PowerShares Education Center

Watch one of our educational videos in our whiteboard series.

What is an ETF? 
Discover the basics of ETFs and how they are constructed.

ETF Misconceptions 
Learn about ETF misconceptions and the underlying truths.

Liquidity 
How do ETFs offer liquidity and how do they differ from stocks and mutual funds in this aspect?

Transparency 
Understand how the ETF structure offers transparent pricing and holdings.

Targeted Exposure 
Find out how ETFs provide targeted exposure while offering potential diversification.

Core and Satellite 
Portfolio construction matters. Find out how ETFs can be used in investor portfolios.



What are ETFs

An ETF is a unique investment tool that combines some of the features of mutual funds with some of the features of individual stocks. Like a mutual fund, an ETF gives investors access to a group of securities through a single transaction. Like a stock, ETF shares are traded on exchanges at market-determined prices.

ETF Benefits

Investors are increasingly drawn to the structural characteristics of ETFs:

  • Tax-advantaged product design: With the ETF structure, ETF shareholders can potentially defer capital gains until they sell their shares.
  • Portfolio transparency: ETFs report holdings on a daily basis allowing investors to see fund investments.
  • Index tracking: ETFs track indexes or baskets of securities. Therefore, performance should typically reflect performance of the underlying index.
  • Targeted exposure: Investors can use ETFs to dial up or down exposure to specific markets, styles, sectors, themes or strategies.
  • Liquidity/flexibility: Investors can buy and sell shares on exchanges throughout the trading day, while also implementing trading techniques such as buying on margin, short selling and placing various order types.
  • Accessibility: ETFS provide access to asset classes such as commodities that were previously available only to institutional investors.
  • Lower ownership cost: * ETFs may provide lower ownership costs because of their efficient structure. Some ETFs have established expense caps to make ownership costs clear and straightforward for investors.

Investors should be aware of the material differences between mutual funds and ETFs. ETFs generally have lower expenses than actively managed mutual funds due to their different management styles. Most ETFs are passively managed and are structured to track an index, whereas many mutual funds are actively managed and thus have higher management fees. Unlike ETFs, actively managed mutual funds have the ability react to market changes and the potential to outperform a stated benchmark. Since ordinary brokerage commissions apply for each ETF buy and sell transaction, frequent trading activity may increase the cost of ETFs. ETFs can be traded throughout the day, whereas, mutual funds are traded only once a day. While extreme market conditions could result in illiquidity for ETFs. Typically they are still more liquid than most traditional mutual funds because they trade on exchanges. Investors should talk with their advisers regarding their situation before investing.

* Since ordinary brokerage commissions apply for each buy and sell transaction, frequent trading activity may increase the cost of ETFs.

Growth of ETFs (AUM)

Source: PowerShares by Invesco, Bloomberg L.P., as of Dec. 31, 2015

Evolution of ETF portfolio construction

Portfolio construction counts. ETFs can be constructed to be market-cap weighted, alternatively weighted or actively managed.

When the first ETF was launched in 1993, its purpose was simple - to track the S&P 500® Index and trade on a major exchange. The first index-based ETFs used market capitalization - multiplying a security's price by the total number of shares outstanding to determine the size or weighting of a company within an index.

Market-cap weighted ETFs are passively managed with the goal to replicate the characteristics and performance of the target index or benchmark and are rebalanced regularly. They are inertia driven; meaning security weights are calculated by multiplying share price by the number of shares outstanding. With automatic index selection, they are designed to produce average performance for the group of securities they track. As an example, the S&P 500 Index is a traditional index that seeks to mirror the performance of the average US stock market investor.

Portfolio composition of actively managed ETFs can be changed at the discretion of an investment team. Because they do not have to mirror a specific index, they are free to pursue the ETF's objective by adjusting securities as they see fit.

Many ETFs available today are based on alternative weighting methodologies including fundamentals weight (determining company weight based upon size of measures such as sales, cash flow, dividends, etc.) or equal weight (allocating the same weight to all constituents within a universe). The first alternatively weighted ETF was launched in 2003.

ETFs based on alternative weighting are called smart beta ETFs. In contrast to market-cap weighted ETFs, smart beta ETFs sever the link between price and portfolio weight. They are rules-based and provide access to a variety of risk factors such as volatility, quality or momentum. Smart beta ETFs may provide better risk-adjusted returns relative to cap-weighted indexes. While some smart beta ETFs are actively managed with the goal of outperforming a stated index, the majority are passively managed with the objective of tracking their respective indexes.

US ETF Industry

Source: Bloomberg L.P., as of Dec. 31, 2015

Why smart beta?

An intersection of active and passive worlds, smart beta offers a menu of portfolio construction tools that:

  • Provide exposure to risk factors across asset classes that historically provided additional sources of returns over the long term.
  • Strive to make risk factors available to investors in a systematic way.
  • Attempt to provide different risk/return characteristics than the broad market.Through smart beta ETFs, investors can access certain markets at a lower cost and have the ability to express market views, fine-tune exposures or diversify exposure through core and satellite positions in pursuit of building better investment portfolios.

Smart beta ETFs provide:

  • Single-factor strategies such as low volatility, dividends, quality, buyback and momentum.
  • Multi-factor strategies which include fundamentals weighted, equal weighted, quantitative weighted and alternatively-weighted fixed income.
  • Access to commodities and alternatives *

Factor definitions:

Low volatility: Utilizes volatility rankings while seeking to minimize the impacts of market fluctuations.

Dividends: Shows how much a company returns to its shareholders on an annual basis. Companies characterized as high dividend tend to issuer higher annual payouts.

Quality/high quality: Ranking that reflects the long-term growth and stability of a company's earnings and dividends. Focuses on companies that have a Standard & Poor's quality ranking of A-* or above which have historically exhibited higher Sharpe ratios and lower volatility. *Standard & Poor's quality rankings reflect the long-term growth and stability of a company's earnings and dividends in a range from A+ (highest to C (lowest), with a ranking of D reflecting an company in reorganization and LIQ representing liquidation. See standardsandpoors.com for additional information.

Buyback: Tracks companies that consistently repurchase their own shares outstanding.

Momentum: Ranks securities relative to peers using relative strength methodology to identify the strongest and weakest investment trends.

Equal weighted: Assigns constituents in equivalent amounts.

Fundamentals weighted: Ranks all publicly listed companies according to four fundamental measures of company size:sales, cash flow, book value and dividends.

Quantitative weighted: A rules-based index where individual components are weighted according to a variety of factors, such as volatility and momentum.

Alternatively-weighted fixed income: An index which assigns issuer weight based on factors other than debt outstanding.

* Commodities and futures generally are volatile and are not suitable for all investors.

As an ETF industry innovator, we are a smart beta pioneer and company of "firsts" with non-market-cap-weighted products. We introduced many of the first smart beta vehicles available today calling them "intelligent ETFs". Our first dynamic market portfolio was introduced in 2003, followed by the first fundamentally weighted index strategy in 2005, with the first broad-based commodity ETF to use futures as underlying investments in 2006 and the first senior loan portfolio in 2011.

We offer a broad suite of ETF strategies with 140+ domestic and international exchange-traded funds representing equity, fixed income and alternative asset classes which seek to outperform traditional benchmark indexes while providing access to an innovative array of focused investment opportunities.

We believe the greatest opportunity for investors to achieve their unique objectives is through a well-constructed portfolio that spans asset classes and considers both truly active, fundamental strategies as well as systematic approaches that go beyond market-cap-weighted benchmarks. PowerShares ETFs trade on the NYSE ARCA and NASDAQ stock exchanges.

ETFs create and redeem existing shares through an "in-kind" process with market participants call authorized participants (APs). APs have a legal agreement in place with an ETF trust and their custodial bank allowing them to create or redeem shares of the ETF in blocks known as creation units. In this process, the tax code provides that capital gains are not recognized at the time of the transaction and are not considered a taxable sale, making an ETF a relatively tax-efficient structure. Thus, this structure may create a meaningfully different after-tax return experience between an ETF and another type of investment vehicle — even if both replicate the same index.

During the creation process, the AP delivers a basket of securities held in the ETF's portfolio to the ETF sponsor in exchange for a creation unit. For a redemption, the same in-kind process is used except the AP receives the basket and the fund receives the creation units. This process is depicted and described below.

In-kind creation process

For illustrative purposes only.

In-kind redemption process

For illustrative purposes only.

With ETFs, capital gains and taxes are generally recognized only upon sale. Below are common events and how they are treated within the ETF structure.

Portfolio rebalancing: Typically handled in-kind with transactions and generally not taxable for the ETF and its shareholders. If the ETF must sell securities no longer in the index and buy additional securities, this may be a cash transaction and a taxable event for the ETF.

Corporate events (stock splits, merger and acquisitions): Typically handled in-kind but again, if the ETF must sell or buy securities for cash, there may be a taxable event for the ETF.

Shareholder redemption: When investors large or small redeem their shares, this is usually handled with "in-kind" transactions.

ETFs can be implemented into portfolios in an almost unlimited number of ways. A common way to use ETFs is in a core/satellite configuration.

Core and satellite: This approach recognizes that overall market trends account for a large part of total returns over time. The core, designed to track closely with the market as a whole, seeks to add increments of performance value while also adjusting overall portfolio risk with the addition of "satellite" positions.

ETFs can be used as core and/or satellite investments in virtually unlimited ways to construct portfolios in pursuit of desired outcomes. Many investors may implement traditional long-term core holdings to access market returns and help reduce costs while aligning with individual risk tolerances. The satellite portion of a portfolio can be used to capture specific market segments and beliefs either through lower correlation of asset classes or attempts to enhance performance or reduce volatility.

Satellites can be:

  • Style-based ETFs
  • Sector or industry group ETFs
  • International or global ETFs
  • Thematic ETFs
  • Factor-based ETFs

US ETF Industry

  • Build a diversified core with single-factor or multi-factor/alternatively weighted strategy.
  • Tactically adjust exposure based on market outlook with the objective of achieving portfolio outperformance.

To learn more about PowerShares by Invesco and our investment products, please email us at info@powershares.com or call (800) 983-0903.


This doesn't constitute a recommendation of investment strategy suitability for any particular investor. Investors should consult their financial advisors before making any investment decisions. Diversification does not ensure a profit or eliminate the risk of loss.

 

PowerShares by Invesco does not offer tax advice. Please consult your own tax advisor for information regarding your own tax situation. While it is not PowerShares' intention, there is no guarantee that a Fund will not distribute capital gains to its shareholders.

There are risks involved with investing in ETFs, including possible loss of money. Index-based ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risk similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply.

Beta is a measure of risk representing how a security is expected to respond to general market movements. Smart beta represents an alternative and selection index-based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both in active or passive vehicles. Smart beta strategies may underperform cap-weighted benchmarks and increase portfolio risk. There is no assurance that an investment strategy will outperform or achieve its investment objectives.