The impressive rise of the ETF industry in recent years is often held out as evidence of an ongoing shift in investor preferences away from costly active management and towards low cost indexing. Investors frustrated with the inability of pricey mutual fund managers to consistently beat their benchmark have abandoned stock picking in favor of simply owning the entire benchmark.
With the relatively recent introduction of actively-managed ETFs, the ETF universe is being split into two groups based on fundamentally different investment strategies (in fact ETFdb's ETF Screener includes an active/passive filter). But within the ETF industry, the active/passive distinction isn’t a black-and-white issue. There are dozens of ETFs available to U.S. investors that blur the lines between active and passive management, replicating “enhanced” indexes that are designed and maintained with the objective of outperforming traditional cap-weighted benchmarks.
As indexes have transitioned from hypothetical measures of performance to (essentially) investable assets, scrutiny of the underlying methodologies has increased considerably. Many of the enhanced index products out there are now attracting interest with impressive returns, and are being embraced as alternatives to traditional S&P and Russell-based products.
Inside the AlphaDEX
One of the leaders in the “quasi-active” ETF space is Wheaton, Illinois-based First Trust, best known for the AlphaDEX line of ETFs. The methodology behind these ETFs is relatively simple: a quantitative analysis process is used to identify stocks that have the “greatest potential for capital appreciation.” For example, the First Trust Large Cap Core AlphaDEX Fund (FEX) ranks stocks from the S&P 500 Index on growth factors (including price appreciation, sales to price and one year sales growth) and value factors (including book value to price, cash flow to price and return on assets). From these rankings, the bottom 25% of stocks are cut out, while the top 75% are included in the benchmark. Those with the highest scores get the biggest weightings, while the lower scores receive a smaller allocation.
In addition to seven size and style specific AlphaDEX ETFs, First Trust also offers sector-specific funds covering the nine primary corners of the U.S. economy. This group of funds recently notched a pretty impressive accomplishment: through April, every one of the AlphaDEX ETFs had beaten its comparable market capitalization-weighted index over the last year (see a complete breakdown here).
First Trust had three sector ETFs that performed exceptionally well compared to their respective indexes. The First Trust Materials AlphaDEX Fund (FXZ), which follows the StrataQuant Materials Index, more than doubled the performance of the Materials SPDR (XLB). The First Trust Health Care AlphaDEX (FXH), which tracks the StrataQuant Health Care Index, was up a whopping 30% over the Health Care SPDR (XLV). And the First Trust Energy AlphaDEX Fund (FXN) outperformed the Energy SPDR (XLE) by roughly 25% for the year ended April 30.
52 Week Return
|As of 4/30/10|
There were also some impressive deltas among the size/style funds that did well against the popular S&P 500 Index, and the S&P MidCap 400 Index. The First Trust Large Cap Core AlphaDEX (FEX), which picks the best stocks from the S&P 500 Index, beat SPY by just over 8 percent. The First Trust Mid Cap Core AlphaDEX (FNX), which tracks the Defined Mid Cap Core Index, beat MDY by about 500 basis points.
For investors who believe in the potential for active management to generate excess returns but are interested in the benefits offered by the exchange-traded structure (enhanced transparency and tax efficiency, intraday trading, etc.), AlphaDEX is an interesting option. These products come with a slightly higher price tag–FEX, for example, charges 0.70%–but the additional returns generated over the last year more than made up for the higher costs.
It is important, of course, to keep in mind that one year is still a relatively short time period to judge the efficiency of an investment strategy. But the perfect batting average over that period is certainly impressive, and may make these funds worthy of a closer look.
Jared Cummans contributed to this article.
Disclosure: No positions at time of writing
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