation can lead to substantial mispricing of stocks and inadequate index weightings – with the result that the individual stock risk of large-cap indices is actually higher than that of actively managed portfolios. This was highlighted by the “tech bubble” of 1999-2000 when the valuations of Internet companies went through the roof and propelled them far ahead of established companies in index weightings. From the perspective of investment managers, this can turn into a self-fulfilling prophesy: during the heyday of the “new economy” when investment managers found it difficult to outperform conventional indices as the companies with the most extended valuations, the “dot-coms,” gained greater representation in benchmark indices. Moving away from the benchmark was either outside the managers’ investment remit or implied the risk of underperformance, at least over the short term. The result: when the bubble burst, many of those who had failed to undertake comparative company research or identify alpha opportunities from in-depth analysis were caught unexpectedly. Yet past mistakes have also taught the investment industry important lessons – for example, on how to leverage the strengths of ETFs as an investment tool while avoiding their weaknesses. Rather than simply incorporating representative securities regardless of their investment merit, the intelligent indices underlying Invesco PowerShares’ ETFs thus select securities for their capital appreciation potential. Quantitative factors are used to identify the most promising companies exhibiting the strongest growth or value characteristics. Companies that do not fulfil these criteria are removed from the investment universe of the index which is usually reweighted on a quarterly or yearly basis. European launch of intelligent etfs Invesco PowerShares’ intelligent ETFs, which include the newer FTSE RAFI products and the Intellidex brand owned by the American Stock Exchange, come in three categories: “Intelligent Index,” “Intelligent Exposure” and “Intelligent Access.” The focus lies on alpha generation, accurate market representation and access to market segments that are usually difficult to access. Having successfully introduced these concepts to the US market, the company has recently also launched its new-generation ETFs in Germany, Italy, France and UK. Invesco PowerShares’ “Intelligent Index” funds are based on indices that are using the proprietary methodology owned by AMEX and the Quantitative Service Group for the US and global markets, respectively. Going beyond traditional benchmarking, these ETFs seek to provide alpha by tracking an index with a rules-based process that selects stocks based on their investment merit, as opposed to their beta or general market representation. To identify stocks within a particular market segment that have the greatest potential for capturing alpha and total return, the “Intelligent Index” concept by AMEX uses a multi-factor approach based on 25 diverse financial factors to develop a comprehensive perspective of companies current investment merits and risk factors. Although index membership depends upon factors relevant to the respective universe, each index is based on quantitative models that examine data such as corporate income statements, balance sheets, cash-flow statements, analysts’ forecasts and pricing trends for more than 10,000 international companies. Based on this information, the model identifies companies that are attractive in different market cycles, economic conditions and historical time frames. Companies are regularly identified for reselection should the model demand it. This realignment can help avoid tracking error, with a stratified sampling procedure aligning exposures to mirror the sector allocation of the market as a whole. The result is a consistent, objective and unemotional approach to stock analysis that is empirically verifiable – the model being based not on subjective opinions, but on pre-defined drivers of stock returns. Similar company analysis is used for the ETFs within the “Intelligent Access” category, which include the PowerShares Global Clean Energy Fund, the PowerShares Palisades Global Water Fund and the PowerShares Global Listed Private Equity Fund. As the names indicate, these ETFs offer investors access to specialist market segments, which in the past were the reserve of closed funds or institutions with very deep pockets. With the help of these funds, investors can delve into compelling investment themes identified by Invesco PowerShares’ experts while profiting from a highly liquid, transparent and low-cost investment tool. In the “Intelligent Exposure” category, Invesco PowerShares has four ETFs based on FTSE RAFI® indices: the Europe Fund, the Developed Europe Mid-Small Fund, the US 1000 Fund and the Developed 1000 Fund. Each of the indices are based on a fundamental indexation methodology developed by the FTSE Group and Research Affiliates, which derives their index constituent weights from company fundamentals. They represent an investable, liquid universe of over 2,000 global equities from more than 20 countries and are designed to track the performance of the fundamentally largest regional equities based on each ETF’s respective index. ETFs based on fundamentally-weighted indices represent a modernisation of cap-weighted indices. Fundamental data, not market-cap is used to determine the weight stocks receive in the index. Fundamentals such as revenues, sales, dividends and book value are used to determine the financial size of the companies. The stock’s speculative element, its share price, is excluded from the analysis. Companies with inflated valuations can be excluded by means of regular reviews of the fundamentals. The aim of the methodology is to reduce holdings in companies whose share price has raised despite static fundamentals and increase holdings in companies whose share price has fallen behind - an effective buy-low, sell-high strategy. As Europe's appetite for ETFs grows, in particular for those that step outside the more traditional structures, Invesco PowerShares projects a bright future for intelligent indices. Far more than a blip, these products with their unique methodology look set to become a vital component in the European investment manager’s toolbox. Thibaud de Cherisey, Product Manager ETFs