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by Paul Weisbruch

In 2007, the ETF provider known as First Trust Portfolios launched their “AlphaDex” methodology, which in hindsight, proved to be well ahead of its time. Prior to 3 years ago, the idea of an ETF generating excess return, or even the concept of an “actively managed” ETF were largely whimsical notions, and foreign to most to say the least. ETFs were, and to this day are still seen by many to be vehicles that grant access to “beta,” or benchmark index returns at low cost.

That said, the majority of ETFs in the marketplace today do exactly just that, mimicking existing indexes and charging a small management fee to deliver index based investment returns. First Trust, however, developed a concept known as the “AlphaDex”, which presented investors with the possibility of owning an ETF vehicle that delivered enhanced returns to a specific index benchmark, thus unlocking alpha but structured in a low cost ETF as opposed to a traditional actively managed mutual fund.

Dan Weiskopf, Co-Portfolio Manager at Forefront Global ETF Strategies, says

As portfolio managers focused on ETFs since 2004, we at Global ETF Strategies have been big believers that the structure of an ETF can add “ Alpha ” to a portfolio. Specifically, structure matters in the case of both the process by which an ETF basket is constructed as well as the ETF wrapper that holds the securities. Moreover, as a tactical portfolio manager we also fall in the camp of those who believe that ETFs are best used as BETA tools and therefore up until recently have been skeptical about “Active ETFs” gaining traction. However, the evolution and revolution that we have seen take place in the ETF market offers many examples of successful products which have bridged the gap between Passive and Active strategies. Case in point – First Trust AlphaDEX Funds. Of course, this does not mean that we expect the process to work all the time, in every sector and in every asset class. We believe that choosing between Active and Passive investing works better in certain asset classes and sectors under different market circumstances.

So how are the results of the AlphaDEX products achieved? The First Trust folks address an existing space such as large cap, mid cap, or small cap, or an industry sector such as Financials or Healthcare for instance, and screen that existing equity index by equity fundamentals so as not to own the entire index, but hone in on specific names that exhibit certain positive qualities. The end goal is to unlock the potential to achieve alpha to the given benchmark index by owning the “right” names in an industry sector or in a size/style category such as large cap growth or value for instance.

The First Trust portfolio team addresses these AlphaDex products on a quarterly basis, reconstituting and rebalancing their ETFs so as to reflect any changes in equity fundamentals that may have occurred over the past quarter, so as to maintain and/or increase weightings to those equities that are believed to have the greatest probability of achieving alpha to a given index, as well as discard or decrease equity names that are exhibiting poor fundamentals that will likely translate in poor returns in the equity market.

For one, Michael McClary, Chief Investment Officer of ValMark Advisers notes,

"Seasoned ETF investors understand that index methodology is important overall, however, it becomes critical for investments that go beyond the popular broad based domestic indices.” Dan Weiskopf adds, “The FirstTrust AlphaDex methodology of screening for the stronger names in an index historically offers a marriage of both passive and active styles of investing."

Benchmark, “beta” type ETFs that track industry sector indexes or style/size category indexes have become immensely popular over the years, with ETFs such as IWF (iShares Russell 1000 Growth) garnering $12.8 billion in assets under management and XLE (SPDR Energy Sector Select) attracting $8.5 billion for example.

It also seems that investment managers tend to be attracted to growth and value ETF strategies since they can “tilt” their portfolio one way or the other depending on what their future market outlook is, and there are also a number of managers that deploy sector rotational models with industry sector ETFs in attempts to overweight those sectors that they believe may outperform the general market and underweight those sectors they perceive as laggards.

These opportunities paved the way for First Trust to develop potential improvements on these already successful market capitalization weighted index ETFs, as a way to keep similar exposures in one’s portfolio but actually have the possibility of outperforming a benchmark index such as the Russell 1000 Growth Index, or say the S&P Energy Index for example.

McClary notes,

I think that it is dangerous to close your mind to any type of investing, which drives me to continue to evaluate different types of index methodologies.

How has First Trust fared since the launch of these AlphaDEX products since 2007 against their cap weighted counterparts? We have summarized the results in the table below.

Large Cap Core

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

IVV

-15.25%

8.29%

First Trust AlphaDEX ETF

FEX

-6.96%

Large Cap Growth

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

IWF

-1.49%

-3.34%

Market Cap Benchmark "Index" ETF

IVW

-3.52%

First Trust AlphaDEX ETF

FTC

-4.83%

Large Cap Value

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

IWD

-25.03%

15.96%

Market Cap Benchmark "Index" ETF

IVE

-25.67%

First Trust AlphaDEX ETF

FTA

-9.71%

Mid Cap Core

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

IJH

2.89%

16.58%

Market Cap Benchmark "Index" ETF

IWR

-6.45%

First Trust AlphaDEX ETF

FNX

10.13%

Small Cap Core

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

IJR

-3.73%

5.79%

Market Cap Benchmark "Index" ETF

IWM

-5.29%

First Trust AlphaDEX ETF

FYX

0.50%

Consumer Discretionary Sector

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

XLY

-6.08%

3.34%

First Trust AlphaDEX ETF

FXD

-2.74%

Consumer Staples Sector

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

XLP

5.37%

0.49%

First Trust AlphaDEX ETF

FXG

5.86%

Energy Sector

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

XLE

9.99%

-1.15%

First Trust AlphaDEX ETF

FXN

8.84%

Financials Sector

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

XLF

-56.42%

30.48%

First Trust AlphaDEX ETF

FXO

-25.94%

Healthcare Sector

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

XLV

-12.75%

45.07%

First Trust AlphaDEX ETF

FXH

32.32%

Industrials Sector

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

XLI

-5.66%

-0.70%

First Trust AlphaDEX ETF

FXR

-6.36%

Materials Sector

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

XLB

-4.04%

23.43%

First Trust AlphaDEX ETF

FXZ

19.39%

Technology Sector

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

XLK

3.27%

14.17%

First Trust AlphaDEX ETF

FXL

17.44%

Utilities Sector

Symbol

Trailing 3 Year % Returns

Cumulative Alpha to Benchmark Index

Market Cap Benchmark "Index" ETF

XLU

-25%

9.95%

First Trust AlphaDEX ETF

FXU

-15.05%

Recently we learned that First Trust was preparing the launches of AlphaDEX ETF products to deliver access to the following countries/regions: Asia Pacific Ex-Japan, Europe, Latin America, Brazil, China, Japan, South Korea, Developed Markets Ex-U.S., and Emerging Markets.

With impressive live investment performance results as detailed in the table above, and with many of the stalwart ETFs in these existing spaces commanding significant assets, there seems to be an enormous opportunity present for First Trust to attract the attention and dollars of ETF investors. For instance, VWO (Vanguard Emerging Markets) and EEM (iShares MSCI Emerging Markets), which both track the same market cap weighted benchmark index, command over $85 billion in assets currently, and are the #2 and #3 largest ETFs by market cap at the moment.

Similarly, EFA (iShares MSCI EAFE) has gathered over $37 billion in assets, and EWZ (iShares MSCI Brazil) over $12 billion, so if First Trust’s AlphaDEX methodology continues to generate excess returns as it has in the U.S. domestic equity sectors as well as the size/style areas since inception, these new international AlphaDEX funds will surely capture the interest, and likely assets, from the investing public.

Christian Wagner, Chief Investment Officer of Longview Capital Management points out,

The launch of the AlphaDex strategies in the international markets is well timed. Our strategy depends highly on the importance of index and sector weightings. Until recently, capital weighted strategies were the only option. Rydex filled the equal weighted void with their recent offerings. We have utilized the AlphaDex strategies on the domestic sector level in the past with great success. The AlphaDex international strategies will add another very important tool for advisors.

Rod Smyth, Chief Investment Strategist of Riverfront Investment Group adds,

What AlphaDEX is doing, is saying that we are going to build a smarter approach than a market cap weighted index.” Smyth adds, “I’m very much in the camp that a disciplined, quantitative approach can outperform cap weighted indexes, and the First Trust AlphaDEXes would serve as a long term holding in this respect. I’m a believer in quantitative approaches to outperforming, but one must understand the environment when one index approach would outperform another.

Smyth further points to the genesis of Riverfront, from their beginnings at Wachovia when his team was building ETF portfolios back in 2003, mentioning that “ETFs are a way for us to get broad exposure to a specific subsector or asset class”, and points to the firm’s allocation to FDM (First Trust Microcap) as an illustrative example.

He states,

FDM is an excellent example of an alpha generating ETF because it is a subsector of an index in essence. A cap weighted index such as IWM (iShares Russell 2000) tends to be underexposed to microcaps.

So FDM is a way for Riverfront to hone in on specific exposure in attempts to generate alpha. FDM seems to be popular among other managers as well.

Paul Frank, the portfolio manager of The ETF Market Opportunity Fund [ETFOX] has been using First Trust's Micro Cap Fund [FDM] to stay ahead of the S&P 500 since last summer.

"I like the way they discard some of the individual equities in the index, many ETF providers reshuffle the index but haven't been able to consistently add alpha" says the Morningstar Five Star Fund manager. "I will keep my eyes on the new International offerings" says Mr. Frank.

What will the ETF industry’s reception for the new AlphaDEX international ETF strategies be? Well, Dan Weiskopf of Forefront expresses his optimism, stating,

We are excited to hear that First Trust is expanding its AlphaDex products to the international segments of the ETF market. While their products rules based and not technically “Actively Managed”, studies have shown that active management works well internationally and they have shown that their Alpha methodology in the US works.

McClary of Valmark obviously favors having more ETFs to select from in the product landscape, noting,

I am a huge fan of having more tools in the ETF space, especially those delivered by quality firms like First Trust.

He concedes that the strategies may not be for everyone, stating,

Whether or not investment managers choose to use the AlphaDex ETFs, the availability of these strategies strengthens the value that portfolio managers can add by providing more options in popular areas of investment.

Rod Smyth of Riverfront summarizes the possible future of the international AlphaDEX products quite well with,

If the international AlphaDEX ETFs, like the existing U.S. based ETFS can prove that they can deliver sustainable alpha with relatively little tracking error, and if there is demonstrable alpha after expense ratios, then we would consider these new offerings as potential core holdings.

The investment community, judging from the prominent ETF portfolio managers we spoke with, seems to believe that a bright future is in store for the First Trust AlphaDEX franchise. We at Street One look forward to the impending launches of these new funds as viable additions to ETF portfolios with the potential to deliver alpha. We also caution advisors, institutions, and investors alike not to judge an ETF by the “trading volume” that they may see on any given day or over some specific time period. Trading volume is not liquidity and vice versa, and many of the existing First Trust ETF products fly under the radar of some ETF driven advisors and institutions simply because they do not trade millions of shares of volume on a daily basis, and this in an unreasonable way to disqualify ETFs from one’s portfolio.

Trading volume is largely a popularity contest, not a measure of liquidity, and if anyone is interested in trading the First Trust ETFs in larger size (shares or notional dollars), we would encourage them to contact a firm such as Street One Financial for aid in executing their trades properly.

Finally, we believe that innovative funds such as these from First Trust will transform popular thinking when it comes to the ETF vehicle, confirming that that they are not simply “beta” vehicles, but truly have the potential to be alpha solutions for one’s portfolio.

Source: Generating Alpha With First Trust ETFs