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Smart beta ETFs just getting started, says Invesco exec

So-called "smartbeta" exchange-tradedfunds have become increasingly popular with retail andinstitutional investors in recent years. Invesco Ltd.'s PowerShares, the fourth-largest U.S. ETFprovider, is one of the product's pioneers. Todd Rosenbluth, director of ETFand mutual fund research at S&P Global Market Intelligence, recently spokewith Dan Draper,managing director of global ETFs at Invesco PowerShares Capital Management LLC. Theconversation included a discussion of non-market-cap weighted equity ETFs, thePowerShares' partnerships and the growth of fixed-income ETFs.

The following is an editedtranscript of that conversation.

S&P Global MarketIntelligence: Smart beta is used to describe a lot of different ETFs. How doyou think of it?

Dan Draper: PowerShares started 13 yearsago, and back then the founders came from a more active background. At thattime, ETFs were only market cap weighted. There was demand from financialadvisers that liked the transparency, the exchange trading, the lower cost andtax advantages of the ETF wrapper, but wanted active management techniques. SoPowerShares looked to fill the gray middle ground with intelligent investing.The firm has stayed true to that.

What is different about ETFinvesting today compared to the early 2000s?

Fifteenyears ago the ETFs available were like analog technologies, but smart betarepresents an evolution to digital technology. You can really have much more ofa data-driven approach to dissect the return distribution in a more narrow way.Investors can have better customization and diversification using factors suchas low volatility, value or momentum. In the past, the world's larger sovereignfunds, pension plans and other institutional investors used hedge funds to getexposure to factor investing for years. Now through an ETF wrapper, theseinteresting strategies are available to a much broader audience. We think this isjust the beginning of usage of smart beta ETFs.

Let's talk about some of thepartnerships PowerShares has with other companies.

Someof our earliest products are what would become known today as multi-factorETFs. Research Affiliates is a firm we have had a long relationship with.Another example of what has become known as smart beta is the ETFs we launched13 years ago with Intellidex Indices. These ETFs continue to provide access tostrategies between traditional passive and traditional active.

One of the more popular smartbeta ETFs across the industry is PowerShares S&P 500 Low Volatility (SPLV).What do you think has been the appeal?

Oneof the reasons we chose S&P is it that the S&P 500 index is a widelyused equity benchmark. Many of the biggest fiduciaries use it, so we wanted tooffer them a tool that will allow them to tactically overlay to lower thevolatility to improve risk-adjusted returns. We have gotten a lot of traction.What's really interesting is the macroeconomic backdrop. Interest rates indeveloped markets for this low for this long are unprecedented, and using lowvolatility has been an enhancement.

Wethought the way sector ETFs have been traded around the S&P 500 was a waythat factors could be implemented with liquidity benefits. So what wasinitially a tactical tool to enhance a portfolio has moved into the core.

We have seen new entrants tothe smart beta universe, such as J.P. Morgan and . Is the smart beta spacegetting too crowded for investors?

Wedon't comment directly on competitors, but we think smart beta is the evolutionof modern portfolio theory. You have the research from academia dating back tothe 1950s, but now there is the technology to implement factor strategies in aninexpensive way. ETFs that can gain scale and liquidity will be thebeneficiaries. PowerShares has a first mover advantage and was able to partnerwith leading benchmarks.

Shifting to fixed income, areinvestors becoming more comfortable getting access through an ETF wrapper?

Wehave the third-most fixed-income ETFs, with a wide range of offerings tied, forexample, to preferreds, senior loans and emerging markets. There has been asecular trend toward fixed income in the last five years. Bonds are traded overthe counter, and liquidity in corporates and other sectors can be limited,particularly as capital requirements for banks have increased. A small assetmanager that needs to trade a handful of individual bonds can be at acompetitive disadvantage with large institutional investors. The ETF wrapperallows a firm to outsource their portfolio rebalancing and get the benefits ofscale.

Thefixed income indices are much younger than equities and initially were tied toa bank's market making. As such, fixed income has not had the same historicalindependence that you have in equities through MSCI or FTSE or S&P DowJones. We think there is room for fixed income index investing to evolve, andthis creates potential in the medium to long term.

S&P Global MarketIntelligence operates independently from S&P Dow Jones Indices. Its parentcompany is McGraw Hill Financial.