AMEX Intellidex ETFs Launch, Pushing the Active/Passive Envelope By John Spence April 30, 2003

PowerShares Capital Management will introduce two exchange-traded funds tracking new proprietary indexes developed by the American Stock Exchange. The Dynamic Market Portfolio and the Dynamic OTC Portfolio will both launch later this week on May 1 and will be listed on the Amex under the symbols XTF.M and XTF.Q, respectively.

The two new funds will be the closest thing yet to an actively-managed ETF, although the Amex insists they shouldn't be classified as such.

"Don't confuse 'dynamic' with 'active,'" said Robert Tull, vice president of the Amex ETF Marketplace.

However, at the minimum the new funds raise some interesting questions regarding how ETFs should be classified as active or passive.

The funds are passive in that they do track a benchmark, although the AMEX Intellidex indexes appear to be based on extremely complex quantitative models. The Intellidex methodology "selects stocks that meet certain quantitative criteria historically indicative of potential stock growth."

Mr. Tull at the Amex said the Intellidex indexes use 25 selection criteria broken into four main groups: risk factors, timeliness (market momentum plus fundamentals), fundamental growth, and stock valuations.

The Dynamic Market Intellidex index starts with an initial universe of the 2,000 largest U.S.-domiciled stocks (by market cap) traded on the NYSE, AMEX, and Nasdaq. Only 100 stocks end up in the index after being screened by the proprietary methodology. The index attempts to achieve sector and size weightings similar to overall broad market - about 70% in large-caps and 30% in mid- and small-caps, said Tull.

The Dynamic OTC Intellidex index (DYO) is similarly constructed and has 100 stocks, although the initial universe is the 1,000 largest U.S-headquartered companies quoted on the Nasdaq National Market. Both indexes are modified equal dollar weighted, and are rebalanced quarterly.

The two new PowerShares ETFs will have expense ratios capped at 0.60%, which is expensive when compared to ETFs tracking broad domestic indexes. For example, the Nasdaq-100 "cubes" (QQQ) are pegged at 0.20%, while the S&P 500 "spiders" (SPY) have an expense ratio of 0.11%.

However, the funds are cheap relative to actively-managed funds, and it could be argued that the PowerShares have at least an element of active management embedded in the indexes they track. Both Intellidex indexes may experience constituent turnover in the range of 50% to 150%.

"We just have a model with a lot of variables that we measure and take into account, at least compared to more standard indexes," said Tull. "What sets the indexes apart is their high level of complexity and automation."

With the new benchmarks, the Amex is leveraging the computer technology it developed in support of its ETF marketplace, as well as its extensive stock database, said Tull. He also indicated more Intellidex indexes, and potential ETFs based on them, tracking other market segments may be launched later this year. The Amex and other stock exchanges have maintained their own equity indexes for years.

Although the new PowerShares track an objective index and therefore have no human component, it could be argued that the funds attempt to repackage active management techniques at a cheaper cost. The funds will certainly have very high turnover relative to comparable index funds, although the ETF format can in theory provide some protection from a tax efficiency standpoint.

The PowerShares have thus far been marketed as index-beaters. For example, the PowerShares press release contains data that shows the Dynamic Market Intellidex has had higher returns and lower risk (as measured by standard deviation) than the S&P 500 index over the last one-, three-, five-, and ten-year periods. The same is true when the Dynamic OTC index is compared against the Nasdaq Composite index.

However, this is back-tested data and there is no guarantee the indexes will continue to outperform in the future (see this article on the practice of 'data mining' for more).

Also, the proprietary Intellidex methodology is truly a "black box" with a stated strategy of winnowing out poor-performing stocks to achieve elevated returns. Index funds, at least traditionally, have reflected broad market segments at low cost, without making calculated bets that certain stocks will outperform.