Know Your ETF's Index -- and Drawbacks

Keying off the Value Line Index seems like a great idea, but its ETF can leave investors lopsided.
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Solid Index
Value Line has trumped the S&P 500

Source: PowerShares.com

The drive to build a better mousetrap has been a big driver behind the recent wave of new exchange-traded funds. That is, ETF providers are looking to add value to their products by going beyond the usual indices, the S&P 500 or Russell 2000.

They're looking to differentiate themselves with innovative concepts that they hope will generate better returns.

But these portfolios can become unintentionally lopsided. In my opinion, this is the biggest flaw of these investment products.

This is not an indictment of the concept, because I believe all investment products have drawbacks.

However, it is vital to understand the drawbacks of what you own; particularly for the example I'll discuss, it's the potential for dramatic shifts within the fund.

PowerShares has a couple of ETFs that tie into this theme, including the still-new (started late 2005)

Value Line Timeliness Select Portfolio

(PIV)

, which I'll use as my example of lopsidedness.

Back to School

The starting point for the methodology is the Value Line stock ratings that we used to go to the library to read back in the 1980s.

Do you remember those? Value Line rates stocks, on a scale of 1 to 5, for timeliness, safety and technicals.

The Value Line Index tries to employ that rating system to beat the major benchmarks, specifically the S&P 500.

The history of the index makes the fund compelling for folks looking to use broad-based ETFs.

The long-term track record of the underlying Value Line Index is excellent.

The Value Line index was closely correlated to the S&P 500 during the bubble years, but began to decouple in 1999 and has been pulling away ever since.

The current makeup of Timeliness Select is tilted heavily toward growth, which constitutes 71.78% of the portfolio. Because of the timeliness aspect of the methodology, it makes sense to think that, after years of value outperforming growth, growth is now cheap. Also, a flat yield curve historically has favored growth.

Timeliness Select is also weighted heavily toward large-caps, with 59.78% of the portfolio in large-caps, 19.97% in mid-caps and 20.26% in small-caps. Again, small-caps has led for many years now, and so the lag in large-caps may make that segment appear cheap.

Strong Results
Pulling away from the indices

Source: PowerShares.com

But Timeliness Select also has some very lopsided sector weightings, with 35% in technology vs. 15% in the S&P 500, and 24% in industrials vs. only 11% for the benchmark index.

I will note here a few basics about the fund: Fees for Timeliness Select are capped at 0.60%, as with most of the other PowerShares ETFs. The fund holds 50 stocks that are equal-weighted and rebalanced quarterly, with an average market cap of $18 billion and an average price-to-earnings ratio of 25.7. So far, there have been no dividend distributions.

Value Line's proprietary method of stock selection is fairly agnostic when it comes to size, style and sector. The fund changes constituents quarterly based on Value Line's research. While the fund today may be tilted to growth, large-caps and tech, the composition could be much different next quarter or next year.

The potential for these big changes makes owning the fund problematic. If an investor who owns Timeliness Select as part of his portfolio has decided to limit his industrial-sector holdings to 15%, the 24% in Timeliness Select might provide a third of the ETF's weight to the sector today. Two quarters from now, Timeliness Select might have only 3% in the sector, which would force the investor to find industrial exposure elsewhere.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Value Line Timeliness Select Portfolio to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. At the time of publication, Nusbaum had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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