Transparency Makes A Difference

But what about parts of the market that had a better 2007? Well, PowerShares Dynamic Large Cap Growth ETF (AMEX: PWB) also outgunned its closest traditional competitor. It gained some 12.2% last year. By contrast, the iShares Russell 1000 Growth Index (NYSE Arca: IWF) returned about 11.6%.

"The quant ETFs that match up closely to traditional market-cap indexes did well in 2007," said Anthony Welch, an advisor at Sarasota Capital Strategies in Osprey, Fla.

Another top performer in 2007 among diversified large-caps was Claymore/Zacks Sector Rotation ETF (AMEX: XRO), which returned 15.4%. It implements a quantitative approach as well. The fund reconstitutes every quarter and tries to pick out 100 of the S&P's names based on fundamental bottom-up factors such as relative value and earnings estimates. It also throws in macroeconomic factors in Zack's computer-generated ratings systems.

"It's more transparent than a lot of quant ETFs," Welch said. "You know they're trying to invest in the hot sectors, which is a broader strategy than picking hot stocks. So it has less risk potential."

A more oddball quant fund he owned last year was PowerShares Dynamic MagniQuant ETF (AMEX: PIQ). It returned 1.7% in 2007. The closest comparisons listed by PowerShares were indexes tracked by iShares Russell 3000 Index (NYSE Arca: IWV) and the S&P 500-tracking SPDRs (AMEX: SPY). In 2007, IWV made 4.6% and SPY gained 5.4%.

"The MagniQuant is a hard ETF to track," said Welch. "The strategy of creating a unique new index of its own seemed innovative. We were at least willing to give it a chance."

Not All Quants Are Alike

He still likes many PowerShares products. "But the whole quant trade has become very crowded," Welch noted. "When the economy really started heading south last summer, a lot of these newer niche quant strategies got hammered."

He added: "We don't have a clue what some of these more proprietary quant strategies are doing. We prefer to have a little better grip on what could impact its performance. So with quant funds, we really emphasize transparency."

Quant funds usually have more volatility than more static indexes. And indeed, this year, PWB has fallen harder than IWF as market conditions continue to deteriorate. "That's something you've got to consider," said Welch. "The PWB ETF's standard deviation, which is a measure of volatility, is about 10% greater than the equivalent Russell 1000 Growth Index ETF. So when the market's up, it should outperform."

In the coming 12 months, providers are lining up to cram even more quant funds into the marketplace. They've come up with all sorts of niche indexes, many of which provide exposure to illiquid and highly volatile markets formerly only open to well-capitalized institutional investors.

As a new crop of funds gains popularity by implementing the latest in computer-generated portfolio construction, skeptics point out that proposals under registration still don't go as far as the freedoms open-end mutual fund managers have to set their own stock-picking parameters.

Still, most quant funds use a myriad of ratios and valuations to screen for stocks that traditional ETFs don't ever consider. This is accomplished by letting computers perform most of the heavy lifting in the selection process.

At least in theory, such high-tech number crunching means more variables can be considered in developing an index. Since quants are highly mechanized, they also can rebalance and reconstitute portfolios more regularly.

Only Time Will Tell

And that's where the quant ETF argument is supposed to come to full fruition. After all, if an index can be replenished by a mere push of a button or two, then concerns about time and waste impacting returns are automatically eliminated.

Traditional indexers argue that simplicity will win out over time. Just pick the names with the greatest market-cap sizes and weight them accordingly. Let the market cast its votes in the form of how much of whatever number of shares are on the market at any given time.

The debate figures to grow as more quant-based ETFs accumulate longer track records. So far, most are very new entries into an already crowded marketplace. That makes evaluating their value to long-term investors more an art than science.

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