SOME THINGS ARE HARD TO

classify. Take tomatoes. They're found in the vegetable aisle in any supermarket and are often put in salads alongside peppers and cucumbers. But technically, they're fruits.

The same sort of ambiguity applies to a group of new exchange-traded funds, or ETFs, launched in June by PowerShares Capital Management, a portfolio management firm. Bruce Bond, president of the Wheaton, Ill.-based company, calls the new ETFs "smart ETFs," a cross between actively and passively managed portfolios. Instead of merely tracking a popular stock index, these new funds replicate PowerShares' proprietary "Intellidexes," which are designed to beat the benchmarks of traditional index ETFs and are updated once a quarter.

The PowerShares strategy seems to be working. Since its May 1, 2003 debut the company's Dynamic Market Portfolio has gained 63%, vs. 34% for the S&P 500 index. Its Dynamic OTC Portfolio, launched the same day, has since climbed 68%, vs. 48% for the Nasdaq Composite.

SmartMoney.com recently asked Bond how simultaneous active and passive investing makes for an intelligent ETF.

SmartMoney.com: What are the new "smart" ETFs, and what's the investment philosophy behind them?

Bruce Bond: The eight different industry ETFs focus on different industries. Each holds 30 stocks. They're intelligent vs. other benchmark indexes. Other indexes say biotechnology will look at biotechnology companies and say, let's just get anyone in biotech of any size...The indexes that PowerShares is based on seek to use intelligence to identify certain stocks, instead of incorporating everyone into the index. We identify stocks with the greatest investment merit.

The funds are: Biotech and Genome; Food and Beverage; Leisure and Entertainment; Media; Networking (computer, hardware, switching) (; Pharmaceuticals; Semiconductors; and Software.

SM: How can an index assess a stock's worthiness?

BB: We have four factors we use for our Intellidexes: fundamentals, valuation, timeliness and risk. For instance, risk looks at the underlying stocks and ranks them for how much risk each individual security has in it. Those four different perspectives are made up of 25 different financial factors. These factors are all designed to have low correlation with one another... Those 25 different factors give us an investment rating. The Intellidex would then select the stocks with the highest ratings. PowerShares replicates the index. In order to have an intelligent ETF, you have to have an intelligent index. That's how PowerShares is able to deliver to investors a way to outperform certain market segments, and yet provide them with specific and focused exposure to the market.

SM: How is your methodology similar to that of an actively managed mutual fund?

BB: With the four factors we use. For example, timeliness looks at the more technical aspects of the marketplace. A company's fundamentals can look great, and it may be a little undervalued in the market now, but the stock may not be moving at all, or it has no momentum. The picture looks great, but the stock is not doing anything. The market isn't realizing its value. The timeliness factor tells us when the market is starting to realize the value in that security. There are technical factors that would help the index understand if this stock is a good investment at this moment. What it's measuring is investor sentiment about the stock. We have six different factors in timeliness to find out how investors are reacting to stocks are they excited about it or not excited about it?... Our methodology is long-term based. But you want to know if it's something you want to get into today. You want to know if sentiment is positive toward the company at that time.

SM: What's a big difference between a traditional indexed ETFs and PowerShares?

BB: [Most traditional ETFs] are market-cap weighted. A market-cap-weighted index would give more exposure to very big companies. You would have a biotech company megacap, and if you strictly weight them, it's not balanced exposure to the biotech sector. Intellidex doesn't give you market-cap weighting; it gives you modified equal weighting. Large caps receive one weight, all equal. Same with midcaps. It's not market-cap weighting where one company can be 40% of the index. It's single stock risk that we want to protect investors from.

The other thing is that we want to make sure that people who invest in PowerShares are investing in stocks that have merit. The approach the index takes is similar to [that of] sophisticated portfolio managers. It's quantitative, it's consistent and disciplined, and carries out same methodology each time. It's unemotional investing, which is important for investors to be successful in the long term...

SM: How is active management incorporated into the index?

BB: The ETFs are hybrids in a way. They're active and passive at the same time. PowerShares passively replicates what we call a dynamic or active index... The index in and of itself is dynamic or active in a greater sense because it's investing for the purposes of outperforming the market, and is buying and selling securities in order to do that.

In that sense, PowerShares indexes are active...

SM: What's a typical turnover for an intelligent ETF?

BB: The indexes do rebalance every quarter. Turnover is anywhere from 75% to 150% annually. So when the index is seeking to provide alpha [or outperformance of the benchmark] and it has that kind of turnover, it seems pretty active in people's minds. The turnover is at the level of most active managers.

PowerShares Dynamic Market Portfolio and PowerShares Dynamic OTC Portfolio] started May 1, 2003. They outperformed the market handily over their first two years. And they had about 150% turnover annually. But they had no capital gains distributions. That's a big deal for investors. Second, you have the transaction costs. In an ETF, both taxes and transaction costs are mitigated because of how the ETF operates.

SM: So if smart ETFs are partly actively managed, are their expenses up there with mutual funds?

BB: They're pretty much in line with the other ETFs... PowerShares are on the higher side of the market average for ETFs. But I say they should really be compared to mutual funds; and they're much less expensive than mutual funds. What they look to provide to investors is intelligent exposure to the marketplace, which is what a mutual fund is going to give you. But it's different from a straight index fund, it's different from a benchmark. We're much more like a mutual fund than just a benchmark index. Therefore, it's more appropriate to compare our expense ratio to that of a mutual fund... In the intelligent ETF arena, we are currently the only ETF sponsor in the country that provides ETFs that replicate intelligent indexes.