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Examiner
  • Ron Finke: How do ETFs select the right stocks?

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  • Last week I focused on improving investing results by emphasis on best performing sectors and industries. First Trust Portfolios L.P. of Wheaton, Ill., has also developed an improved form of indexes to use.
    First let me define an ETF. This stands for exchange-traded fund. It is a mutual fund because it contains a basket of different stocks (or bonds or whatever the investment for other ETFs.) There is one that includes the Dow 30 Industrials called the SPDR Dow Jones Industrial Average ETF (symbol DIA), and one with the 500 largest companies’ stocks, SPDR S&P 500 Trust Series ETF (symbol SPY). They are exchange traded because they trade on the market exchanges at different prices all day long like individual stocks.
    Traditional indexes and ETFs such as the S&P 500 include every component company stock and weight them by their relative market value. Therefore, the value of that index is most affected currently by the performance of Apple, Exxon Mobil, Google, Microsoft and GE, the five biggest by value.
    The other issue is performance itself. If you own all 500 company stocks by owning the index, then you own all the winners and all the losers. For example, Microsoft is higher by 34 percent in the past 12 months, but IBM (14th largest) is down by 7 percent. Therefore, the question arises: If you could have a way of weeding out the worst performers and emphasizing the winners, why would you not use it?
    Now back to First Trust and its effort. Based upon a collection of fundamental valuation factors, its strategy sorts the stocks into fourths or quartiles. The first cut throws out the entire bottom quartile of stocks. They are not in the mix at all.
    The remaining 75 percent are then divided into quintiles. The 20 percent of stocks with the best fundamentals get pumped up to 33 percent of the total fund value. The 20 percent with the lesser quality fundamentals are reduced to 6.7 percent of the total. This process is performed each quarter, and the portfolio is changed accordingly. Voila. You have a trend-following-passive ETF that might get better gains in good times and reduced losses in bad times.
    First Trust calls this process AlphaDex and has it patent protected. Does it work? Thus far, the answer is usually, but not always. Through Sept. 30, 2013, in the past year, 35 of 39 ETFs outperformed regular indexes by an average of 4.7 percent. The S&P 500 AlphaDex (FEX) outperformed the benchmark total return by 7.3 percent in that 12-month period. But the three years of results ending this past Sept. 30 gave a 0.3 percent margin per year in favor of the regular index. Over five years, FEX wins by 2 percent per year.
    As you know, past performance is no guarantee of future results. This information is general in nature and does not constitute specific advice for anyone. The website for more information is www.ftportfolios.com. Click on ETF’s and look for AlphaDex. Stewardship Capital owns some of these in its client portfolios at the present time.
    Page 2 of 2 - Ron Finke is president of Stewardship Capital in Independence. He is a registered investment adviser. Reach him at rcfinke@stewcap.com.

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