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Morningstar: “UK PowerShares ETFs could be cheaper”

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The three new PowerShares exchange-traded funds launched by the Invesco subsidiary on the London Stock Exchange earlier this month are an encouraging sign for the development of the ETF ma

The three new PowerShares exchange-traded funds launched by the Invesco subsidiary on the London Stock Exchange earlier this month are an encouraging sign for the development of the ETF market in the UK, says Morningstar’s director of fund research Christopher Traulsen, but their expense ratios look pricy and the methodology of some funds has its risks.

Invesco PowerShares, as the ETF provider is branded in Europe, has launched the PowerShares Dynamic US Market, PowerShares FTSE RAFI US 1000, and PowerShares Global Clean Energy in London as the first of 12 planned offerings, and is the latest in a series of providers to launch ETFs in the UK over the past two months.

‘We are encouraged by broadening of this comparatively low-cost investment universe, but these particular funds have some quirks that are worth noting,’ Traulsen says. ‘Costs for the ETFs are on the high side.

‘By the standard of UK funds, the new PowerShares offerings are reasonably cheap, with total expense ratios of 0.75 per cent per annum. However, Morningstar thinks that PowerShares could do better. For the two broad US market offerings, the 0.75 per cent total expense ratios are nearly double the 0.40 per cent charged by the London-listed iShares S&P 500 ETF.

‘For the Energy offering, it’s slightly more expensive than the 0.65 per cent charged by iShares S&P Global Clean Energy. It’s also worth noting that the fees levied by the new PowerShares ETFs are higher than those PowerShares charges for the US versions of the funds, which clock in at 0.60 per cent for Dynamic US Market and 0.70 per cent for the FTSE RAFI 1000 offering. The iShares Stateside S&P 500 ETF charges only 0.09 per cent.’

Traulsen argues that the PowerShares fund range to some extent reflects the background of Bruce Bond, a former sales and marketing executive from Chicago-based Nuveen Investment Management who founded the firm in 2002 (Invesco bought the company last year). He notes that its US offerings include various narrowly targeted funds, such as PowerShares Lux Nanotech, and PowerShares Global Clean Energy.

‘PowerShares is different from others in that it has an indexing methodology that blurs the line between active and passive management,’ Traulsen says. ‘The indices, run by the American Stock Exchange, don’t simply try to replicate the market or a slice thereof, but actively attempt to add alpha via rules-based stock selection.’

He believes the attempt to add value brings certain risks, pointing to the US-listed version of the Dynamic US Market fund, which has existed since May 2003. The fund (and the London-listed version) tracks the Amex Dynamic Market Intellidex, which uses a 25-factor quantitative model including both technical and fundamental factors to select 100 stocks from the 2,000 largest companies listed on major US exchanges.

‘The model’s rules ensure sector weightings stay close to those of its selection universe,’ Traulsen says. ‘It also caps position sizes and employs a weighting scheme to keep large stocks from dominating the portfolio. These criteria have meant that, relative to popular indices such as the S&P 500 and Russell 1000, the fund has had a persistent mid-cap tilt with an additional slant towards value securities. That worked well for it early on, and the fund’s three-year return easily bests the S&P 500.

‘However, this approach will leave the fund vulnerable when growth-oriented fare and large-caps lead the US market. This hurt the fund in the second half of 2006 and has done so thus far in 2007, leaving it with a bottom quartile one-year return and 229 bps behind the S&P 500 for the same period.’

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