AlphaDEX ETFdb Portfolio

Published on September 20, 2011 | Updated February 5, 2014

Portfolio Strategy

Long Time Horizon

The AlphaDEX ETFdb Portfolio is designed for clients who wish to construct a well-rounded portfolio comprised of funds which employ the proprietary AlphaDEX methodology. This “quasi active” investment strategy, which selects only the most appealing companies based on a variety of fundamental factors from popular benchmarks, may be appealing to investors who believe this methodology has the potential to generate alpha over the long haul relative to traditional cap-weighting strategies.

Traditionally, index funds are market cap-weighted, leaving them prone to some significant drawbacks. One common criticism is that the underlying portfolio employs a passive investment approach that can be best described as “bigger means better”. By nature, cap-weighted indexes determine the allocation given to each security based on the company’s market capitalization–and therefore the price of the stock– resulting in a tendency to overweight overvalued companies and underweight undervalued stocks.

The AlphaDEX methodology avoids such pitfalls by undertaking a fundamental analysis approach, and selecting only the stocks deemed to maintain the greatest potential for capital appreciation. Even if markets are assumed to be efficient, they are by no means immune to speculation. Stocks prices are subject to factors that can cause their share price to deviate (sometimes greatly) from the company’s true value, which has lead to the increasing popularity of fundamental indexing strategies amongst equity investors.

The AlphaDEX methodology undertakes an enhanced indexing approach that seeks to generate positive alpha relative to comparable broad-based passive indexes from which it selects stocks. This strategy is inherently passive, as no active judgment is made when evaluating the companies in the screening process; each step is completely transparent and quantitative. The fundamental criteria that are considered during the screening  process and used  to evaluate price momentum include book value-to-price, cash flow-to-price and sales-to-price ratio. From these rankings, the bottom 25% of stocks are cut out, while the top 75% are included in the benchmark. Those with the highest scores get the biggest weightings, while the lower scores receive a smaller allocation.

Historical performance shows that the AlphaDEX methodology most certainly offers the potential to generate alpha over time. For example, during the market rebound in 2009, FEX, which selects stocks from the S&P 500 index, outperformed its benchmark index by as much as 1000 basis points.

The AlphaDEX ETFdb Portfolio similar to traditional investment portfolios in the sense that exposure is tilted towards equities, although fixed income holdings certainly play a key role in rounding out exposure across all asset classes.This portfolio is likely too risky for retired investors given its fairly sizable allocation to international equities, but may appeal to those with a longer-term bullish outlook on the global economic recovery who can stomach the volatility. The risk/return profile of this ETFdb Portfolio may be altered by changing the split between stocks and bonds.

  • Risk Tolerance: Moderate. This portfolio has a sizable allocation to equities, however, the AlphaDEX methodology certainly helps to reduce volatility by giving greater weights to the more promising stocks from the underlying index.
  • Time Horizon: Long. The benefits of this alternative methodology are best realized over the long haul, resulting in an portfolio strategy geared for those with a long-term investment horizon.
  • Current Income Needs: Moderate. The fixed income holding of this portfolio pays a monthly dividend and generates a fairly attractive yield given its inclusion of international bond market segments.

Portfolio Snapshot

Below are the holdings and allocations for the AlphaDEX ETFdb Portfolio. For each ETF included in this portfolio, we have also provided alternative funds that offer similar exposure.

Ticker ETF Asset Type Allocation Expense Ratio Alternative ETFs
FEX Large Cap Core Domestic Equities 10% 0.70% SPY
FNX Mid Cap Core Domestic Equities 10% 0.70% IJH
FYX Small Cap Core Domestic Equities 10% 0.70% IJR
FEM Emerging Markets International Equities 20% 0.80% GMM
FDT Developed Markets Ex-US International Equities 20% 0.80% GWL
FWDB Madrona Forward Global Bond ETF Fixed Income 30% 0.95% n/a
Weighted Average Expense Ratio     0.82%  

Historical Return Analysis

Ticker 2009 2010 2011 2012 2013
FEX 36.8% 20.7% -0.4% 14.5% 36.0%
FNX 46.8% 26.6% 0.8% 14.0% 37.9%
FYX 37.8% 27.4% -0.4% 15.4% 43.2%
FEM n/a n/a n/a 21.2% -3.3%
FDT n/a n/a n/a 15.8% 18.6%
FWDB n/a n/a n/a 8.2% -2.2%
Portfolio n/a n/a n/a 14.3% 13.9%
Compare to SPY 26.3% 15.0% 1.8% 16.0% 32.3%
Compare to AGG 3.3% 6.4% 7.7% 3.8% -2.0%

The adjacent table provides historical results for each component of this ETFdb Portfolio, as well as backtested results (as available) for the entire portfolio From 2008 to 2012. The table also shows how this ETFdb Portfolio performed relative to a popular stock market benchmark (SPY) and bond benchmark (AGG).

Following the most recent financial crisis its not much of a surprise to see that domestic equities took a nosedive lower. Notice the importance of staying diversified across market cap levels, seeing as how in the following years of recovery, mid cap stocks lead the way higher by as much as 1000 basis points ahead of large and small cap equities.

Although performance data is not available, investors can expect for FWDB to exhibit lower volatility and produce uncorrelated returns, serving as an essential tool that can help improve this portfolio’s overall risk-adjusted returns.

Portfolio Expenses

This ETFdb Portfolio is designed for long-term use consistent with a “buy, hold, and rebalance” strategy. As such, minimization of expenses is necessary to avoid return erosion resulting from compounding costs. To this end, we constructed a portfolio with a weighted-average expense ratio of 82 basis points, which is higher than many other ETFdb Portfolios but still significantly lower than fees charged by actively-managed mutual funds. The impact of this reduced cost structure over a hypothetical time horizon of 30 years is significant:

    Growth of $1 Million Over 30 Years @ Annual Return Of:
Portfolio Expense Ratio 5% 10% 15%
AlphaDEX ETFdb Portfolio 0.82% $3,421,022 $13,960,126 $53,489,888
Actively-Managed Mutual Fund Portfolio 1.00% $3,243,398 $13,267,678 $50,950,159

Holdings Overview

Below is a brief overview of each component of this ETFdb Portfolio.

  • FEX: This ETF uses the AlphaDEX methodology to select stocks from the ultra-popular S&P 500 Index.
  • FNX: This ETF tracks the performance of select stocks from the S&P 400 MidCap Index.
  • FYX: This fund tracks the performance of select stocks from the S&P SmallCap 600 Index.
  • FEM: This ETF tracks the Defined Emerging Markets Index, which is a modified equal-dollar weighted index designed by S&P to objectively identify and select stocks from the S&P Emerging Markets BMI Index.
  • FDT: This fund tracks the performance of  select stocks from the S&P Developed Markets Ex-US BMI Index that may generate positive alpha relative to traditional passive-style indices through the use of the AlphaDEX selection methodology.
  • FWDB: This one of a kind product is structured as an ETF of ETFs and is benchmarked against  the Barclays Capital Aggregate Bond Index.

Portfolio Risk Analysis

This ETFdb Portfolio spreads its exposure across the risk continuum, including significant weightings to domestic and international equities as well as a healthy allocation to the global bond market. Thanks to the fundamental screening process employed by all of the products included, the result is a portfolio with moderate risk exposure and well-diversified holdings.

Equity funds with mainly large-cap equity holdings, like FEX, are towards the “safer” end of the spectrum, while emerging market exposure, represented by FEM, introduces a greater level of risk in this portfolio.

Equity Overview

This ETFdb Portfolio contains an allocation of 70% to equities, including both domestic and international stocks. From a market capitalization perspective, this ETFdb Portfolio’s equity component is very well diversified across both large, mid, and small cap size equities, achieving diversified exposure that is essential for those with a longer-term investment horizon.

The equity portion of this ETFdb Portfolio is slightly tilted towards international stocks, although as a whole exposure is equally split between foreign and domestic equities. Historically, U.S. equities have tended to be more stable than equities listed in developing economies. However, we feel that including emerging market equities is essential since it offers the potential to achieve uncorrelated returns and ideally improve the portfolios overall risk/return profile.

FEX [Fact Sheet]

Large cap U.S. equities are a core holding in most portfolios and we have achieved exposure to this traditional asset class through FEX. This ETF employs the AlphaDEX methodology and selects its holdings from the world popular S&P 500 Index. FEX is certainly towards the high end of the expense spectrum when considering large cap equity funds, however, it employs a unique methodology that has proven to be effective at generating alpha. Moreover, it should noted that FEX offers excellent balance; its top ten holdings receive only about 5% of total assets. These distinguishing features set this ETF apart from its more popular cap-weighted counterparts, which have different risk profiles as they are prone to sector biases and top-heavy portfolios.

For example, SPY, the biggest and most popular S&P 500 ETF on the market, has close to 20% in its top ten holdings alone and the top three allocations by sector are technology, financial services, and energy. The AlphaDEX methodology re-balances holdings on a quarterly basis, which results in varying mixes of holdings and a unique risk/return profile over the long-run for these products. It should be noted, however, that FEX is considerably more expensive than other ETF offering exposure to large cap stocks.

FNX [Fact Sheet]

Mid cap equities are fairly correlated with their large cap counter parts, however, this asset class does offer the potential for greater gains and a risk/return profile that may reduce portfolio volatility. This ETF screens and selects stocks from the S&P MidCap 400 Index and it too boasts a well-balanced portfolio along with the other AlphaDEX offerings.

Cost conscious investors looking to minimize expenses over the long haul and willing to settle for a cap-weighted strategy ought to consider SCHM, which is by far the cheapest fund in the Mid Cap Equities Blend ETFdb Category.

FYX [Fact Sheet]

FYX screens and selects its underlying holdings from the S&P SmallCap 600 Index, and it is worth nothing that close to half its portfolio is actually micro cap stocks. Investing  in small cap stocks is appealing to investors for a variety of reasons and we deem this asset class to be a key component in any long-term portfolio. From a historical perspective, small cap stocks have exhibited favorable return profiles relative to their large cap counterpart.

EWSM is a cheaper equal-weighted fund offering similar exposure, while IJR is the cheapest product available tracking the S&P SmallCap 600 Index.

FEM [Fact Sheet]

Emerging market exposure is necessary given the potential for unparalleled gains and uncorrelated returns. FEM selects stocks from the S&P Emerging BMI Index, and firms included have a float-adjusted market capitalization of at least US$ 100 million and a minimum annual trading liquidity of US$ 50 million. This ETF is quite appealing as it provides investors with a “safer” approach to accessing the investable emerging market equities universe by employing a fundamental screening methodology to help weed out some of the more riskier stocks and focus on the more promising ones.

FEM offers exposure to stocks from dozens of different emerging markets, maintaining a portfolio that is balanced in terms of both regional and sector exposure. SCHE is the cheapest, market cap-weighted alternative available in the Emerging Markets Equities ETFdb Category.

FDT [Fact Sheet]

FDT serves to fill our international developed market exposure and it tracks a modified equal-dollar weighted index which is comprised of select stocks from the S&P Developed Markets Ex-US BMI Index. Many of this fund’s holdings will tend to be giant and large cap multinational companies, which are often times correlated with the performance of broad U.S. equity markets.

FDT provides exposure to developed markets outside the U.S., including Europe, Australia, and Asia. Think of this fund as an alternative to products such as EFA and VEA; FDT is more expensive, but offers the potential to outperform those cap-weighted products. Investors may wish to consider PXF, which provides similar, slightly cheaper, exposure and employs the RAFI methodology, screening and selecting stocks based on several fundamental factors.

Fixed Income Overview

Despite the diversification across sizes and geographies within the equity component of this ETFdb Portfolio, many of these funds maintain relatively high correlations with each other (as evidenced below). Staying true to the alternative methodology theme of this portfolio, we have elected to achieve the fixed income exposure with a fairly new offering that provides unmatched “all-in-one” access to the global bond market.

FWDB [Fact Sheet]

This product is an ETF of ETFs, meaning it uses other exchange-traded products to construct a broad-based portfolio which offers exposure to at least 12 global bond classes. That diversification will make FWDB unique among bond ETFs, since most fixed income funds are dominated by high quality U.S. debt issues, often times with tilted exposure towards low-yielding Treasury notes.

While FWDB is not a member of the AlphaDEX family, the methodology employed by the managers of this fund also set it apart from most market cap-weighted offerings in the ETF universe. FWDB utilizes a weighted allocation system based on historical yield curve analysis and a mean reversion strategy. Based on an analysis of how historical yield curves compare to the current environment, certain classes of bonds are overweighted or underweighted relative to traditional fixed income indexes.

FWDB spreads out exposure across multiple maturities and holds a wide host of debt notes from all segments of the global bond market, with over a third of holdings rated “BBB” and lower.

ETF Correlation Matrix

Diversification is a key component of any client portfolio. The chart above shows the correlation between each component of the AlphaDEX ETFdb Portfolio over the last two years.

As is expected, there is a very strong correlation between the equity components in this ETFdb Portfolio, amongst both domestic and foreign stocks. The fixed income element of this ETFdb Portfolio adds much needed diversification benefits, as this asset class has historically maintained a fairly weak correlation with equity markets.

Disclaimer

The information herein is not represented or warranted to be accurate, correct, complete, or timely. Past performance is no guarantee of future results. All investors should read applicable prospectuses before investing.

From time to time, the authors of this report or other employees of ETF Database may have a long or short position in securities referred to herein. The factual statements herein have been taken from sources we believe to be reliable, but such statements are made without any representation as to the accuracy or completeness or otherwise.[/hide]

$3,972,123