ETF.com: Is the AlphaDex methodology an easy sell to advisors?
Waldron: The thing we talk about most with AlphaDex is the simplicity of it. You sit down with a financial advisor and first, you challenge him with this notion that you should own every stock in the market, or that you should weight stocks based on market cap. This flies in the face of everything we know about stock selection and investments.
We begin with that as a perspective. We say, “Well, how about if we own the top 75 percent of the market, and we weight those stocks not based on market cap, but based on merit?” We have a six-factor model—three value and three growth—that we apply to the market. On top of that, we added our additional factors that we know have high predictive qualities. That’s designed to generate, after all the fees and expenses, risk-adjusted excess returns.
It’s easy to take the AlphaDex story and make it kind of complicated by getting into the weeds. But if you can simply tell the story that there are certain ways of picking stocks that make more sense, based on the fundamentals—this is all about fundamentals—it resonates with the financial advisor.
Issakainen: Yes, it’s a simple strategy, but that doesn’t mean it was easily accepted by financial advisors out of the gates. Certainly now that they’ve had the track record that's developed since 2007 when we launched the funds, they can look back and actually see how they performed in the worst of times as well as the best of times for equities.
That gives us a clear advantage, versus some of the newer strategies that have launched over the last couple of years, where there is an elegance and simplicity to explaining all of them, but in the real world, they haven’t had their performance tested. That track record has certainly made it easier for financial advisors to look at AlphaDex funds and understand how to use them in their portfolios.
ETF.com: Have you tried anything that hasn’t worked? Anything on which you look back and say, “This really was a bad idea”?
Waldron: I would say we do a really good job of bringing products that have long-term merit. That being said, there are some funds that haven’t raised a lot of money. For one reason or another, they haven’t gotten the attention of a financial advisor.
We’re a very patient firm—we’ve never closed a single ETF. We’ve made some modifications to some, but I don’t think there is anything on the horizon where we’re going to shutter any of our ETFs, because we feel that at some point they’ll take off.
ETF.com: Who would have ever thought that a cloud computing ETF (the First Trust ISE Cloud Computing Index fund (SKYY | B-48)), for instance, would stick? I guess patience is paying off.
Issakainen: People bashed it like crazy when it came out, saying that this was some sort of a crazy theme. But guess what? A few years later, the fund has actually performed well, it’s been embraced by certain model managers and it’s gathered critical mass in terms of assets.
ETF.com: Are there pitfalls to building an entire portfolio around AlphaDex strategies?
Waldron: We haven’t seen any yet. There are going to be periods of time when active underperforms. Last year, all of the beta guys were pounding their chests because it was a great year for beta. But the fact of the matter is it goes back and forth.
Fundamentals always matter. Good active managers will always do better—in the long haul—than their benchmarks. We like to consider ourselves in that category. But there will be periods of time when we don’t meet the benchmark, and that’s when we hear “I told you, it doesn’t work.” Last year was a great example.
But if you look at market variance, there will be periods like last year where market variance is so low, and it’s really hard to find outperformers, because the standard deviation of the market is very narrow. But we come back with another year.
ETF.com: You have to agree that it’s tough to argue against, say, a SPIVA report. SPIVA is such an indictment against active management year over year over year.
Waldron: It drives me crazy. The problem is that most people use mutual funds as a proxy for that debate. When you look at what goes on with the mutual funds—whether it’s expense ratio, the money that sits in cash, the capital gain implications outside of a qualified account—we unfortunately join in on the criticism of these actively managed mutual funds. But at the end of the day, that should not be the proxy for active management.
You can outperform. It’s not easy. You have to be disciplined about it, and you have to ride out the good and the bad periods. That's really what AlphaDex offers somebody who believes in active management but doesn’t want to pay all of those expenses in tax inefficiency.
We’re about half of what you’d pay for a typical mutual fund in terms of expense ratio. But we’re delivering that risk-adjusted excess return that the financial advisor is looking for.
But there is an important point we make all of the time. No. 1, AlphaDex does not work all of the time. It works over time. It’s about following the strategy of finding cheap value stocks, finding good momentum growth stocks and holding them for months, at least, and revisiting.