Scott Burns: Looking for alpha in ETFs. I'm Scott Burns, director of ETF
analysis with Morningstar. Today I'm joined with Eric Anderson
from First Trust Group. Eric is an ETF analyst with First Trust.
Welcome to Morningstar.
Eric Anderson: Thank you.
Scott Burns: You guys have a very interesting lineup of ETFs out there called
the AlphaDex Series. It's kind of this enhanced indexing strategy
out there, where as a group you're using quantitative strategies to
try and generate alpha, which is opposed to what we generally see
in the ETF world, which is more just pure beta. Why don't we talk
about the reason for alpha and what you guys see out there?
Eric Anderson: Sure. Thank you. 16 of our 40 ETFs that we have out there are
based on the AlphaDex methodology, following seven different
styles and nine different sector focuses. And really what we're
doing with AlphaDEX, I think you put it very well, is enhancing
indexing. It's still a rules-based strategy in that we follow a
systematic program every three months when we're rebalancing the
strategies, but we're taking a different look at the market, whether
it be a sector or consumer discretionary sector, or a style such as
large-cap core.
We're saying in the S&P 500 there are stocks that you want to
own, and there are stocks that you don't want to own. Instead of
just basing our weighting on the market capitalization of stocks
within that index, we're going to say what are the fundamental
factors that seem to drive performance?
So, we look at stocks either from a value perspective or from a
growth perspective. We think there are three very simple factors in
each of those lenses that tend to drive performance, or predict
performance to a certain extent, over the shorter term.
Scott Burns: So, those are factors. We take a look. We take growth. We take
value. You have your kind of basic sector, and then the
quantitative engine is looking at three factors inside of each of
those and bringing that back into the final decision, basically.
Eric Anderson: Right, and that's really what's going to drive the stocks that we
decide to not hold, the stocks that we decide to give an overweight
to. But the fundamental difference is, instead of just looking at
market capitalization as a merit or a reason for basing your
weighting, we're going to look at those factors that tend to drive
performance and have predictive value.
Scott Burns: So it really is active strategy. I always describe these as sort of
active indexes. The SEC may not call it active, but I call it active.
Eric Anderson: Right. It definitely can be considered active. I think one distinction
that's worth making is that it is rules-based and it is very
transparent. As portfolio managers we're not going to be picking
stocks--at the end of the quarter we're not going to say, "I like
Apple " or "I like Microsoft this quarter," because of this or that.
The strategy, the rules-based strategy that's very transparent and
very well-known is what's going to drive the selection each
quarter.
Scott Burns: Right. So when we look at the value lens, you're looking for
components like price-to-book.
Eric Anderson: Price-to-book, price-to-cash, and return on assets: Those are
factors that have a wide body of research around them, and tend to
drive some performance, tend to have predictive value.
Scott Burns: Now on the growth side, I think it's interesting you actually have a
momentum, a price momentum factor in there. What's some of the
rationale behind that?
Eric Anderson: Price momentum is really one of the number one indicators of
performance for growth stocks. It's a big part of why it's in there.
Again, there's a wide body of literature around price momentum
driving growth stocks. But in addition to price momentum, we also
want to look not just at how the stocks are doing over the last three
months, six months, or 12 months, but also is the price-to-sales
multiple--is that good? It's kind of a little bit of a barometer there
that's going to lessen the volatility.
Scott Burns: Kind of a governor?
Eric Anderson: Exactly, a governor.
Scott Burns: On letting the momentum run too much.
Eric Anderson: Yeah, exactly.
Scott Burns: It's interesting; I know these funds are actually coming up on their
three-year anniversary, which means that they're...
Eric Anderson: Next May.
Scott Burns: Next May. So we should expect Star Ratings on them in June. How
overall have they been doing, and what are we looking at?
Eric Anderson: They've done very well. We've benefited from 2009. As the
market's come back, we've come back even more, and there's
plenty of excess returns or alpha, which is really what we're trying
to deliver. 2008 was a little bit of a harder year, as it was for
anyone in the equity markets, but we've more than made that up in
2009. So, we're really excited about the three-year track record
coming. We think it's going to be a positive thing.
Scott Burns: That's great. I will say one thing, when we look at the AlphaDEX
strategy and analyze it, that it's worth noting--and investors should
really be comfortable with--is that when you're using these you're
going to get a tilt away from the cap-weighted beta. You're going
to get a little more mid-cap, a little more small cap, and they're
naturally going to have just a little bit more than that. Investors
need to make sure that they're comfortable with that exposure.
Eric Anderson: Yeah, definitely, taking our large-cap core example, FEX is our
large cap core, and it's based on the S&P 500. So, we're still going
to hold S&P 500 stocks. We're going to hold 75% of that S&P 500
universe each quarter, quarter to quarter, but we're going to weight
them a little bit differently. We're going to invariably underweight
Exxon Mobil and Chevron, and we're going to tend to overweight
some of the smallest stocks in the S&P 500. So, we will have a
little bit of a lower capitalization bias.
Scott Burns: Right. And depending on the markets, we can see in ‘08 that being
out of large caps, unless it was financials, hurt a little more. And in
'09, during the junk rally, that definitely was the place to be.
Eric Anderson: And we definitely think that's something that, over the long term,
you want to consider investing in, smaller-capitalization stocks.
Those are the stocks that are more agile, that are more often going
to be the target of acquisition activity and typically have a better
ability to capitalize on market conditions.
Scott Burns: Eric, thanks for joining me.
Eric Anderson: Sure.
Scott Burns: We think the strategy is very interesting, and we're excited to see
where the chips fall when the Star Ratings come out in June.
Eric Anderson: We're looking forward to it. Thanks, Scott.
Scott Burns: I'm Scott Burns, director of ETF research with Morningstar. For
this and other ETF information, please check out
Morningstar.com's ETF Center and Morningstar's ETF Investor
newsletter. Thanks.