Gaming The Cockroach Effect

February 08, 2006

PowerShares to launch a small-cap Zacks ETF, tracking companies that consistently beat analyst earnings estimates.

According to Zacks Investment Research, a company that beats analyst earnings estimates this quarter is 2.5 times more likely to beat estimates next quarter than a company that reports in-line or below expectations.  They call it the cockroach effect - if you see one earnings surprise, you're going to see a thousand. What's more, says Zacks, companies that beat estimates tend to outperform the market.  Put those two features together and you have an easy way to beat the market: Invest in companies that are beating analyst expectations.

That's the idea behind the latest PowerShares exchange-traded fund (ETF), the PowerShares Zacks Small Cap Portfolio, which is expected to launch on February 16.  The fund is based on a custom-designed index created by Zacks, which will hold 250 equally-weighted small cap companies that meet Zacks' "cockroach effect" earnings surprise screen. The index will be re-balanced on a quarterly basis.

"Zacks is excited to leverage our years of investment research and quantitative modeling experience to create this new semi-active small cap index", says Mitch Zacks, vice president of Zacks Investment Research.

According to Zacks, this index would have delivered five-year annualized returns of 15.81 percent through December 2005, compared to just 6.75 percent for the Russell 2000 Index.

This is the second Zacks ETF to be created by PowerShares, following on the August 2005 launch of the PowerShares Zacks Microcap Portfolio (PZI) .  That fund uses an undisclosed methodology in an attempt to deliver solid returns to investors; through February 7, it had attracted $115 million in assets while posting 8 percent returns for investors.

Despite the name difference, there may be quite a bit of overlap between the small-cap and micro-cap ETFs.  According to Zacks, the new small cap index will have an average market capitalization of $850 million; the "microcap" ETF has an average market cap of $660 million.

From an indexers perspective, the best part about these new funds is that they will put to the test the incredible claims made by market timing services like Zacks.  Zacks, for instance, claims that an investor following its core recommendations to purchase its "#1 ranked stocks" since 1998 would have tripled the performance of the S&P 500.  As noted above, the small cap index offers similar backtested results.  Now,  we'll be able to put these claims to the test in a real-world situation.

The February 16 launch will also set up a incestual battle for small cap assets and performance within PowerShares, as the company already offers small cap growth and value funds based on Intellidex indexes from the American Stock Exchange (AMEX). While the comparison between those funds and the Zacks offering are not exact, it will be very interesting to see which enhanced indexing approach can deliver the best returns - and attract the most assets.

AMEVSCAP Cuts Costs Amid Asset Losses

In related news, PowerShares-parent AMEVSCAP said it would redice headcount and lower expenses by 8 percent in an attempt to compensate for a 15 percent drop in assets under management last year.  AMEVSCAP, which bought PowerShares in January, suffered from poor performance in its funds and lingering regulatory problems.

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