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Morningstar's Scott Burns talks to First Trust's Eric Anderson about the 'enhanced indexing' strategy behind the AlphaDEX ...
Tags:Looking for Alpha in ETFs,alphadex etf,business tips,enhanced indexing strategy,Exchange Traded Funds,morningstar
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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.