The quest for superior performance is also motivating the development of new ETFs and indexes. On May 1 of last year PowerShares Capital Management launched two funds on the ASE, the Intellidex Dynamic Market (PWC) and Dynamic OTC (PWO) Funds. Their portfolios are based on Intellidex indexes developed by the ASE and licensed to PowerShares. According to the ASE, "The Intellidex Indexes consist of securities that meet objective screening criteria. [They] are designed to identify stocks that have capital appreciation potential using a proprietary stock selection and portfolio construction methodology."
PowerShares' performance is also promising, and is likely to inspire further attempts at launching ETFs that outperform the benchmark averages. PWC and PWO have outperformed their respective benchmarks since began trading. PWC has a total return of 43.6%, 18% better than the S&P 500's 25.6%, with a slightly higher annualized standard deviation of 9.1% versus 7.6% over its first ten months. PWO's 56.8% total return outperformed the Nasdaq Composite's 48% over the same period with a 27.1% annualized standard deviation that more than doubled the Nasdaq's 12.7%. Following the success of these ETFs, PowerShares Capital Management licensed six additional Intellidex indexes for use in ETFs: growth and value indexes for large-, mid-, and small-cap stocks.
Applications For Controlling Risk
The trend towards building ETFs to achieve superior performance is expected to intensify, and for good reason. If ETFs can be created to routinely provide an incremental return above their benchmark indexes while closely tracking them, a variety of profitable market-neutral strategies could be devised. Many experts believe that the next stage in the evolution of ETFs will involve enhanced index funds (EIFs), funds designed to replicate the volatility of a benchmark index but provide an excess return above it.
To illustrate their primary advantage, assume an EIF in the form of an ETF could produce an annual return of 2% above Standard & Poor's Depository Receipts (SPDR) while tracking it, and that it existed on January 28, 1993, the SPDR's inception date. An initial long position of $100,000 would have grown to $368,715 by December 31, 2003. A similar long position in the SPDR would have grown to only $301,731 or $66,984 less.
Alternatively, a long position in the EIF could be hedged against a short position in the SPDR to create a market neutral strategy that captures its excess return with minimal risk. Furthermore, the strategy could be leveraged to produce a multiple of the EIF ETF's excess return less the costs of borrowing the shorted SPDR and the funds used for leverage.
Currently, market-neutral strategies are in great demand among hedge funds, arbitrageurs and other institutional investors as a means of profiting while controlling risk. These strategies can be leveraged to a level yielding returns above a hedge fund's management fees while reducing its exposure to market risk.
Since the holding period for strategies using ETFs is indefinite, arbitrageurs can maintain positions without concern for roll periods, as in the case of futures, or expiration dates, as in the case of options. The asset gathering potential for ETFs that can be used in such strategies is enormous and, therefore, very likely to spur their development.
The use of leverage to enhance an ETF's performance may soon become a reality. ProFunds, a Bethesda, Md.-based mutual fund family, has filed for Securities & Exchange Commission approval to sponsor several leveraged ETFs. Since ETFs trade like stocks, they have been eligible for margin trading all along, permitting the use of margin debt for leverage. What is unique about ProFunds' planned use of leverage is that it will be imbedded in its ETFs.
Perhaps the most under-represented asset class among ETFs is fixed income. At this writing, there are only five fixed-income funds, all sponsored by iShares: three based on Lehman Bothers Treasury Indexes with maturities of one to three, seven to ten and 20-plus years; one on the Lehman Aggregate Bond Index, and the last on Goldman Sachs' $InvesTop Corporate Bond Index. Barclay's Global Investors seems intent on increasing that number, as iShares recently filed for two additional fixed-income funds, one using Treasury Inflation Protection Securities and another using high-yield bonds.
Supporting Developments In Financial Services
ETFs' popularity is also gaining momentum as a result of three seemingly unrelated industry developments. First, advisors have been moving rapidly toward fee-based compensation in the last five years in their desire for more predictable income streams. Fee-based advisors tend to use ETFs instead of mutual funds due to the ease with which diversified portfolios can be built and rebalanced, in addition to their other advantages. As the number of fee-based advisors grows, so will the assets invested in ETFs. Commission-based advisors normally shun ETFs in favor of mutual funds to capture their higher sales charges.