Fundamentally Indexed ETFs Make a Comeback

Ed McRedmond is the senior vice president of portfolio strategies at Invesco (IVZ) PowerShares. He joined the exchange-traded funds provider in 2005 after working for 17 years at A.G. Edwards, where he was associate vice president. While at A.G. Edwards, McRedmond served as a senior analyst covering ETFs and closed-end funds and was part of the team that launched and managed A.G. Edwards' discretionary ETF wrap portfolios.

Earlier this week, IU.com Managing Editor Murray Coleman caught up with McRedmond to find out the reasons behind PowerShares' recent plan to cut fees on its fundamentally based ETFs, as well as developments with other products. (See related story here about the changes to the funds, which are maintained and designed with FTSE Group and Research Affiliates.)

IU: Why did PowerShares decide to cut expense ratios on the fundamental-based ETFs now?

McRedmond: The main reason is that the fundamentally weighted indexes have been positioned as alternatives to traditional market-cap-weighted indexes. The RAFI [Research Affiliates Fundamental Indexation] indexes reconstitute and rebalance once a year. That's different than our quantitatively based Intellidex-based ETFs, for example. Those indexes rebalance on a quarterly basis. So in an Intellidex-based ETF, you have a lot more going on in terms of the seeking-alpha methodologies. The FTSE RAFI indexes have very low turnover, which provides somewhat fewer costs involved in managing those ETFs. And we definitely want to be competitive in the marketplace with lower-turnover types of funds, such as the more-traditional market-cap-weighted indexes—although they still offer a different methodology.

IU: Why were they originally priced at 60 basis points if they're competing against lower-cost market-cap-weighted indexes?

McRedmond: Any time you're bringing out a new product in a dynamic marketplace, you can't always be perfectly sure about how quickly or effectively it's going to attract new investors and assets. And you don't always know the total start-up costs when starting out. But it's not a question of whether the fundamental rating methodology doesn't add value over time compared to a market-cap-weighted ETF. If you look at the historical backtested data, they have added value versus a passive, cap-weighted benchmark over the long term. We're certainly not trying to be simply the low-cost provider. All of our products follow a theme of bringing to market a value-added type of portfolio.

IU: The fundamental indexes have had a tough time the past 12 months, haven't they?

McRedmond: Certainly earlier in the year and part of last, that was the case. I think the timing of the most recent RAFI rebalancing in March is a key. Remember that late last February and early March 2007 is when financials went through a particularly tough period when financials were hit hard. But contrast that with what's going on now. During the recent downturn that we've been undergoing in the last few months, the fundamental-based ETFs have made up a lot of ground as compared to traditional market-cap-weighted benchmarked funds. But it's also important to note that the earlier performance trend has been a phenomenon we've seen only in U.S. portfolios. Internationally, the RAFI indexes have actually outperformed over the last 12 months.

IU: The RAFI ETFs still haven't attracted a lot of assets yet, have they?

McRedmond: On a relative basis compared to new products and their typical evolution, the acceptance has been pretty good. That's particularly true in the flagship ETF, the PowerShares FTSE RAFI US 1000 Portfolio (NYSE: PRF). That's also true with the other broad-based fundamental ETF, the PowerShares FTSE RAFI US 1500 Small-Mid Portfolio (NasdaqGM: PRFZ). But the sector-related products certainly don't have as broad of an audience. Those are intended to be a tool for people using sectors to build broader portfolios. 

IU: How have the enhanced indexes branded as the dynamic line using Intellidex methodologies been doing lately?

McRedmond: Some are performing particularly well and others are having more-challenging times. The standouts are the ones related to financials, particularly the PowerShares Dynamic Banking Portfolio (AMEX: PJB) and the PowerShares Dynamic Insurance Portfolio (AMEX: PIC). They've either had very little, or in some cases, completely avoided names that've been in the headlines in recent months. And that's what we'd hope from an ETF with an underlying index that has a methodology taking into account a variety of factors. As you probably recall, Dynamic Portfolios use quantitative systems to consider different types of risk, momentum and valuation factors to rank stocks. There are a total of 25 different factors involved in the process. By taking the universe of stocks and not owning every single one—and again, by using a quantitative methodology to screen by a number of fundamental and technical factors—you'd expect a lot more opportunities to remove stocks that are running into difficulties. And rebalancing and reconstituting portfolios on a quarterly basis provides more opportunities to make adjustments than a traditional market-cap-weighted index that rebalances and reconstitutes once a year.

IU: Invesco is launching a mutual fund using different PowerShares ETFs. Do you see more cross-marketing opportunities to work together in the future?

McRedmond: It's something we've been doing on a number of fronts, both on the sales and marketing side as well as the investment and product development side. Two of our actively managed ETFs are being subadvised by Invesco managers. That's something we definitely intend to continue to look at since Invesco has a great number of resources. They've certainly got an enormous amount of investment talent to leverage for our ETFs. While PowerShares has its own sales force, we're also leveraging off our counterparts on the Invesco side.