PowerShares Capital Management recently celebrated the three-year anniversary of the launch of their first two exchange-traded funds (ETFs): the PowerShares Dynamic Market Portfolio (AMEX: PWC) and the PowerShares Dynamic OTC Portfolio (AMEX: PWO). In the intervening 36 months, PowerShares has enjoyed a number of milestones, including launching more than 30 additional ETFs, capturing more than $6 billion in assets, and being bought out for huge money by AMEVSCAP.
But on June 12, PowerShares celebrated a milestone of a different sort. With three years of performance data in hand, its ETFs earned "star" ratings from Morningstar, and in one case, the news was very good: the PowerShares Dynamic Market Portfolio (PWC), which aims to outperform the S&P 500, earned 5 stars - the highest possible rating. (The second fund, PWO, which aims to outperform the NASDAQ Composite, earned 3 stars.)
It may seem strange to call this data out, as I've written before about why and how the Morningstar star rating system is a somewhat difficult fit for ETFs. (http://www.indexuniverse.com/index.php?section=6&id=1307 ) The Morningstar star rating system is based on risk-adjusted return: The higher your risk-adjusted return, the more stars you receive, to a maximum of 5. Since most ETFs are straight index funds, it's not especially informative to learn that most earn 3 or 4 stars: Guess what? They track the market.
But the PowerShares funds aim to outperform the market, and that puts the Morningstar rating system into play. For PWC to achieve the highest possible rating is a real achievement.
"We are very pleased with the performance of the two initial PowerShares," said Bruce Bond, CEO of PowerShares Capital Management LLC. "We believe that their performance further substantiates PowerShares' leadership role in the ETF industry and highlights the unique value proposition on which PowerShares is built."
I'm very pleased with the performance, too. As a kind of experiment, I moved some of the money I had in a traditional large cap index fund into PWC back in April of 2005. The rule was that if the fund lagged the S&P 500 over any quarter, I would sell it. Instead, PWC has outperformed the S&P 500 by nearly 10 percent in the intervening 15 months, delivering roughly 16 percent returns against a 6 percent rise in the benchmark index. I'm rich! (Well, not rich, but I do have an extra few thousand dollars as a result.)
It's been a particularly good stretch for PWC. Over the 3-year period, PWC has beaten the S&P 500 by 7.26 percent per year, returning 21.96 percent against 14.69 percent for the index.
As excited as I am about those returns, however, they also make me nervous. Investing in PowerShares is a blind leap. The funds track quantitatively driven indexes created by the American Stock Exchange (Amex), called "Intellidexes," which use a variety of factors to choose stocks with the greatest potential for outperformance.
Which factors? Well, they really don't say, although they are generally acknowledged to be some combination of valuation and momentum-related points.
To invest in PowerShares, then, you have to believe that the Intellidex methodology works. In other words, you have to believe that past performance is a predictor of future success. And … well … that makes a reversion-to-the-mean indexer like me nervous. And it's for that reason that I was glad to see PowerShares publish a sponsored research paper looking into the methodology of the Intellidex indexes.