Fourteen years after the first exchange-traded fund hit the market, the ETF industry celebrated a milestone on May 10th when the 500th ETF started trading.
And not just the 500th … the industry roared past the 500 mark, to 515, as seventeen new ETFs from First Trust launched on the American Stock Exchange. Sixteen of those funds make up First Trust’s new “AlphaDEX” family of ETFs, which use quantitative strategies in an attempt to beat the market. They are:
AlphaDEX Style Funds
§ First Trust Large Cap Core AlphaDEX Fund (NASDAQ:FEX)
§ First Trust Mid Cap Core AlphaDEX Fund (NASDAQ:FNX)
§ First Trust Small Cap Core AlphaDEX Fund (NASDAQ:FYX)
§ First Trust Large Cap Growth Opportunities AlphaDEX Fund (NASDAQ:FTC)
§ First Trust Large Cap Value Opportunities AlphaDEX Fund (NASDAQ:FTA)
§ First Trust Multi Cap Growth AlphaDEX Fund (NASDAQ:FAD)
§ First Trust Multi Cap Value AlphaDEX Fund (NASDAQ:FAB)
AlphaDEX Sector Funds
§ First Trust Consumer Discretionary AlphaDEX Fund (Symbol: FXD)
§ First Trust Consumer Staples AlphaDEX Fund (Symbol: FXG)
§ First Trust Energy AlphaDEX Fund (Symbol: FXN)
§ First Trust Financials AlphaDEX Fund (Symbol: FXO)
§ First Trust Health Care AlphaDEX Fund (Symbol: FXH)
§ First Trust Industrials/Producer Durables AlphaDEX Fund (Symbol: FXR)
§ First Trust Materials AlphaDEX Fund (Symbol: FXZ)
§ First Trust Technology AlphaDEX Fund (Symbol: FXL)
§ First Trust Utilities AlphaDEX Fund (Symbol: FXU)
The orphan stepchild in the launch was the First Trust S&P REIT Index Fund (NYSEARCA:FRI), a broad-based REIT fund that tracks the S&P REIT Composite Index. It charges 0.50 percent in annual expenses. FRI doesn’t break much new ground, but gives investors a new REIT choice tied to a familiar index.
The AlphaDEX ETFs are the latest in the ever-expanding line of quantitative, “beat the market” ETFs. They follow closely in the footsteps of the PowerShares Intellidex ETFs, which have been on the market for a little over 3 years and have compiled a solid track record so far.
The new AlphaDEXes are “quantitatively driven” or "active" index funds: they take existing indexes and tweak the methodology to try to create a better-performing product. The style funds are based on S&P indexes (the S&P 500 for large-caps, S&P MidCap 400 for mid-caps, etc.), while the sector funds are based on the Russell 1000 Index.
The methodology for enhancing those indexes is transparent, but complicated. The stocks in each index are divided into growth, core and value buckets. The growth stocks are evaluated by five metrics and given a score:
• three-, six- and 12-month price appreciation (i.e., momentum)
• one-year sales growth
• sales-to-price ratio.
The value stocks are evaluated by three metrics and given a score:
• book value-to-price
• cash flow-to-price
The core stocks are evaluated on both metrics and the higher of the two scores is taken.
First Trust then looks at all the scores and assigns the highest weight in each AlphaDEX to the highest scoring stocks. The goal is to create an index that emphasizes the “best” growth stocks and “best” value stocks.
The funds charge 0.70 percent in expenses, among the highest fee for any non-leveraged equity ETF. First Trust says that the upside performance will more than compensate for the higher fees.
The prospectus is available here.
Does It Work?
Does it work? Who knows? I don’t have to tell you that the backtested results look good. For instance, the First Trust Consumer Discretionary AlphaDEX has trounced the Russell 1000 Consumer Discretionary and Services Index, delivering 10-year compounded returns of 14.78 percent, compared to just 6.80 percent for the Russell index.
Then again, backtested data is … backtested. By definition, you wouldn’t launch a quantitative strategy that had poor backtested performance. The proof will lie in the real-time performance. So far, advisors have been slow to pick up on these “enhanced index ETFs,” waiting for the funds to have 3+ years of real-time results before believing the hype.
One issue with the new, fundamentally weighted ETFs is that they all emphasize, to some extent, traditional “value” metrics like the price-to-book ratio. The AlphaDEXes attempt to broaden that exposure to include growth stocks, but even the growth stock score has a “value screen” on it: the use of “price-to-book” ratio as one of five growth metrics will de-emphasize the “growth-iest” growth stocks.
That may be a good thing – we all remember the Internet bubble – but it is something to keep an eye on. Value stocks have performed very well over the past 10 years, but that can and will eventually change.
The AlphaDEXes may be better positioned to perform well during growth periods than other quantitatively screened ETFs, but even First Trust said that the AlphaDEXes tend to trail the broader markets during these times. That doesn’t make them bad products, but investors should understand that they’re getting a value tilt when they buy almost any of the new alternatively-weighted index funds.