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Rise of Smart Index ETFs

NEW YORK (TheStreet) -- ETFs that employ quantitative indexing strategies shouldn't be overlooked by investors.

These products cover the same slices of the market as plain vanilla index ETFs, but rather than offering investors a "dumb" market-capitalization-weighted index, provide a "smart" index designed to outperform the market.

One of the most important strengths of quantitative index ETFs is the dynamic aspect of their portfolios. A fund using a valuation measure such as price-to-earnings, for instance, would sell expensive stocks and buy cheap stocks when it reallocates.

However, this can be considered a drawback in terms of transparency. The portfolio you purchased a few weeks ago may not be the same as it is today if the fund went through a rebalancing. For instance, the First Trust ISE-Revere Natural Gas Index (FCG), which uses some valuation methods to determine which stocks to include in the index, recently rebalanced and added several large integrated oil companies.

While I believe that FCG is still a good option for playing natural gas because its portfolio holds many smaller natural gas companies, investors need to realize that when they purchase a quantitative index ETF, they are buying a strategy, not necessarily a portfolio of stocks. The strategy may stay the same, but the portfolio will change, sometimes substantially.

PowerShares Intellidex lineup and First Trust AlphaDEX funds use multifactor models that can include earnings, dividends, valuation and performance.

Within the PowerShares Intellidex model are four "perspectives": valuation, timeliness, fundamentals and risk.

The valuation perspective consists of seven factors designed to determine whether a stock's price is undervalued based on its price relative to its current earnings and expected growth.

Timeliness uses seven factors to determine the short-term attractiveness of a company's shares based on investor sentiment and recent changes in investor expectations regarding the stock.

The fundamental perspective uses seven criteria, including earnings sustainability and operational efficiency, to evaluate the financial strength of a company.

Finally, the Intellidex's risk perspective examines the risk-reward profile of a company using both fundamental and technical market measures of investment risk.

For AlphaDEX, the calculations are slightly different. For instance, to constitute the index for its Large Cap Core AlphaDEX Fund (FEX), each stock in the S&P 500 is first ranked according to its three-, six- and twelve-month price appreciation, sales-to-price ratio, and one-year sales growth.

Next, the stock is evaluated according to its book value-to-price and cash flow-to-price ratios, as well as its return on assets. The bottom 25% of stocks are eliminated, and the remaining 75% of stocks are split into quintiles, with the top quintile receiving 5/15 of assets and successive quintiles receiving 4/15, 3/15 and so on. The stocks are equally weighted within each quintile.

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