ETFs: Inside Look at Enhanced Indices

NEW YORK ( ETF Digest) -- Typical ETFs can only hope to do as well as the index that they track, but they don't necessarily need to be married to the same weightings. ETFs that track specialized indices can provide the breadth of a common index, but with weighting criteria that may differ substantially from "the norm."

Many enhanced ETF issuers, such as First Trust and PowerShares, apply quantitative analysis to determine how they should balance an index's constituents. They may take under consideration price-to-book, dividend growth, price-to-earnings, and any number of other variables in their calculations.

A "normal" index such as the S&P 500, for example, is used to indicate the aggregate strength of the 500 large-cap companies that are listed on it. These companies are then in turn weighted by their market capitalization. SPY, which follows and tracks this index, is weighted accordingly.

First Trust, though, has a series of what it calls AlphaDEX ETFs, which follow specialized indices. They cover everything from individual countries, to market sectors, to investment styles, but the way the indices are weighted is decidedly more complicated.

Take the First Trust Energy AlphaDEX Fund (FXN), for example. Its investment objective is to track the StrataQuant Energy Index (STRQEN), which is sponsored and maintained by NYSE Euronext. STRQEN begins with the Russell 1000, and uses a series of criteria, including "three, six and 12-month price appreciation, sales to price and one year sales growth, and, separately, on value factors including book value to price, cash flow to price and return on assets" to begin the complex weighting process , which has an additional four or five steps. With all of that maneuvering involved, perhaps its high expense ratio should be no surprise: 0.70%.

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In the last six months, FXN (green) has underperformed the Russell 1000 Energy Index (orange), but it outperformed the index for much of 2011.

PowerShares also deals extensively in enhanced index ETFs such as its PowerShares Dynamic Market Portfolio (PWC). PWC's investment objective is to track the Dynamic Market Intellidex (DYI). DYI in turn attempts to select U.S. companies "with superior risk-return profiles." According to AMEX , DYI is "composed of stocks selected quarterly based on a proprietary quantitative method." What exactly this "proprietary quantitative method" actually consists of they leave to our imagination, although PWC's fact sheet states that the index (DYI) factors in "fundamental growth, stock valuation, investment timeliness, and risk factors." PWC also has a relatively high expense ratio of 0.60%.

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PWC (red) tracks the relatively opaque Dynamic Market Intellidex (DYI). It has consistently underperformed the S&P 500 (blue) over the last 6 months.

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Over the long term, it does appear that PWC has outperformed the market on several occasions.

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