Just last week I attended an Insight Forum sponsored by First Trust. Interestingly, neither First Trust nor any of the other top five fund families are based on Wall Street or even in the New York City environs. State Street and Natixis are in Boston, American Funds and Pimco are in southern California and First Trust is headquartered in Wheaton, a suburb of Chicago where I once lived.
None of these firms are known for their offerings of passive index investments, although they may be invested so close to their benchmark in some cases that they may as well be. By the way, if you don't recognize the name Natixis you will more likely recognize some of its affiliated funds like Oakmark, Oakmark International, Loomis Sayles and so on.
Remember, these rankings are based upon one year only. "One swallow does not a summer make!" it does, however, bring to the fore some offerings with which we may not have been familiar prior to seeing these rankings.
First Trust differentiates itself in two ways from most of its competitors:
(1) While the firm offers mutual funds, closed-end funds, unit trusts, variable annuities and other products, its primary offerings are in ETFs. First Trust offers 114 different ETFs that cover the waterfront. It is the breadth of its coverage and the variety of styles, many combining the best of passive and active investing, that set First Trust apart.
(2) The company has reviewed the data, studied the history and analyzed the current risks and rewards of investing in various markets and come away with the inescapable conclusion that being anything but optimistic on America and American companies is short-sighted.
As to First Trust's breadth of offerings, its AlphaDEX roster of ETFs is the one that will likely appeal most to current passive index investors. The AlphaDEX methodology is a smart beta approach to quasi-passive investing. The terms smart beta, enhanced indexing, beta plus, etc., are all different ways of saying the same thing. Beta is nothing more than a measure of volatility – it measures how a particular investment moves in relation to a benchmark index. A passive index will have a beta of 1.0. Smart beta begins with an index and applies some rules-based approach in order to select securities from that index. In particular, it seeks to provide a better risk-return profile than capitalization-weighted indexes.
This can be done in a number of ways. At First Trust the emphasis is on fundamental indexing. The idea is to avoid or at least limit exposure to overpriced stocks and increase exposure to those companies trading at more attractive valuations based upon company fundamentals. Some of these factors might include the price-book (P/B) value, price to cash flow, price-sales (P/S) and return on assets.
The philosophy behind AlphaDEX ETFs is not to provide active management but rather to provide returns from a different subset of a typical capitalization-weighted benchmark. The approach is passive in that the stock selections are completely rules based. It begins with the same broad-based index constituents that form the basis for ETFs that many passive investors buy. But the AlphaDEX rules then analyze the securities and determine if they are primarily value stocks, growth stocks or a blend.
For value stocks they rank all stocks based upon value factors like P/B value, price to cash flow and return on assets. For growth stocks, they look more to momentum, P/S and sales growth. Core (blend) securities are ranked on the higher of their value or growth ranking.
The next step is to eliminate from consideration the lowest 25% in each area and instead place its portfolio funds in the other 75%. This makes these ETFs weighted not by capitalization but by fundamental factors.
The portfolio managers aren’t finished yet. They then take those 75% of stocks still worthy of consideration and create five quintiles. The lowest 20% of the 75% receive only 6.7% of the total portfolio. The next 20% receive 13.3% of the total portfolio, the middle quintile 20%, the second-best 26.7% and the 20% with the best growth or value profile receive the highest share, 33.3%.
Then they leave it alone, exactly as passive ETFs do – except! Except they run a completely new analysis every three months and reconstitute and rebalance the portfolio to always keep the most worthy firms based upon the rules they have established as the biggest factor in the portfolios.
Here is one example of the philosophy at work, one which I own for a number of clients. The First Trust Materials AlphaDEX Fund (FXZ, Financial) –  subject to change four times per year – counts among its largest positions Owens-Illinois (OI, Financial), FMC Corp. (FMC, Financial) Canada’s Tahoe Resources (TAHO, Financial), Owens-Corning (OC, Financial), Eastman Chemical (EMN, Financial) and so on. Morningstar gives the ETF five stars and states it is below average risk with a high return profile. Mutual Fund Observer credits it with the “Great Owl” label. It has been a steady performer, much like the market itself, albeit with less day-to-day or week-to-week fireworks.
For comparison, during this period the biggest passive ETF, SPY, advanced from 210 to 245, or the equivalent of 21 to 24.50.
I like the idea of a rules-based strategy that uses the kinds of measures I also use to decide what to own – and that discards the least favorable and then reallocates on a regular schedule. It doesn’t always guarantee success, but it does well after all expenses (0.66% for those who care deeply about such things) and results in a rational approach that has shown fine results thus far.
The second thing I respect and like about First Trust is that it recognizes the distinction between politics and investing. Too many times of late I’ve had people tell me they are getting out of the market because they “just don’t trust that guy in the White House,” as if that somehow was the most compelling reason to exit the market. I try to tell them that, in my investing lifetime, I heard the same words about Presidents Nixon, Carter, Reagan, Clinton, both Bushes and Obama. And do you know what the markets did while people were avoiding it because they didn’t like the current president?
The market cares about corporate revenues, not Congress. It cares about corporate earnings, not the president. It cares about solid balance sheets, not whether the Fed is adding or subtracting 25 basis points from the Fed Funds rate.
And in these areas, American ingenuity has never been more on display and American entrepreneurs more in evidence. We hear that the U.S. is the No. 1 economic power, followed by China and Japan. But not as frequently discussed is “by how much?”
The U.S. is still the leader and is not giving ground. Shale oil and, more importantly, shale gas will enlarge the U.S.’s share of world GDP, not diminish it. While China, Japan, Germany and the rest of the world burn as much coal as ever (China), import more oil and gas than ever (Japan) or spend GDP jousting at windmills when natural gas is abundant and cheap (Germany), the U.S. just keeps rolling along. (That’s why our subscribers know that I continue to add to pipeline holdings whenever the price is right, like it is today. If government never spends a dime on infrastructure I know who will – energy firms – and I know where much of it will go – to improve and increase our nation’s pipeline infrastructure.)
This nation is on the leading edge in health care improvements, in computing, in robotics, in energy and in so many other areas. A nation that guarantees intellectual and property rights and lives under the rule of law will always dance circles around the many more numerous nations that do not. My respect for First Trust’s offerings rests upon more than its portfolio managers and rules-based and other ETFs, mutual funds and closed-end funds. It is that, rather than trying to time this or that Fed announcement or congressional or presidential faux pas, they are constantly asking, “Who is likely to increase revenues going forward? Who is likely to increase earnings? Who has the most bullet-proof balance sheets, returns the most on assets?" etc., etc.
We all know what is most important in investing. Most forget it regularly. First Trust employs a discipline that keeps these things uppermost in their minds.
Disclosure: I am long First Trust Materials AlphaDEX Fund.
