Not All Smart Beta ETFs are Perfect

Traditional market capitalization-weighted funds are still the dominant offerings in the world of exchange traded funds, but data continue to point rapid, accelerating growth for alternatively-indexed ETFs.

One of the largest lineups of alternatively-weighted ETFs hails from First Trust by way of the firm’s AlphaDEX funds. AlphaDEX may imply a level of complexity that belies the ease of understanding and use of these ETFs.

“Starting with either a market-cap segment or a sector, AlphaDEX funds group all stocks into a value bucket or a growth bucket based on the S&P style designation. Separate models are applied to the value stocks and to the growth stocks. Stocks that S&P classifies as core take the higher score from the two models,” according to Morningstar ETF analyst Michael Rawson.

Well-known AlphaDEX ETFs, such as the First Trust Technology AlphaDEX Fund (NYSEArca: FXL) and the First Trust Energy AlphaDEX Fund (NYSEArca: FXN), are home to stocks that are selected based “based “on growth factors 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,” according to First Trust.

While some investors have previously taken a wait-and-see approach to smart beta ETFs, First Trust’s growth trajectory, helped in large part by the AlphaDEX suite, is astounding. At the end of 2012, the firm was the eleventh-largest U.S. ETF issuer. Today, it is up to number six with close to $28 billion in assets under management. [AlphaDEX Drives First Trust’s Growth]

Some AlphaDEX ETFs have delivered the goods in terms of returns, earning praise along the way.

“Of the 23 First Trust AlphaDEX market-cap and sector funds (excluding the international AlphaDEX funds), the average Morningstar Rating is 4 stars, which is truly impressive,” notes Rawson.

Today, the AlphaDEX lineup is comprised of 18 global or international ETFs, nine sector funds and 12 size and style funds.

Even with asset-gathering and performance success of select AlphaDEX ETFs, investors should realize that there is no such thing as a free lunch on Wall Street. Said differently, not every AlphaDEX ETF is guaranteed to be a better replacement for its cap-weighted counterpart. [Forgotten Smart Beta ETFs]

Take the case of the First Trust Large Cap Core AlphaDEX Fund (NYSEArca: FEX). Clearly, there are money managers and investors that like FEX as $363.4 million of the ETF’s $1.1 billion in assets under management have come into the fund just this year. FEX is up about 8.5% year-to-date, but as Rawson notes, the ETF is not perfect.