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Over the last several years, investors have embraced the benefits of the exchange-traded structure, transforming ETFs from a closet industry to a mainstream investment option that threatens to continually grab market share from traditional actively-managed mutual funds. As the popularity of ETFs has surged, so too has the number of funds available to investors. While the majority of assets remain in ETFs linked to well known stock and bond indexes, ongoing innovation in the industry has produced dozens of ETFs that utilize various weighting methodologies, proprietary screening processes, and even asset allocation strategies to determine holdings.

While somewhat more complex than traditional “plain vanilla” ETFs, many of these products offer unique risk and return characteristics that may serve a valuable purpose in investor portfolios. In a new weekly series, we take a look under the hood of some of the more complex ETF products. In the Quantitative Methodology ETFdb Category, there are a variety of ETFs that use unique approaches in order to select securities for inclusion in the fund. One of the more widely traded funds in this category is the PowerShares Dynamic Markets Portfolio (NYSEARCA:PWC).

Under The Hood

PWC is based on the Dynamic Market Intellidex Index, a benchmark that is comprised of U.S. stocks from each sector identified as having the greatest capital appreciation pursuant to a proprietary Amex Intellidex Methodology. While the exact index methodology is obviously kept under wraps, the general considerations for inclusion in the index are readily available. PWC tracks one of PowerShares’ Intellidex benchmarks, an “enhanced” index that combines many of the facets of traditional active management with the benefits of the exchange-traded structure.

This methodology evaluates companies based on criteria such as fundamental growth, stock valuation, investment timeliness and risk factors. The index underlying PWC is comprised of stocks from each sector identified as having the greatest potential for capital appreciation pursuant to the proprietary technology. As such, PWC is diversified across all parts of the economy: seven sectors are given an allocation of at least 10%.

The enhanced indexing methodology upon which PWC is built seems to have a tilt towards value stocks, as the fund is currently split about 63%/37% between value and growth equities. PWC also avoids a significant concentration in mega-cap companies: large caps are given a weighting of less than 40%. Two of the current top holdings of the fund are Williams Companies (NYSE:WMB) and National Oilwell Varco (NYSE:NOV), suggesting that the quantitative index is bullish on the oil and gas sector. Also in the top five holdings are Reynolds American (NYSE:RAI) and Kimberly-Clark (NYSE:KMB), both of which are often considered stable, low risk, consumer staples firms due to the nature of their products (cigarettes for Reynolds and diapers and tissues, among other items, for Kimberly-Clark).

Launched in May 2003, PWC is one of the oldest “enhanced” index ETFs, and has put together a pretty good track record (see this special feature on “alpha-seeking” ETFs). According to PowerShares, PWC has an average annual return of 6.8% since its inception, more than 170 basis points ahead of the S&P 500 over that time. Given PWC’s inclusion of mid and small cap stocks, however, the Russell 3000 may be a better benchmark: PWC has beaten the broader stock index by about 1% per year since its launch.

PWC

For those investors looking beyond the usual suspects–SPY, IWM, etc.–for U.S. equity market exposure, PWC may be worth a closer look. The Intellidex methodology offers the potential for enhanced returns, and the track record of the fund indicates some degree of success in identifying stocks poised to outperform. Moreover, diversified sector and size exposure is a nice feature.

The obvious drawback is the expense issue: PWC charges investors 0.60% compared to as little as 8 basis points for traditional passively-indexed products.

Author's Disclosure: No positions at time of writing.

Source: PowerShares Dynamic Markets: A Look Under the Hood