First Trust Readies International “AlphaDex” ETFs (IWF, XLE, VWO, EEM, EFA, EWZ, FDM)

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 iShares Russell 1000 Growth (NYSE:IWF) garnering $12.8 billion in assets under management and SPDR Energy Sector Select (NYSE:XLE) 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, Vanguard Emerging Markets (NYSE:VWO) and iShares MSCI Emerging Markets (NYSE:EEM), 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, iShares MSCI EAFE (NYSE:EFA) has gathered over $37 billion in assets, and iShares MSCI Brazil (NYSE:EWZ) 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 First Trust Microcap (NYSE:FDM) 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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Written By Paul Weisbruch From Street One Financial

Street One Financial LLC (S1F), specializes in agency ETF/ETP, equities, and options trade execution. On the ETF/ETP end, S1F works with the ETF product issuers to understand their products thoroughly and how they can complement an investor’s portfolio. We also assist portfolio managers in constructing their portfolios and identifying which ETF provides the best desired exposure by portfolio objective. The ETF/ETP landscape is evolving rapidly and has diversified quickly beyond passive equity index ETFs. Now actively managed strategies, fundamental and quantitative ETFs, as well as those that offer exposure to Fixed Income, Commodities or even Volatility Indexes are available to investors. That said, understanding how specific products work and where they fit within portfolios and perhaps more importantly, “how to trade” these products, has become something of major importance to portfolio managers on all levels. At S1F, we assist portfolio managers in screening by true underlying liquidity, not “shown liquidity” or “perceived liquidity” as reflected by average daily trading volume. S1F then sources liquidity without identity or information slippage, through all available access points in the marketplace to minimize the market impact of the trade, delivering a lower total cost of trading to the portfolio manager. This allows the portfolio manager to, in essence, recapture basis points on each trade, and outperform over the course of the year, and maintain a competitive edge over their peers.

Street One specializes in ETF (and options on ETFs) execution/liquidity provision for RIAs and institutional fund managers and our aim is to provide fair and accurate pricing in the broad product spectrum of ETFs, including newer and/or esoteric ones, that may be perceived to be “illiquid.” Having worked at an ETF issuer, RevenueShares for 2 years as an institutional/RIA wholesaler, Paul Weisbruch understands that many of the challenges to doing business revolve around a portfolio managers not being comfortable with trading in and out of ETFs that don’t trade hundreds of millions of shares per day like SPY and QQQQ, and that may also have wide bid/ask spreads. At Street One, we competitively price your ETF buy/sell orders anonymously in the marketplace to ensure that you receive fair and accurate pricing, with price impact being kept to a minimum. Paul Weisbruch has 10 years of ETF trade execution and product strategy experience from his years at Susquehanna International Group as an ETF Specialist on the PHLX trading SPY and DIA, as well as roles including Energy Futures/Derivatives Trader and Options/Derivatives Strategist.

Scott Freeze, the Director of Street One, has been involved in ETF trade execution and liquidity provision since 1999 at a number of Wall Street firms and Mike Blasczyk is formerly an employee of a buy side manager, Cooke and Bieler Investment Counsel. For more information, please access our website at www.streetonefinancial.com or call 855-S1F-ETFS (855-713-3837)

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