Financial engineers create enhanced indexes. By Joshua Brockman May 31, 2006 Exchange-traded funds are dull. How can we say that about the fastest-growing segment of the mutual fund business? Simple. The overwhelming majority of ETFs track traditional indexes -- such as Standard Poor's 500 -- or slices of them. Because index funds, including those that trade on exchanges, try to do nothing more than match a particular index, they are -- in a word -- boring.Behind the scenes, though, financial engineers are working feverishly to inject pizzazz into the world of ETFs. They are creating new varieties that, unlike traditional index funds, carry the fingerprint of active management. These designer ETFs track everything from selected dividend-paying stocks to shares of ultra-small companies to biotechnology companies. Leading the way into the brave new world of enhanced ETFs is PowerShares Capital Management, a Wheaton, Ill., firm. It offers more than 20 funds that rely on a research-based screening system that is designed to identify companies with the greatest capital-appreciation potential, says Bruce Bond, chief executive of PowerShares, which is being acquired by Amvescap, the parent of the Aim and Invesco mutual funds. "Intelligent indexes discriminate between stocks with investment merit and stocks without investment merit." This is a far cry from traditional indexing, which usually determines a stock's suitability for an index on the basis of its market value. Creators of enhanced indexes typically validate them by back-testing -- that is, simulating how groups of securities would have performed in the past. Advertisement Although PowerShares is in the vanguard of intelligent indexing, it wasn't the first to enter the field. That honor goes to ETF powerhouse Barclays Global Investors, which in 2003 introduced iShares Dow Jones Select Dividend Index, an ETF designed to whet investor appetite for dividend-paying stocks. It has attracted more than $6 billion in assets. Select Dividend is relatively tame, but many other enhanced ETFs are narrowly focused and risky. Use them as side dishes rather than as entrees. "They are more portfolio enhancers than core building blocks," says Valerie Corradini, business-development manager for Barclays. Some observers are wary of customized ETFs. "Overall, while there may be a lot of good academic research behind some of them, they are still unproven concepts," says Morningstar analyst Dan Culloton. Russell Wild, an Allentown, Pa., financial adviser who is writing a book called Exchange-Traded Funds for Dummies, cautions that enhanced funds run the risk of lagging traditional index funds to the extent that they introduce an element of active management. Still, we think some intelligent ETFs are worth considering for your portfolio. These five look particularly interesting: Advertisement It may be the biggest and oldest of the designer ETFs, but iShares Dow Jones Select Dividend Index (symbol DVY) is still compelling. The fund holds 114 of the highest-yielding U.S. stocks (excluding real estate trusts) that meet three criteria: Dividends must have risen in each of the past five years; no more than 60% of earnings are paid as dividends; and the stock is sufficiently liquid. The fund returned 18% in 2004 (its first full year), 3% last year and 3% in the first quarter of 2006 (compared with 11%, 5% and 4%, respectively, for the SP 500). Annual expenses are 0.40%. Success breeds imitators, so the arrival of other dividend-oriented ETFs is no surprise. One noteworthy new entrant is SPDR Dividend ETF (SDY), which invests in the 50 highest-yielding companies in the SP Composite 1500 that have consistently raised their payouts for at least 25 years. The requirement for a long history of dividend hikes makes this ETF a bit more growth-oriented than Dow Jones Select Dividend and a bit less concentrated in the utility and financial sectors. SPDR Dividend, which started last November and rose 4% in the first quarter of 2006, charges 0.30% a year. If you want to take a chance on a hot sector, consider PowerShares Dynamic Energy Exploration Production (PXE). The fund tracks an index that ranks U.S. exploration-and-production companies on growth, stock price, investment timeliness and risk factors, among other things. The fund, which began last October, holds the 30 highest-ranked stocks (the stocks are re-ranked quarterly). It gained 8% in the first quarter. Annual expenses are capped at 0.60% until April 30, 2007. Market value determines a stock's weighting in most key indexes, such as the SP 500. But during stock-market manias -- remember the late 1990s -- the impact of companies with huge stock values but minuscule sales or profits can be out of kilter with their true economic impact. PowerShares FTSE RAFI US 1000 (PRF) addresses this problem by evaluating the 1,000 biggest U.S. companies on the basis of average sales and cash flow over the previous five years, total dividends distributed over the previous five years and latest book value (assets minus liabilities). As with the PowerShares energy fund, annual expenses are capped at 0.60% until April 30, 2007. The fund gained 5% in the first three months of 2006. Advertisement The dearth of good funds focusing on small-company stocks and open to new investors enhances the appeal of First Trust Dow Jones Select MicroCap Index (FDM). Introduced last September, this ETF invests in the smallest of the small -- so-called microcaps. The index it tracks puts a value spin on the stocks it includes by excluding the 20% of eligible microcaps with the highest price-earnings and price-sales ratios. It also excludes companies with the lowest per-share profit change for the previous quarter, the lowest operating profit margins and the lowest six-month total returns. The fund, which has an expense ratio of 0.60%, gained 11% in the first quarter.