Most exchange-traded funds (ETFs) are paired with passively managed indexes that aim to produce average returns. This stands in direct contrast to actively managed mutual funds. in which professional managers attempt to add performance beyond the averages. Read on to find out why the lines between passive and active management are not always straight and clear when it comes to ETFs.

Intelligent ETFs

A genre of intelligent ETFs has emerged to occupy a middle ground between these two camps. Pioneered by PowerShares Capital Management, this type of ETF has the potential to produce above-average performance at lower costs than most active mutual funds. In addition, intelligent ETFs offer the same structural benefits and targeted exposures as passive ETFs.

An intelligent ETF attempts to track an intelligent index. This index uses quantitative analysis to select and periodically rebalance index components. The holdings of intelligent ETFs typically aren’t changed as frequently as actively managed funds. Rather, the index tracked by the ETF follows objective rules to select components and a defined schedule to rebalance them.

Intellidex

The intelligent ETF concept was pioneered by CEO Bruce Bond and Director of Research John Southard, executives at PowerShares. Working closely with the American Stock Exchange. Bond and Southard crafted a new type of index with built-in stock-picking intelligence, which they dubbed an Intellidex. In 2002, the AMEX secured a global exclusive license to develop new indexes under the Intellidex brand. In turn, PowerShares received exclusive rights to develop ETFs tracking these indexes. PowerShares brought the first two Intellidex Index products to market in May 2003.

PowerShares Dynamic Market Portfolio (PWC) offers investors broad exposure across the whole U.S. stock market by tracking an index of stocks chosen through quantitative measures and rebalanced quarterly. The index’s stock-picking selectivity was demonstrated by the fact that it held just 100 stocks, a small fraction of those included in such broad benchmarks as the Standard & Poor’s 500 Index (S&P 500) or Russell 3000.

Almost all investment indexes seek to simulate the performance of a hypothetical average investor with broadly diversified exposure to the whole market, or specific market sectors. However, it is possible to select specific index components that offer attractive characteristics based on factors such as growth, valuation, timeliness and risk. In short, it is possible for an index to offer market exposure and disciplined stock selection at the same time.

Mechanics of an Intelligent ETF

To illustrate the mechanics of an intelligent ETF, let’s focus on Powershares Dynamic Market Intellidex (AMEX:PWC ). This index selects 100 component stocks drawn from the 2,000 largest and most liquid U.S. companies listed on exchanges. The index stock selection process has the following three steps:

1. The stocks are evaluated based on 25 merit factors including, fundamentals. valuation, timeliness and risk. The goal of this quantitative analysis is to select stocks that can outperform their peers in the current market environment.

2. Sector screens are then applied to make sure that the index has market-like sector weights, similar to those of the S&P 500.

3. Within each sector, stocks are chosen in two capitalization bands (large-cap and mid/small-cap) to provide broad exposure to the U.S. stock market while avoiding a cap-weighted bias.

All three steps are repeated quarterly in a rebalancing process designed to keep index components current. At each rebalancing event, turnover can be relatively high compared to purely passive ETFs.

The goal is to create an index and paired ETF that provide U.S. core equity market exposure with the potential to outperform other similar indexes through individual stock selection. Because there is no style -based screen built into the index, PWC can dynamically shift emphasis between growth and value stocks as a market cycle progresses. When growth stocks offer stronger quant values, they will be emphasized in the index and vice versa for value.

Quant Black Boxes

An intelligent index is only as good as the quant black box that drives its component selections and rebalancing events. In each case, the black box is designed and programmed by humans, based on particular views about why some stocks perform better than others.

There are two advantages to tracking quant black boxes in ETFs, compared to using similar approaches in mutual funds. First, you can be fairly sure that the ETF is not straying from the quant system through the intervention of a human manager. Secondly, management fees and expenses can be low compared to actively managed funds.

Portfolio Applications

Like passive ETFs, intelligent ETFs can provide exposure to the broad stock market or specific sectors. For example, PowerShares offers both style-based (large-cap growth, small-cap value) and sector-based (healthcare, banking) intelligent ETFs. These can be attractive for investors who want targeted exposures to specific styles or sectors, along with the potential to outperform averages.

Investors who normally prefer mutual funds may be attracted to these ETFs by the structural benefits of ETFs, such as the ability to trade shares during the market day or use limit orders. Intelligent ETFs can at times produce performance that rivals successful mutual fund managers, with less income tax impact.

Sector-based intelligent ETFs can be used by sophisticated investors to develop custom indexes. For example, a customized high-tech index could be created by combining semiconductor ETFs, software ETFs, networking ETFs, and hardware and consumer electronics ETFs. This custom blend could outperform the broad market average if these specific tech sectors do well, or if each intelligent index outperforms the average return of its sector.

Recent Developments

Although PowerShares invented the intelligent ETF genre and has remained its leader, other firms are contributing innovations. They include:

• Claymore Securities — It developed a quantitative method to screen for companies that hold valuable patents. Claymore also offers a rotation ETF that selects 100 of the S&P 500’s components (with quarterly rebalancing) based on Zack’s computer-generated stock ratings.
• First Trust Portfolios — Introduced an AlphaDEX series of ETFs in 2007, tracking enhanced indexes created by Standard & Poor’s by periodically ranking and rebalancing components of S&P indexes based on growth and value factors. Index components are ranked and divided into quintiles. and the higher-ranked quintiles receive more index weighting. The indexes and paired ETFs are rebalanced quarterly.
• XShares Advisors with TD Ameritrade and Zacks Investment Research — Created a lifecycle ETF. These funds, which fall under the TDAX Independent brand, automatically reallocate U.S. equity, international equity and debt securities, as each series moves closer to a future target maturity date. In this case, the intelligence is built into the preprogrammed glide path of each ETF in the series.

The Bottom Line

Intelligent ETFs do not pursue average investment returns. The success of the first generation of intelligent ETFs has encouraged more innovation among different types of quant models, blends of passive and active investment styles, and alternative types of intelligence. As a result, the line between intelligent ETFs and actively managed mutual funds keep blurring.