Structure Matters: AlphaDex in Europe

March 06, 2014

First Trust’s Issakainen discusses how the firm’s methodology applies its value model.

“Structure Matters,” by Dan Weiskopf, portfolio manager of Access ETF Solutions, examines issues about ETF structures in a series of interviews with ETF portfolio managers, index developers and other people who affect the structure of ETFs. The goal of the series is to highlight the different operating roles that individuals have that make the ETF structure work well for the investor.

In this installment, Weiskopf interviews Ryan Issakainen, senior vice president and ETF strategist at First Trust, one of the key people who work behind the scenes to make sure the strategies managed by First Trust work efficiently and effectively. In this interview, we focus on Europe, and use a sample list of six different ETFs that provide advisors direct exposure to Europe.

Dan Weiskopf: The portfolio allocations across European countries, sectors and market-cap size are very different. How does the AlphaDex methodology work for Europe?

Ryan Issakainen: The First Trust Europe AlphaDex fund (FEP | C-38) diverges from other broad Europe ETFs primarily due to the rules-based, multifactor model by which FEP’s underlying index selects and weights its portfolio. Rather than allowing the relative market capitalization of stocks in the index to determine portfolio allocations—which is the model followed by most traditional index ETFs—the AlphaDex methodology selects and weights stocks on the basis of investment merit.

After establishing the universe from which the AlphaDex methodology selects stocks, which in this case is the S&P Europe Broad Market Index (BMI), stocks are scored based on both a value model and a growth model. The better of the two scores becomes the stock’s “selection score,” and the 200 top scoring stocks are selected for the index.

Value and growth models are scored separately because of the intuition that there are different attributes that tend to drive performance for value stocks versus growth stocks.

The value model scores stocks on three separate factors: price-to-book ratio; price-to-cash-flow ratio; and return on assets. The first two factors identify cheap stocks relative to certain fundamental measures (book value and cash flow). We think of return on assets as a good indicator of balance sheet quality.

The growth model, on the other hand, is built upon the foundation of the so-called momentum anomaly. Once again, momentum is a factor that academics have studied for years. What they’ve established is that, as counterintuitive as it may seem, stocks that have performed best in the recent past have a tendency to continue to outperform.

So the AlphaDex growth model ranks stocks based on three-month, six-month and 12-month price appreciation. As these fundamental improvements persist, investors end up chasing stock prices higher.

In addition to the three momentum factors, the model also scores stocks based on one-year sales growth. This helps to identify companies whose momentum has fundamental underpinnings, rather than just market speculation.

Lastly, the growth model scores stocks based on price to sales ratios. The purpose for this valuation factor is to help temper the price multiple that certain momentum stocks can trade at.

The First Trust Europe AlphaDex Fund applies this methodology to the S&P Europe BMI universe. Value stocks are given a “value” score, and growth stocks are given a “growth” score. The 200 highest scoring stocks are then included in the portfolio, with weightings determined by how well stocks scored in the model.

The end result, when compared with other traditional market-cap-weighted indices, is a portfolio that favors stocks that have the value and growth characteristics I described, as opposed to a portfolio that favors stocks that are have already grown to be the largest companies in Europe or another market segment.

 

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