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Strategic Beta: Taking the Alpha Out of AlphaDEX

At first blush, this fund's strategy appears complex, but it is essentially a combination of traditional factors and equal weighting.

Michael Rawson, CFA, 07/18/2014

Perhaps the biggest surprise in fund flows for exchange-traded products during the past year is the strength of First Trust. The firm has catapulted itself from the 11th largest provider of exchange-traded products to the sixth largest in just one year. Much of the strong flows are accumulating to funds that have been around for years. What has changed is the increasing acceptance of strategic beta. While they may track an index, strategic beta funds are active, so it is no surprise that investors might take a wait-and-see approach before investing, particularly when the methodology appears to be complex and untested. However, of the 23 First Trust AlphaDEX market-cap and sector funds (excluding the international AlphaDEX funds), the average Morningstar Rating is 4 stars, which is truly impressive. Unlike some single factor funds, the methodology behind AlphaDEX is fairly opaque, but their performance warrants a deep dive. 

Starting with either a market-cap segment or a sector, AlphaDEX funds group all stocks into a value bucket or a growth bucket based on the S&P style designation. Separate models are applied to the value stocks and to the growth stocks. Stocks that S&P classifies as core take the higher score from the two models. The model used on value stocks includes book value/price, cash flow/price, and return on assets. Growth stocks are scored using three-, six-, and 12-month price appreciation, sales/price, and one-year sales growth. What is unique about this approach is that value models typically would not use return on assets, which is usually regarded as a quality measure and growth models typically would not use sales/price, which is more of a value measure. While traditional style funds typically split stocks into separate value or growth groups, this fund retains top-scoring stocks from both models. The result of using different models for value and growth stocks and using unique factors is a balanced portfolio with only a slight tilt toward value, yet with growth characteristics similar to a blend fund. 

After ranking stocks by the appropriate model, the top 75% of companies are included in the final portfolio and the bottom 25% are eliminated. The remaining stocks are sorted into quintiles, and stocks in the best-scoring quintiles receive larger weights than stocks in lower quintiles. Stocks are equally weighted within each quintile. This weighting methodology shares some characteristics with equal weighting in that it results in a tilt toward smaller-cap stocks and it rebalances back toward these target weights.

Suitability
First Trust Large Cap Core AlphaDEX FEX is a suitable core equity holding for investors looking to tilt toward mid-cap and value stocks. This fund attempts to outperform traditional market-cap-weighted indexes. Despite its complex methodology, the fund provides no discernible edge beyond what is obtained through traditional size and value tilts. Those exposures are available more cheaply and transparently through other funds.

The weighting methodology results in an average market capitalization of $21 billion, nearly one fifth of the $100 billion average for the large-blend Morningstar Category. The fund has 44% of assets in mid-cap stocks compared with just 16% for the category average. Within the Morningstar Style Box, the fund has 24% of its assets in mid-cap value stocks, the most among the nine partitions. 

The strategy's mid-cap and value tilts do not come without risk. Since inception, the fund has had a volatility of 19%, 2 percentage points greater than the S&P 500. It also fell more than the S&P 500 Index during the financial crisis in 2008. Still, it has offered decent performance, and investors have been compensated for accepting this greater risk--at least during the past several years. While the fund has outperformed the large-blend category to which it is assigned, most of that outperformance can be explained by its significant tilt toward mid-cap stocks. Investors might be disappointed if mid-cap stocks start to lag.

Fundamental View
A number of indicators suggest that the U.S. stock market is no longer attractively priced. At 18.6 times trailing earnings, the current price/earnings ratio for the S&P 500 Index is above its median level of 16.0, dating back to 1947. In the past, when the valuation multiple has been above its long-term average, future returns have tended to be lower versus periods marked by a below-average valuation multiple. With its mid-cap and value tilts, the current price/earnings valuation for this fund is slightly lower, at 16.9 times. 

Morningstar equity analysts cover 340 out of 376 stocks in FEX, accounting for 90% of the assets. They build discounted cash flow models for each stock and assign a fair value estimate, which can then be aggregated to the fund level. Based on their fair value estimates, the fund is currently trading at a price/fair value multiple of about 1.06. That is slightly higher than the corresponding figure for the S&P 500 (1.03).

Michael Rawson, CFA is an ETF Analyst with Morningstar.
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