In my last article, I presented a small study on how we now have opportunities for strategies that go beyond tracking simple broad market exposure. I mentioned investment adviser First Trust and its line of AlphaDex funds, so I figured I’d take a closer look at this strategy, how it works and how it’s been doing.
Before we dive into the methodologies, I thought I’d try out the new cool thing all the kids are doing and ask Open AI’s Chat GPT-3 what it thought smart beta investing is. I created an account and entered the following prompt: “describe smart beta investing.”
The following is what I got back:
“Smart beta investing is an investment strategy that uses alternative index weighting methods to provide investors with a different way of capturing returns. It combines traditional passive investing strategies with the idea of active management, allowing for more customized exposure to markets. Smart beta portfolios are typically constructed using quantitative models and rules-based methodologies, which can include factors such as value, momentum, quality, or volatility. This approach allows investors to benefit from market movements while still mitigating some of the risks associated with actively managed portfolios.”
Aside from some stylistic nits and adding that alternative security selection criteria are also used as well as alternative weighting methodologies, I’d say that this autonomously generated description, while fairly high level, is pretty good.
Intellidex / AlphaDex
While AI is good enough for a broad description, folks like me have yet to be made completely redundant, at this point, anyway, so here we go into the methodology.
First Trust has three broad categories of AlphaDex funds, which are Size & Style, Global & International, and U.S. Sectors. All these funds track indexes, but through quirks of history, ICE Data calculates and maintains only the U.S. Sector Indexes. You can search for these “Intellidex” and other indexes on their Index Platform. The other groups of indexes are calculated and maintained by the Nasdaq Index Group, and, while I couldn’t find a standalone methodology document, it has a dedicated AlphaDex Index page.
Despite being managed by two providers, the methodology is essentially the same across both the ICE and Nasdaq, as the selection and weighting methodologies were originally developed by First Trust. Companies are evaluated on a variety of factors grouped into the five broad categories of Price Momentum (volatility-adjusted price momentum, price/52-week high, etc.), earnings momentum (earnings estimate changes, cash flow surprises, etc.), quality (including return on equity and free cashflow margin), management action (capital expenditure changes, share buybacks and, dividend policies), and value (book value, sales/enterprise value and cash/equity). In all, roughly 50 factors were found to be statistically significant in identifying stocks that were better positioned to deliver outperformance. What I like about this approach is that analysts at First Trust took the time to model factors for each sector, meaning that they aren’t trying to simply use 50 factors to provide guidance on every company in every portfolio. Per the index methodology, each sector uses on average about a dozen factors that tie best to each segment.
Once everything has been evaluated and scored, weighting begins and can vary across the various products depending on the final constituent count. One common thread across size and style, and global and international funds is that final constituent lists are set into quintiles with higher ranking quintiles being given a higher weight with names within the quintile being weighted equally. Sector funds split final lists into what is described as “larger” and “smaller” capitalization buckets with the 16 highest-scoring larger names being given an overall 40% allocation and the 44 best-scoring smaller names representing 60% of the overall index. Once again, these names are equally weighted within their respective groups.
Wrap It Up
As you can see there are more than a few moving parts in this smart beta/factor-based approach to index/portfolio development. While I like the security selection approach here, I have to note that another thing I like about this approach is that some of these funds have been around since 2007, with the bulk of them coming to market in the early 2010s so they have a fairly long history as well.
In the “proof is in the pudding” part of this introduction, I took samples from each of the three broad categories of funds and compared them to the basic beta versions.
Source: Factset, All You Can ETF
As you can see, except for mid-cap stocks, the AlphaDex approach provided some significant advantages to fund shareholders in 2022. As we all know, and as the Financial Industry Regulatory Authority & the Securities and Exchange Commission make fund issuers state as often as possible, historical performance is not indicative of future results. I agree wholeheartedly with this statement. That said, as I laid out in the previous article, I do believe we are in a period where simple beta is not going to be as dominant as it has been through the back half of the 2010s. From my perspective, First Trust’s AlphaDex line of factor-based ETFs should help investors find that edge over broad markets now and through much of this part of the economic cycle.