Exchange traded funds focusing on global markets, developed and emerging markets, often share something in common with their U.S. broad market and sector products. That being a dependence on cap-weighting methodology or the allocation of the largest stocks by market value at the top of the fund and the smallest names at the bottom.
This scenario is seen time and time again with ETFs ranging from the iShares MSCI Brazil Index Fund (NYSE:EWZ) to the SPDR STOXX Europe 50 ETF (NYSE:FEU). EWZ is dominated by Brazilian large-caps such as Petrobras (NYSE:PBR) and Vale (NYSE:VALE) while familiar names such as Nestle (OTCBB: NSRGY), BP (NYSE:BP) and Royal Dutch Shell (NYSE: RDS-A) dot FEU's top-10 holdings.
Arguably the primary risk with cap-weighting methodology is that in the wrong environment or when particular stocks fall out of favor, an ETF's heavy exposure to a small amount of stocks diminishes one of the major reasons for owning ETFs in the first place. That reason being diversification.
First Trust, the Illinois-based ETF sponsor behind the AlphaDEX suite of funds, has shown a different approach to sector funds not only provides with more choices, it can generate superior returns. The same can be said when it comes to global funds.
"The largest mega-caps don't outperform over time," said First Trust ETF Strategist and Senior Vice President Ryan Issakainen in an interview with Benzinga from the Morningstar ETF Conference in Chicago that the AlphaDEX funds. "The law of large numbers says it can't happen."
The AlphaDEX funds do not eschew the largest, most familiar stocks. Rather, ETFs such as the First Trust Energy AlphaDEX Fund (NYSE:FXN) allocate less weight to stocks with the largest market values. In the example of FXN, Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM) combine for less than five percent of that fund's weight. That compares with those two stocks representing almost 37 percent of the Vanguard Energy ETF (NYSE:VDE).
What is important to note is that AlphaDEX sector funds have shown a tendency to outperform traditionally weighted ETFs. That provides the impetus for probing the performance of AlphaDEX country and global funds against larger ETFs.
"The same applies to individual countries," Issakainen said. "Look at Brazil. It is very concentrated in the largest stocks. If Petrobras is the best performer we're (First Trust) going to have a hard time outperforming, but generally, that is not the case."
The example of Brazil is relevant. The struggles of Petrobras, Brazil's state-run oil giant, have plagued the iShares MSCI Brazil Index Fund this year. That ETF is off 5.4 percent year-to-date. Two different Petrobras securities account for over 17 percent of EWZ's weight. On the other hand, the First Trust Brazil AlphaDEX Fund (NYSE:FBZ) allocates less than 3.2 percent of its weight to Petrobras and that fund is slightly positive on the year. FBZ debuted in April 2011 and has attracted $5.7 million in AUM.
Brazil is not the only example. The First Trust China AlphaDEX Fund (NYSE:FCA) has outperformed the SPDR S&P China ETF (NYSE:GXC) by nearly 100 basis points this year. The First Trust United Kingdom AlphaDEX Fund (NYSE:FKU) has topped the iShares MSCI United Kingdom Index Fund (NYSE:EWU).
Even with those superlatives, the AlphaDEX country funds have yet to attract assets on part with direct rivals or the AlphaDEX sector funds. FKU has almost $6.5 million in AUM after debuting in February. FCA has just $3.1 million in AUM after launching in April 2011.
Issakainen notes that many of the AlphaDEX country funds currently have AUM totals that resemble where the sector funds were at similar points in their life spans. Today, all nine of the AlphaDEX sector funds have over $100 million in AUM.
"Our approach is unique,"Issakainen said. "We have a long-term business we're buildings and don't launch products hap-hazardly."
First Trust, which has never closed an ETF, now issues 39 AlphaDEX ETFs.
For more on AlphaDEX ETFs, click here.
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