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By Michael Rawson

Perhaps the biggest surprise in fund flows for exchange-traded products during the past year is the strength of First Trust. The firm has catapulted itself from the 11th largest provider of exchange-traded products to the sixth largest in just one year. Much of the strong flows are accumulating to funds that have been around for years. What has changed is the increasing acceptance of strategic beta. While they may track an index, strategic beta funds are active, so it is no surprise that investors might take a wait-and-see approach before investing, particularly when the methodology appears to be complex and untested. However, of the 23 First Trust AlphaDEX market-cap and sector funds (excluding the international AlphaDEX funds), the average Morningstar Rating is 4 stars, which is truly impressive. Unlike some single factor funds, the methodology behind AlphaDEX is fairly opaque, but their performance warrants a deep dive.

Starting with either a market-cap segment or a sector, AlphaDEX funds group all stocks into a value bucket or a growth bucket based on the S&P style designation. Separate models are applied to the value stocks and to the growth stocks. Stocks that S&P classifies as core take the higher score from the two models. The model used on value stocks includes book value/price, cash flow/price, and return on assets. Growth stocks are scored using three-, six-, and 12-month price appreciation, sales/price, and one-year sales growth. What is unique about this approach is that value models typically would not use return on assets, which is usually regarded as a quality measure and growth models typically would not use sales/price, which is more of a value measure. While traditional style funds typically split stocks into separate value or growth groups, this fund retains top-scoring stocks from both models. The result of using different models for value and growth stocks and using unique factors is a balanced portfolio with only a slight tilt toward value, yet with growth characteristics similar to a blend fund.

After ranking stocks by the appropriate model, the top 75% of companies are included in the final portfolio and the bottom 25% are eliminated. The remaining stocks are sorted into quintiles, and stocks in the best-scoring quintiles receive larger weights than stocks in lower quintiles. Stocks are equally weighted within each quintile. This weighting methodology shares some characteristics with equal weighting in that it results in a tilt toward smaller-cap stocks and it rebalances back toward these target weights.

Suitability
First Trust Large Cap Core AlphaDEX (NYSEARCA:FEX) is a suitable core equity holding for investors looking to tilt toward mid-cap and value stocks. This fund attempts to outperform traditional market-cap-weighted indexes. Despite its complex methodology, the fund provides no discernible edge beyond what is obtained through traditional size and value tilts. Those exposures are available more cheaply and transparently through other funds.

The weighting methodology results in an average market capitalization of $21 billion, nearly one fifth of the $100 billion average for the large-blend Morningstar Category. The fund has 44% of assets in mid-cap stocks compared with just 16% for the category average. Within the Morningstar Style Box, the fund has 24% of its assets in mid-cap value stocks, the most among the nine partitions.

The strategy's mid-cap and value tilts do not come without risk. Since inception, the fund has had a volatility of 19%, 2 percentage points greater than the S&P 500. It also fell more than the S&P 500 Index during the financial crisis in 2008. Still, it has offered decent performance, and investors have been compensated for accepting this greater risk--at least during the past several years. While the fund has outperformed the large-blend category to which it is assigned, most of that outperformance can be explained by its significant tilt toward mid-cap stocks. Investors might be disappointed if mid-cap stocks start to lag.

Fundamental View
A number of indicators suggest that the U.S. stock market is no longer attractively priced. At 18.6 times trailing earnings, the current price/earnings ratio for the S&P 500 Index is above its median level of 16.0, dating back to 1947. In the past, when the valuation multiple has been above its long-term average, future returns have tended to be lower versus periods marked by a below-average valuation multiple. With its mid-cap and value tilts, the current price/earnings valuation for this fund is slightly lower, at 16.9 times.

Morningstar equity analysts cover 340 out of 376 stocks in FEX, accounting for 90% of the assets. They build discounted cash flow models for each stock and assign a fair value estimate, which can then be aggregated to the fund level. Based on their fair value estimates, the fund is currently trading at a price/fair value multiple of about 1.06. That is slightly higher than the corresponding figure for the S&P 500 (1.03).

The holdings of FEX appear to be slightly lower-quality compared with the S&P 500 but higher than the typical mid-cap value fund. Firms in the S&P 500 generated an average return on invested capital of 14.3% over the trailing 12 months through June 2014 compared with just 12.4% for FEX and 8.6% for the mid-cap value category average. In addition, FEX has only 15% of assets in wide-moat stocks, versus 46% for the S&P 500. Still, this is higher than the 6% of assets in wide-moat stocks for the mid-cap value category. This lower weighting in quality stocks might help explain why the fund has exhibited greater volatility than the S&P 500. Consensus earnings forecasts call for 10% earnings growth over the next three to five years for the stocks in the fund, the same as the S&P 500, but greater than the 6% earnings growth forecast for stocks in the average mid-cap value fund.

With its tilts toward value and mid-cap stocks, the performance of the portfolio is likely to diverge from the broad market at times. For example, mid-cap stocks outperformed in 2013, which helped this fund beat both the S&P 500 and its category. But that will not always be the case. While they have a good long-term record relative to their growth counterparts, value stocks tend to be less profitable and may underperform during tough economic climates.

Fees
The fund charges 0.66%, well above the average large-cap exchange-traded fund and well above other strategy ETFs. Still, the expense ratio is half of the average large-blend mutual fund. During the past five years, the fund has lagged its index by about 0.90% per year, suggesting implementation costs have created a drag on the fund's performance.

Alternatives
PowerShares FTSE RAFI US 1000 (NYSEARCA:PRF) (0.39% expense ratio) may be a suitable alternative. This fund weights stocks based on fundamentals, such as sales and book value, thus breaking the link between stock price and index weight. This approach gives it a value tilt and a disciplined rebalancing strategy that may help boost returns over the long term. WisdomTree LargeCap Dividend (NYSEARCA:DLN) (0.28% expense ratio) takes a different tack and weights its holdings by the dollar amount of dividends paid. This approach introduces a similar rebalancing discipline. Guggenheim S&P 500 Equal Weight (NYSEARCA:RSP) (0.40% expense ratio) also applies a disciplined rebalancing strategy by assigning equal weightings to all of the stocks in the S&P 500 Index, resulting in a pronounced mid-cap tilt.

Those looking for a cheaper way to tilt toward mid-cap value stocks might consider Vanguard Mid-Cap Value ETF (NYSEARCA:VOE), which charges just 0.09%.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Strategic Beta: Taking The Alpha Out Of AlphaDEX