Fundamentally Indexed ETFs Making Comeback

October 30, 2008

PowerShares exec discusses RAFI-based ETFs' original fee structure and plans to slash those costs, and recent performance turnarounds. 


Ed McRedmond is the senior vice president of portfolio strategies at Invesco 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, 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.

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