ETFs owe much of their success to providing investors with exposure to asset classes that have been difficult for them to access in the past. ETFs that offer a way to invest in international and emerging markets have proved particularly popular, because those markets have not been available to investors without the help of a professional fund manager.
As innovative and exciting as these ETFs are, they are typically based on indices designed to reflect the investable universe of a particular market, sector, or investment style. These indices tend to change very little year after year.
A new breed of ETF has emerged, however, based on indices that are designed not to reflect the investable universe of a particular market niche, but to pick the best stocks within a specific sector or style. These indices use a series of screens or follow a set of rules to manage the portfolio in hopes of outperforming the broader market.
There are dozens of ETFs based on indices that use quantitative methodology to select their components. In terms of assets under management, the largest of these is the First Trust Materials AlphaDEX ETF, which has about $490 million in assets, according to company data. This ETF is one of about 15 such ETFs First Trust operates that target other sectors, as well as style/size categories. These ETFs use the proprietary “AlphaDEX” methodology, which screens stocks from the Russell 1000 into three groups: growth, core/blend and value. It ranks stocks in each group according to a scoring method that uses various financial metrics such as price/book ratio or one-year sales growth, and then eliminates the bottom 25%. Of the remaining stocks, the top 20% get a 33% weighting, while the bottom 20% get only a 6.7% weighting. The index is reconstituted and rebalanced quarterly.
All well and good, but the proof is in the performance. Since its inception in May 2007, the materials fund posted an average annualized gain of 6.22% as measured by its net asset value (which includes the effects of fees), compared with 1.48% for the materials sector of the S&P 500 and -2.36% for the Russell 1000 (which do not include fees). Over the three-year period ending Dec. 31, 2010, the fund returned an average of 4.32% annually at net asset value, compared with negative returns for the S&P 500 materials sector or the Russell 1000.