New First Trust ETF Aims for Value Indexing (FDV)

Jul.11.06 | About: First Trust (FTCS)

First Trust Portfolios is expected to launch a new ETF onto the American Stock Exchange this morning that will put a new spin on the idea of value investing. The new First Trust DB Strategic Value Fund (ticker: FDV) will attempt to look beyond the cover story of reported financial metrics and instead suss out the true, underlying value in the market by selecting stocks with strong profits and excellent operating margins.The prospectus is available here.

First Trust faces a tremendous challenge selling this ETF to the public, as the product is complicated – by necessity, the product literature is weighed down by acronyms, assumptions and confusing jargon. But let’s hope they succeed, because deep down, FDV is an exciting new ETF that represents a new direction in the rapidly expanding field of fundamentally weighted investing.

Here’s how it works:

The fund will track something called the Deutsche Bank CROCI US+ Index, which captures 40 stocks from among the 251 largest names in the S&P 500 Index with … here comes the jargon … the “lowest positive CROCI Economic Price Earnings Ratio.”

The “economic” price/earnings ratio is an attempt to look past the traditionally reported financial metrics – price/earnings, price/book, dividend yield, etc. – and instead focus on measures that are more meaningful for investors.

The methodology uses various assumptions to make reported financial metrics more comparable across sectors and markets. For instance, while many of us accept the “price/earnings” ratios we read on Morningstar and Yahoo! Finance as valuable information, the truth is that they are impacted by various accounting methodologies that render them less than reliable. If Enron didn’t teach you that lesson (there are still some people who think the accounting was legal), consider this: Cable TV companies almost never report profits, but I’ve yet to see a cable TV CEO in my local bread line.

Of course, the methodology for adjusting these ratios comes with its own assumptions and risks … risks that should not be overlooked. Deutsche Bank’s assumptions won’t be perfect, and could skew the results.

Once these adjustments are made, the CROCI index selects companies with the ability to earn profits above and beyond their weighted average cost of capital. These 40 companies are assigned equal weight in the index. The current component list is available here.

The result is a “value-based” ETF that reflects firms’ underlying profitability … a factor that has historically had a strong tie to performance. Over the past ten years, for instance, the index has delivered returns of 17.94 percent per year, compared to just 9.16 percent for the S&P 500 Value Index.

The fund reminds some market commentators of Gotham Capital principal Joel Greenberg’s best-selling book, The Little Book That Beats The Market. That book also emphasizes the importance of picking stocks that earn more than their cost of capital, and promises backtested returns of over 30 percent per annum.

We've seen a tremendous amount of innovation in the "value indexing" space over the past few years, with companies using more and more complicated methodologies to seperate value from growth stocks. This new fund takes a different slant, based on the premise that reported financial statistics aren't accurate, and that focusing on the right statistics can lead to improved performance. Importantly, this fund (and the index it tracks) should not be thought of as represnting the "value" sector. Rather, it is a quantitatively driven, quasi-active strategy that attempts to outperform the market.

Interestingly, the First Trust fund actually has a relatively high traditional price/earnings ratio at 16.02, just a shade below the broader S&P 500’s P/E ratio of 16.6 and above the S&P 500 Value’s ratio of 15.4. It also has a significantly higher price/book ratio than either index.

Compared to the S&P 500, the index is overweight the Consumer Discretionary, Energy, and Healthcare sectors, and underweight Consumer Staples. The fund does not hold Financial companies, which represents the largest sector dislocation from the S&P Index.

Since it chooses components from among the 251 largest names in the S&P 500, the fund has a significant large-cap slant.

The fund charges 65 basis points in annual expenses.