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.
Looking at 3-year annualized returns, I compared First Trust, PowerShares and SPDR funds in the same sector (one fund each of eight sectors, or 24 total). There were some major wins for the "smart" indexes in financials. PowerShares Dynamic Financials ( PFI) and First Trust Financials AlphaDEX ( FXO) suffered three-year annualized losses of less than 10%, while Financial Select Sector SPDR ( XLF) had a three-year annualized loss of more than 20%. In most cases the results were more mixed, but the First Trust AlphaDEX funds generally did slightly better. Of the eight sector ETFs where there is crossover, the results are mixed. Head to head between the quantitative indexes, First Trust won 75% of the time. Adding in the market-capitalization-weighted SPDR index, First Trust has four wins out of the eight sector groups, while PowerShares wins one and the market-cap-weighted index takes the other three. However, performance was inconsistent. For instance, in the energy sector, Energy Select Sector SPDR ( XLE) performed much better during the crash in 2008, but since the bottom, both the PowerShares ( PXI) and First Trust ( FXN) quantitative funds outperformed. Similarly in health care, the period since the market bottom in March 2009 has generated the bulk of the outperformance in First Trust Health Care AlphaDEX ( FXH), the best-performing fund of the 24 I examined. At this point, the record appears inconclusive and neither lineup can claim total victory. What does jump out is the fact that the difference between the various sector ETFs tends to be larger than the difference between the various indexing strategies. If an investor picked any consumer staples ETF, that investor did much better than holding financials, for example, over the past three years. The other pattern is that these funds are streaky. One of the best examples from the past two years is the PowerShares Dynamic Banking Portfolio ( PJB). The fund beat the SPDR KBW Bank ETF ( KBE) by more than 20% during the market crash, falling 60% from its inception in October 2006 versus the more than 80% drop in KBE over the same period. From the March 2009 bottom, however, KBE trounced PJB, gaining more than 150% versus about 30% for PJB. Since inception in October 2006, PJB is down about 46% compared with a 53% loss in KBE.
This year through August 10, the S&P 500 consumer discretionary sector was up 7.5%, but PowerShares Dynamic Leisure & Entertainment ( PEJ) gained 11.6%. While the long-term performance verdict has yet to come in, investors who use momentum or short-term trading strategies should have quantitative indexes on their radar. -- Written by Don Dion in Williamstown, Mass.
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