Analyzing The First Trust Health Care AlphaDEX ETF: How Did It Do It?

| About: First Trust (FXH)
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Summary

FXH has posted an impressive +210% performance since its inception in May 2007 (annualized 28%), outperforming the benchmark XLV by 89% (annualized 12%).

FXH is a fundamental index that utilizes AlphaDEX's proprietary weighting methodology.

This article compares FXH with other health care ETFs to understand the characteristics of the fund.

Introduction

In a previous article, I analyzed the performance of the First Trust AlphaDEX sector funds and compared them to the SPDR Select sector ETFs. The results showed that the AlphaDEX funds outperformed the SPDR ETFs by an average of 1.9% annualized over 7.5 years. However, one performer that really stood out for the AlphaDEX line-up was the The First Trust Health Care AlphaDEX ETF (NYSEARCA:FXH), which posted an impressive return of +210% over 7.5 years (annualized 28%). In contrast, the Health Care Select Sector SPDR Fund (NYSEARCA:XLV) posted a +122% return over the same time period, meaning that FXH beat the SPDR benchmark by +89% (annualized 12%). Note also that health care was the best-performing sector over this period.

The First Trust AlphaDEX sector ETFs utilize the AlphaDEX methodology, which is a proprietary, rules-based fundamental stock selection investment process that seeks to produce similar correlation and risk characteristics as broad market indexes while seeking outperformance due to stock selection and weighting. Fundamental-weighted ETFs such as the AlphaDEX funds have been gaining popularity in recent years as investors seek to harness academic understanding of the factors that drive portfolio returns without having to pay for the pricey but often disappointing performance of conventional active management.

As XLV is a market cap-weighted index, it will be biased towards large-cap stocks by default. However, a fundamental-weighted ETF like FXH does not have this restriction. Therefore, this article will compare FXH not only to XLV, but also to two other health care ETFs to further understand the characteristics of the fund.

The First Trust Health Care AlphaDEX ETF

Constituents

FXH currently has 75 holdings, which are shown in the table below. The data are obtained from the First Trust website.

Name Ticker Classification Weighting
Centene Corporation (NYSE:CNC) Health Care Providers & Services 2.60%
AmerisourceBergen Corporation (NYSE:ABC) Health Care Providers & Services 2.39%
Aetna Inc. (NYSE:AET) Health Care Providers & Services 2.26%
Actavis Plc (NASDAQ:ACT) Pharmaceuticals 2.22%
Mallinckrodt Plc (NYSE:MNK) Pharmaceuticals 2.22%
Medivation, Inc. (NASDAQ:MDVN) Biotechnology 2.21%
Quest Diagnostics Incorporated (NYSE:DGX) Health Care Providers & Services 2.20%
McKesson Corporation (NYSE:MCK) Health Care Providers & Services 2.18%
HCA Holdings, Inc. (NYSE:HCA) Health Care Providers & Services 2.13%
Universal Health Services, Inc. (Class B) (NYSE:UHS) Health Care Providers & Services 2.12%
Edwards Lifesciences Corporation (NYSE:EW) Health Care Equipment & Supplies 2.10%
DaVita HealthCare Partners Inc. (NYSE:DVA) Health Care Providers & Services 2.09%
United Therapeutics Corporation (NASDAQ:UTHR) Biotechnology 2.09%
Gilead Sciences, Inc. (NASDAQ:GILD) Biotechnology 2.05%
Celgene Corporation (NASDAQ:CELG) Biotechnology 1.99%
Amgen Inc. (NASDAQ:AMGN) Biotechnology 1.95%
Allergan, Inc. (NYSE:AGN) Pharmaceuticals 1.92%
Regeneron Pharmaceuticals, Inc. (NASDAQ:REGN) Biotechnology 1.91%
Cigna Corporation (NYSE:CI) Health Care Providers & Services 1.86%
Alexion Pharmaceuticals, Inc. (NASDAQ:ALXN) Biotechnology 1.84%
Cardinal Health, Inc. (NYSE:CAH) Health Care Providers & Services 1.79%
Biogen Idec Inc. (NASDAQ:BIIB) Biotechnology 1.76%
Tenet Healthcare Corporation (NYSE:THC) Health Care Providers & Services 1.76%
Quintiles Transnational Holdings Inc. (Q) Life Sciences Tools & Services 1.74%
Anthem Inc. (NYSE:ANTM) Health Care Providers & Services 1.72%
Jazz Pharmaceuticals Plc (NASDAQ:JAZZ) Pharmaceuticals 1.70%
LifePoint Hospitals, Inc. (NASDAQ:LPNT) Health Care Providers & Services 1.67%
Envision Healthcare Holdings, Inc. (NYSE:EVHC) Health Care Providers & Services 1.63%
Myriad Genetics, Inc. (NASDAQ:MYGN) Biotechnology 1.52%
Salix Pharmaceuticals, Ltd. (NASDAQ:SLXP) Pharmaceuticals 1.51%
MEDNAX, Inc. (NYSE:MD) Health Care Providers & Services 1.48%
UnitedHealth Group Incorporated (NYSE:UNH) Health Care Providers & Services 1.44%
Patterson Companies, Inc. (NASDAQ:PDCO) Health Care Providers & Services 1.43%
Health Net, Inc. (NYSE:HNT) Health Care Providers & Services 1.42%
Zoetis Inc. (NYSE:ZTS) Pharmaceuticals 1.42%
Illumina, Inc. (NASDAQ:ILMN) Life Sciences Tools & Services 1.40%
Pharmacyclics, Inc. (NASDAQ:PCYC) Biotechnology 1.35%
Cerner Corporation (NASDAQ:CERN) Health Care Technology 1.31%
Pfizer Inc. (NYSE:PFE) Pharmaceuticals 1.31%
Charles River Laboratories International, Inc. (NYSE:CRL) Life Sciences Tools & Services 1.29%
Thermo Fisher Scientific Inc. (NYSE:TMO) Life Sciences Tools & Services 1.28%
Vertex Pharmaceuticals Incorporated (NASDAQ:VRTX) Biotechnology 1.28%
Laboratory Corporation of America Holdings (NYSE:LH) Health Care Providers & Services 1.26%
The Cooper Companies, Inc. (NYSE:COO) Health Care Equipment & Supplies 1.26%
Bio-Techne Corp (NASDAQ:TECH) Life Sciences Tools & Services 1.21%
BioMarin Pharmaceutical, Inc. (NASDAQ:BMRN) Biotechnology 1.05%
CareFusion Corporation (NYSE:CFN) Health Care Equipment & Supplies 1.05%
VCA Inc. (NASDAQ:WOOF) Health Care Providers & Services 0.99%
Catamaran Corp (NASDAQ:CTRX) Health Care Providers & Services 0.96%
DENTSPLY International Inc. (NASDAQ:XRAY) Health Care Equipment & Supplies 0.95%
Henry Schein, Inc. (NASDAQ:HSIC) Health Care Providers & Services 0.95%
AbbVie Inc. (NYSE:ABBV) Pharmaceuticals 0.94%
Zimmer Holdings, Inc. (ZMH) Health Care Equipment & Supplies 0.92%
Humana Inc. (NYSE:HUM) Health Care Providers & Services 0.91%
Brookdale Senior Living Inc. (NYSE:BKD) Health Care Providers & Services 0.90%
Perrigo Company Plc (NASDAQ:PRGO) Pharmaceuticals 0.90%
Hill-Rom Holdings, Inc. (NYSE:HRC) Health Care Equipment & Supplies 0.89%
Baxter International Inc. (NYSE:BAX) Health Care Equipment & Supplies 0.84%
Community Health Systems, Inc. (NYSE:CYH) Health Care Providers & Services 0.80%
Johnson & Johnson (NYSE:JNJ) Pharmaceuticals 0.80%
Covance Inc. (NYSE:CVD) Life Sciences Tools & Services 0.53%
Alnylam Pharmaceuticals Inc. (NASDAQ:ALNY) Biotechnology 0.52%
Medtronic, Inc. (NYSE:MDT) Health Care Equipment & Supplies 0.49%
C.R. Bard, Inc. (NYSE:BCR) Health Care Equipment & Supplies 0.48%
Sirona Dental Systems, Inc. (NASDAQ:SIRO) Health Care Equipment & Supplies 0.47%
Express Scripts Holding Company (NASDAQ:ESRX) Health Care Providers & Services 0.46%
Intuitive Surgical, Inc. (NASDAQ:ISRG) Health Care Equipment & Supplies 0.46%
Eli Lilly and Company (NYSE:LLY) Pharmaceuticals 0.45%
Hologic, Inc. (NASDAQ:HOLX) Health Care Equipment & Supplies 0.45%
St. Jude Medical, Inc. (NYSE:STJ) Health Care Equipment & Supplies 0.45%
Teleflex Incorporated (NYSE:TFX) Health Care Equipment & Supplies 0.45%
athenahealth, Inc. (NASDAQ:ATHN) Health Care Technology 0.43%
QIAGEN N.V. (NASDAQ:QGEN) Life Sciences Tools & Services 0.42%
Merck & Co., Inc. (NYSE:MRK) Pharmaceuticals 0.40%
PerkinElmer, Inc. (NYSE:PKI) Life Sciences Tools & Services 0.40%

The average market cap of FXH is $17.4B (source: Morningstar). This is much lower than that of the benchmark XLV, at $78.0B (source: Morningstar). As described above, this is expected because FXH is a fundamental-weighted index rather than a market cap-weighted index. Therefore, FXH will also be compared to the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB), which has an average market cap of $18.7B (Morningstar), and PSCH PowerShares S&P SmallCap Health Care ETF (NASDAQ:PSCH), which has an average market cap of $1.4B (Morningstar).

Fund details

The table below shows the details for the four healthcare funds, and the data are obtained from Morningstar.

  FXH XLV IBB PSCH
Expense ratio 0.66% 0.16% 0.48% 0.29%
Inception May 2007 Dec 1998 Feb 2001 Apr 2010
Assets $2.6B $13.0B $7.2B $0.2B
Avg Vol. 365K 8500K 1600K 6.2K
No. holdings 75 56 119 69
Annual turnover 81% 3% 39% 16%

From the above table, we can see that FXH has the highest expense ratio out of the 4 funds analyzed. FXH also has a respectable $2.6B in assets and an average turnover of 365K shares. Meanwhile, XLV and IBB are larger funds that have $13.0B and $7.2B in assets, respectively. PSCH, which to my knowledge is the only small-cap health care ETF on the market, is a tiny fund with only $0.2B in assets.

In terms of the annual turnover of its constituents, FXH has by far the greatest turnover at 81%, which is likely a consequence of its fundamental-weighting methodology that is applied on a quarterly basis. IBB has the next-highest annual turnover at 39%, while XLV has the lowest turnover at 3%.

Performance

FXH Total Return Price Chart

FXH Total Return Price data by YCharts

The graph above shows the total return performance of the four ETFs since April 2010, which is the inception date of the newest fund PSCH. IBB has the highest 4.5-year performance at 276%, while PSCH has the lowest 4.5 year performance of 139%. Notably, all four funds have outperformed S&P500 (106%) over the same period.

The below shows various performance metrics for the four healthcare funds plus SPY over the past 10 years. All data are from Morningstar, except for volatility and beta which are from Investspy and are calculated from April 2010.

Metric FXH XLV IBB PSCH SPY
1-year return 32.2 30.3 45.8 13.7 16.0
3-year return (ann.) 33.7 30.3 47.3 26.1 22.0
5-year return (ann.) 23.9 19.8 32.3 - 15.6
10-year return (ann.) - 10.9 15.8 - 7.7
Volatility 16.9% 14.7% 22.4% 19.8% 16.0%
Beta 0.93 0.82 1.05 1.01 1.00
Sharpe (3Y) 2.32 2.76 2.10 1.62 2.15
Sharpe (5Y) 1.70 1.68 1.61 - 1.20
Sharpe (10Y) - 0.76 0.80 - 0.49

The volatility of IBB is the highest at 22.4%, which is followed by PSCH at 19.8% and FXH at 16.9%. XLV has the lowest volatility at 14.7%. The beta of the four funds follows the same trend as their volatility. IBB and PSCH have betas just over 1.00, while FXH has a volatility of 0.93 and XLV has a beta of 0.82. The low beta of XLV lends credence to the notion that health care is a defensive sector.

In terms of Sharpe ratio, FXH and XLV have higher ratios than IBB over 3- and 5-year spans, even though the latter fund has had a higher total return. This suggests that FXH and XLV have had superior risk-adjusted return profiles compared to IBB.

The total return performances of the funds (data from Morningstar) are also displayed below in graphical form.

A correlation table for the four funds over a 4.5-year span is shown below (data from Investspy). We see a generally high correlation between the four healthcare funds, as expected.

  FXH XLV IBB PSCH SPY
FXH 1.00 0.92 0.87 0.87 0.88
XLV 0.92 1.00 0.83 0.80 0.89
IBB 0.87 0.83 1.00 0.80 0.75
PSCH 0.87 0.80 0.80 1.00 0.82
SPY 0.88 0.89 0.75 0.82 1.00

Size

The next factor to analyze is the size of the funds. The table below shows the market cap distribution (Morningstar) of the four healthcare funds and SPY.

  FXH XLV IBB PSCH SPY
Giant 15.8 62.1 31.6 0 51.3
Large 32.6 31.4 26.5 0 36.3
Mid 45.0 6.5 22.1 3.5 12.4
Small 6.6 0 12.7 58.9 0.1
Micro 0 0 7.1 37.6 0

The same data is shown below in graphical form:

The results show that FXH is relatively diverse in terms of market cap distribution, with 15.8% in giant-cap, 32.6% in large-cap, 45.0% in medium-cap and 6.6% in small-cap stocks. Additionally, FXH is the only health care ETF out of the four that has its highest allocation towards mid-cap stocks. XLV, as a market-cap weighted index, is obviously dominated by giant and large-cap stocks. IBB is more diverse in terms of market cap distribution than XLV, but still has its highest allocations in giant-cap and large-cap companies. On the other hand, PSCH has the majority of its holdings in small and micro-cap stocks.

Given that FXH has outperformed both the large-cap XLV and the small-cap PSCH, size may not be the primary reason for the superior performance of FXH.

Industry groups

The next factor to consider are the industry groups of the constituents of the different funds. The graph below shows the weightings of the different industry groups in FXH (data from etftrends).

Interestingly, despite not explicitly targeting industry group diversity in its methodology, FXH has quite a diverse range of industry groups in the healthcare sector, with the largest industry group (health care facilities) occupying only 14% of the total allocation.

The figure above (using data from etftrends) shows the industry group distribution for the four healthcare funds. (Not shown are minor industry groups that are present only in PSCH but not the other three funds, such as application software, IT services, and others). We can see from the above chart that FXH is more diverse than XLV or IBB. XLV has a large allocation to large pharma (37%) and biotech (21%), while IBB is obviously heavily focused on biotech (72%). PSCH is also spread across multiple industry groups, but is less even in its distribution compared to FXH. I consider the even diversity of FXH across different industry groups to be a positive feature of the fund.

Value and growth metrics

Here we come to perhaps the most important part of the analysis: value and growth metrics. Given that the AlphaDEX methodology purportedly selects for stocks that have superior value or growth metrics, how does the valuation parameters of FXH compare to the other health care funds? The table below show various value and growth metrics for FXH alongside those of the other health-care funds and SPY (data are from Morningstar, value metrics including dividend yield are forward looking). The first five rows can be considered as value metrics while the last five rows can be considered as growth metrics.

  FXH XLV IBB PSCH SPY
Price/Earnings 24.1 (2) 21.8 (1) 30.8 (3) 31.1 (4) 18.0
Price/Book 3.6 (2) 3.8 (3) 7.3 (4) 2.7 (1) 2.5
Price/Sales 1.1 (1) 2.0 (3) 8.2 (4) 1.4 (2) 1.8
Price/Cash Flow 14.9 (2) 17.7 (3) 17.8 (4) 9.0 (1) 7.8
Dividend yield % 0.5 (2) 1.5 (1) 0.2 (4) 0.3 (3) 2.1
Projected Earnings Growth % 12.1 (3) 9.6 (4) 16.2 (2) 16.8 (1) 9.7
Historical Earnings Growth % 7.5 (2) 5.6 (3) 30.7 (1) 2.4 (4) 8.2
Sales Growth % 11.3 (2) 7.8 (3) 11.9 (1) 4.4 (4) 3.1
Cash-flow Growth % 6.2 (2) 1.3 (4) 10.9 (1) 5.1 (3) 6.4
Book-value Growth % 11.7 (1) 9.0 (3) 10.5 (2) 8.1 (4) 7.6
Rank average (1.9) (2.8) (2.6) (2.7)  

Next to the value and growth measures in the table, I have included in parentheses the rank of that metric out of the four health care funds sampled (SPY not included). FXH scores well in many of the value and growth categories, coming first in price/sales (1.1) and book-value growth % (11.7), while coming second in seven other categories. The rank average then gives a crude measure of the overall value and growth metrics of the fund. We can see that FXH scores the highest in this exercise, with the other three ETFs being significantly further behind.

These data appear to validate AlphaDEX's weighting methodology in selecting for stocks with superior value and growth metrics. Note that this analysis may belie the true characteristics of the fund because the AlphaDEX process ranks growth and value stocks on completely separate metrics. In other words, value stocks are ranked according to value metrics and growth stocks are ranked according to growth metrics. Given that value stocks don't tend to score highly for growth metrics and vice versa, this would have been expected to "average out" the overall value and growth measures, possibly resulting in lukewarm statistics. Yet, FXH still possessed the best overall performance out of the four funds studied in this analysis.

However, due to healthcare's strong performance over the past several years, the funds have now become quite expensive relative to the broader market SPDR S&P 500 Trust ETF (NYSEARCA:SPY). This is perhaps best exemplified by IBB, which has very poor value metrics but very good growth metrics. Clearly, the biotechnology sector has been explosive in recent years with fantastic growth numbers across the board. However, the valuation of this sector has become quite expensive now, reflecting high growth expectations. The other three healthcare funds are not as pricey as IBB, but are still significantly more expensive than SPY. On the positive side, the funds show better growth metrics compared to SPY.

Conclusion

This article compared to FXH to the benchmark health care ETF, XLV, as well as to two other health care funds that have different investment mandates, the biotech-based IBB and the small cap-based PSCH. FXH outperformed XLV by 12% per year over the past 7.5 years, a significant outperformance.

While IBB showed the best 3-year and 5-year total return performances out of the four health care funds studied, it had inferior risk-adjusted performance (Sharpe ratio) compared to FXH and XLV.

In terms of market cap distribution, FXH's greatest allocation was to mid-cap stocks, whereas XLV and IBB favor giant and large-cap stocks. Moreover, FXH appeared to have a more even distribution of industry groups within the healthcare sector compared to XLV or IBB. PSCH, the small-cap healthcare ETF, was also quite diversified.

FXH's value and growth metrics were, on average, the best out of the four health care funds studied. This might be due to the AlphaDEX selection methodology which ranks stocks on value or growth metrics. Stocks that score higher in the methodology have a greater weighting in the fund.

If an investor were interested in investing in a health care ETF, I would highly recommend FXH due to the factors mentioned above. The main drawback however is that its expense ratio is quite high, at 0.66%. An additional risk is that healthcare may be possibly due for "mean reversion" given its exceptional performance over the past few years.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is long FXH through FV.