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Powershares ETFs blur active and passive boundaries

Invesco PowerShares has launched its first exchange traded funds on the London Stock Exchange.

The company groups its ETFs into three categories – – intelligent index, intelligent exposure and intelligent access.

The Dynamic US Market ETF is an example of the Intelligent index category, which brings a degree of active management to the ETF market. It is based on one of the quant-based indices developed by the American stock exchange under the Intellidex brand.

Intellidex indices are designed to objectively identify stocks, using quant screens, which have the greatest potential to provide total returns using. Selection is based on company-specific fundamentals, corporate income statements, balance sheets, cash flow statements, analysts’ forecasts, and pricing.

The Dynamic Market Intellidex is the broadest index that is made up of 100 US stocks selected from 2,000 of the biggest and most liquid stocks in the US.

An example of the intelligent access category is the Powershares global clean energy ETF. With this category, Invesco Powershares is opening up niche areas of the market that may otherwise be difficult to access. The indices upon which the ETFs are based are specialist, so are devised by experts within the specific industry. Stocks initial have an equal weighting, which is then modified by sector and market capitalisation bands, to provide greater diversification across specialist markets.

The global clean energy ETF is based on the WilderHill New Energy Global Innovation Index, which is composed of companies that focus on renewable sources of energy and technologies facilitating cleaner energy. It is rebalanced quarterly.

Finally, The Powershares RAFI 1000 is an example of the third category, intelligent exposure. This category is based on the idea that fundamentally-weighted indices, where weightings are determined by a company’s financial size, provide the opportunity for higher returns and lower risks compared with ETFs based on cap-weighted benchmarks.

According to Powershares, cap-weighted indices can be problematic because market speculation can cause mispricing of stocks, resulting in disproportionate weights in the index.

The FTSE RAFI indices are fundamentally weighted and take into account sales, cash flow, book value and dividends, so market bubbles may have less influence on performance.

Blurring the boundaries between active and passive management is something that makes these ETFS stand out but research from Morningstar has highlighted some risks.

The selection criteria of the Dynamic Market Intellidex means the ETF has had a mid-cap and value tilt which will not perform well when growth stocks and bigger companies lead the US market.

Similarly, the RAFI 100 index has a value tilt, with a focus on smaller companies, which could hurt performance going forward. Morningstar also observes the constituent companies of the WilderHill New Energy Global Innovation Index tend to be quite small while the focus is narrow, which is likely to increase volatility.

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