First, Trust Russell

September 13, 2006

Waldron hopes advisors will use the new sector funds to execute traditional asset allocation strategies; the excess returns will simply juice the performance of those strategies.

Will The Alpha Be There?

The big question is: will they deliver?  First Trust and Russell will unveil 10-year historical data for the AlphaDexes in the coming weeks, but I can let you in on a little secret: the performance will look good.

I say that not because Waldron gave me a sneak peak at the data - although he did, mentioning that the Energy AlphaDex outperformed the S&P 500 Energy segment by 10 percent over the past three years - but because you simply do not launch quant strategies onto the market with weak historical data. Quant strategies are developed in the rear-view mirror all the way; I'm guessing the historical data will have returned a few extra percent a year with a little less volatility. The real proof will be in the long-term, live performance data.

The Methodology

With that said, one of the best things about the new filings is that the methodology is transparent.  Many existing "enhanced index" and quant-driven ETFs use a "black box" strategy, offering only a vague description of how the funds works. The PowerShares/AMEX Intellidex indexes, for instance, use a proprietary combination of 15 data points … they just won't say exactly which 15.

The new Russell AlphaDex methodology, in contrast, is open, even if it is a bit complicated.  Here's how it works:

The index starts with all the stocks in the Russell 1000, which is then divided into ten major sectors. First Trust is only launching funds based on nine of these sectors; it says that there are not enough Communications stocks to run the AlphaDex strategy in that space.

Within the nine live sectors, however, stocks are divided into three buckets: growth, value and core/blend.  Within each of those categories, Russell ranks the stocks based relevant metrics - in other words, it tries to pick the best value stocks, the best growth stocks and the best core stocks.

For value, that means measuring companies based on three metrics: cash flow/price, book/price and return on assets.  Growth stocks, in turn, are ranked based on one-year historical sales growth and price momentum (stock performance measured over the past 3-, 6- and 12-months). Russell says that the price momentum is used to "confirm" the information in the sales growth: if a company's sales are rising but the stock is going down, something funny is happening.

Core/blend stocks are ranked based on both the growth and the value metrics, and are then assigned whichever score comes out higher.

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