Alpha Dex Seminar Presentation

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  • First Trust Portfolios L.P. (the funds’ distributor), along with its affiliate, First Trust Advisors L.P. (the adviser to the funds), were founded in 1991. We operate nationwide as well as in Canada and provide a variety of investment services, including asset management, financial advisory services, and municipal and corporate investment banking. We believe a focused, disciplined approach to investing gives us the best opportunity to outperform the markets and help investors achieve their long-term financial goals. Our mission, to help our clients build and preserve wealth, remains the cornerstone of our investment management philosophy.
  • The first exchange-traded fund (ETF), an S&P 500-index fund, began trading on the American Stock Exchange in January 1993. At the end of 2011, overall ETF assets totaled more than $1 trillion , more than doubling in the last five years.
  • Targeted market exposure, transparency, low expenses, general tax efficiency, and flexibility. These are attributes that advisors and their clients are demanding from their investment products. For this reason the demand for exchange-traded funds or ETFs has steadily increased over the past 10 years as investors become more educated on the benefits that ETFs provide. ETFs provide an efficient and simple way to invest in worldwide markets. ETFs offer investors the opportunity to buy and sell an entire basket of securities with a single transaction throughout the trading day. They are built like an index fund, but trade like a stock. With ETFs you know exactly what you own. The holdings of ETFs are listed on a daily basis, whereas mutual funds generally release their holdings quarterly. The transparency of the ETF’s portfolio allows investors to easily obtain exposure to a specific group of securities. Lower Cost – Most ETFs are index-based and not actively managed. Because of this, they are less likely to carry high management fees and usually have lower annual expense ratios than actively managed mutual funds. Diversification – Owning an ETF allows investors to hold a basket of securities and have exposure across the entire index that the ETF seeks to track. An ETF can offer the day-to-day trading opportunities of an exchange-listed stock with the diversification of a mutual fund. Diversification primarily helps reduce volatility and also has the potential to enhance your returns; however diversification does not guarantee a profit or protect against loss. Intraday Liquidity –ETFs offer continuous pricing throughout the trading day and intraday liquidity just like a stock. Generally Tax-Efficient – The ETF’s structure allows it to substantially lessen and/or possibly avoid capital gains distributions through an in-kind redemption process. The Creation/Redemption Process allows all share activity to be facilitated through the in-kind distribution transfers with institutional investors (authorized participants) in creation unit/redemption unit aggregations, preventing the fund from incurring capital gains as a result of shareholder trades. The ETF structure does not necessarily eliminate all capital gain distributions. Flexibility – Shares of any ETF can be bought and/or sold with the same flexibility as an individual stock. This allows investors to place stop-limit orders, buy on margin, or sell short. Any of these transactions would make them subject to the same terms that would apply to the purchase or sale of individual common stocks listed on an exchange.
  • ETFs offer many of the same characteristics found in individual stocks and index mutual funds.
  • Originally, indexes were designed to measure the average performance of a group of stocks that were considered representative of either the broad market or a specific segment of the market. Indexes were also developed to serve as benchmarks that investors could use to gauge the performance of an active portfolio manager. The vast majority of these traditional indexes weight stocks based on their market capitalization. Indexes that own all of the stocks in a particular market segment and weight them based on size and other factors provide beta. Simply put, beta is the market – the risk and return is attributable to a particular market segment. There are many investment products available in the marketplace that provide beta offering market returns at market risk.   There is a new approach to indexing – enhanced indexing, which weights the holdings on fundamental measures such as a cash flow and return on assets in an attempt to achieve alpha. Alpha is a statistical measure of the portion of a return arising from non-market risk. In other words, alpha is an indication of how much an investment outperforms or underperforms relative to its benchmark. Enhanced indexes attempt to provide better risk-adjusted returns than a broad-based market benchmark index. Investment products which are based on enhanced indexes seek to deliver the same return as a beta index but with lower risk or may have more risk than a beta index but attempt to generate a greater return.
  • Market cap-weighted indexes, by their very nature, overweight larger companies and underweight smaller companies. Let me illustrate why this over-simplified formula is less than perfect. Let’s take the S&P 500 Index as an example. The strategy behind an index fund which tracks the S&P 500 Index is to invest in 500 large U.S. companies and own them in proportion to their market cap size. Because they are weighted by market cap, the largest holdings have a significant impact on overall performance. This example plots the average return of the ten largest S&P 500 holdings relative to the performance of all 500 stocks in the index. As you can see, an average of the top ten holdings have only been in the top half three times in the last twelve years. It should be noted that the period illustrated was one in which U.S. small-capitalization stocks generally outperformed U.S. large-capitalization stocks. During a period when larger stocks outperform smaller stocks, the relative performance of the 10 largest stocks in the S&P 500 would likely be better.
  • Although beta indexing has become popular for its simplicity and market matching returns, fundamental valuation factors are still important when seeking alpha. To illustrate this point, we started with a large universe of stocks and divided them into deciles based on their ranking on a single valuation factor - price to cash flow. The chart shows the average annual performance of the stocks in each decile held for one year with the process repeated each year. This example shows that stocks that are ranked higher have historically outperformed the lower ranked stocks. The fact is, valuation still matters. While many single valuation factors can be useful in stock selection, we believe multi-factor models are a more prudent approach and generally more consistent over time. The stability of a quantitative selection model over time is an important consideration when choosing the proper mix of valuation factors.
  • When it comes to investing approaches, there are an array of options. There are many mutual funds and ETFs to choose from. Some are actively managed; some are passively managed. There has been a lot debate over active vs. passive investing approaches. Active managers aim to provide a better return than a stock market index. On the surface it may seem that active management might be the better option. The problem is that active managers often underperform the index and very few consistently beat it. And there is no guarantee that the few which do outperform will continue to outperform in the future. Because of the obstacles that active managers face, passive management has grown in popularity and index-based ETFs have led the way, providing an alternative to traditional passive mutual funds, and offer a way of investing in a wide range of asset classes. Passive index investors aim to match the average performance of an index, before charges and expenses. We believe that sometimes it is okay to be average, but NOT when it comes to investing. AlphaDEX ETFs, combine elements of both active management and passive indexing to seek a happy medium of the two. On the passive side, AlphaDEX takes advantage of rules-based methodologies and because it is an ETF it can provide greater transparency, relatively low cost and turnover, and general tax efficiency along with all of the other benefits of ETFs. On the active side, the AlphaDEX methodology seeks to take advantage of the pursuit of alpha relative to a benchmark.
  • AlphaDEX is an index-based investment process that seeks to produce similar correlation and risk characteristics as broad market indexes while providing outperformance due to a unique stock selection and weighting methodology.
  • First Trust’s AlphaDEX family of ETFs are based on a group of custom enhanced indexes. An enhanced index begins with a broad benchmark index and applies fundamental screens and factors to refine the constituent stocks and create the enhanced index. The AlphaDEX methodology is simple, it uses only 3 growth and 3 value factors. In addition, since AlphaDEX funds are structured as ETFs, the methodology and holdings are completely transparent. Because of the additional benefits provided by ETFs such as tax efficiency, exchange-traded liquidity, and transparency, we believe ETFs based on an enhanced index may be a better alternative to active management when seeking alpha. We offer several AlphaDEX ETF funds such as, core, style, multi cap, sector and international portfolios to meet various investment objectives.
  • Based on the AlphaDEX screening methodology, the worst scoring stocks from the starting universe are eliminated from the selection. The best scoring stocks are selected and are not weighted based on market capitalization, but on the basis of potential investment merit. The selected stocks are divided into quintiles based on their AlphaDEX methodology scores; the higher scoring quintiles are given greater weight than lower scoring quintiles.
  • Because of the additional benefits provided by ETFs such as general tax efficiency, exchange-traded liquidity, and transparency, we believe ETFs may be a better alternative to active management when seeking alpha.
  • Alpha Dex Seminar Presentation

    1. 1. You should consider a fund’s investment AlphaDEX® ETFsobjectives, risks, and charges and expensescarefully before investing. Contact First Trust An Enhanced IndexingPortfolios L.P. at 1-800-621-1675 or visitwww.ftportfolios.com to obtain a prospectus Approach to Investingor summary prospectus which contains thisand other information about a fund. Theprospectus or summary prospectus should beread carefully before investing. Not FDIC Insured · No Bank Guarantee · May Lose Value
    2. 2. About First Trust First Trust Portfolios L.P. along its affiliate, First Trust Advisors L.P., were established in 1991. We operate nationwide as well as in Canada. We provide a variety of investment services, including asset management, financial advisory services, and municipal and corporate investment banking. Our products: Closed-end funds Mutual funds Separate managed accounts Unit investment trusts Variable annuity sub-accounts Exchange-traded fundsAn Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    3. 3. ETF Industry Growth $1,048 $992  Assets have doubled in 5 years $777  1120+ ETFs available $608 $531 $423 $301 $228 $151 $66 $83 $102 $16 $34 $1 $0 $1 $2 $7 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: Investment Company Institute in $billions.An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    4. 4. Factors Driving ETF Demand  Targeted Market Exposure  Transparent  Low Expenses*  Diversification  Intraday Liquidity  General Tax Efficiency $  Flexibility *Compared to the average expense ratio of all domestic stock mutual funds tracked by Morningstar.An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    5. 5. How Do ETFs Compare? Index Mutual ETFs Stocks FundsTax Efficient   Low Expenses   Low Investment Minimums   Intraday Liquidity  Diversification  Fully Invested   PossiblePortfolio Transparency   PossibleAble to Sell Short  Able to Buy on Margin  Able to Use Limit and Stop Orders  Listed Options Available  Ease of Dollar Cost Averaging An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    6. 6. Alpha vs. Beta Indexes Beta Alpha  All Which Stocks to Own?  Select Group  Size How are they Weighted?  Fundamental Factors Alpha is an indication of how much an investment outperforms or underperforms on a risk-adjusted basis relative to its benchmark. Beta is a measure of price variability relative to the market.An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    7. 7. Large Market Cap = Outperformance? Large Market Cap = Outperformance?Data obtained from the Compustat database.Average return rank is determined by taking the average total return rank (based on calendar year total return) of the ten largest stocks by marketcapitalization. Market capitalization is as of the previous year end. Past performance is no guarantee of future results. This example is for illustrativepurposes and does not represent any actual investment. An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    8. 8. Fundamental Factors Matter Price to cash flow 1952-2010 22.00% 20.00% Average Annual Total Return 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Worst-10 9 8 7 6 5 4 3 2 Best-1 DecileSource: Kenneth R. French data library using the CRSP database. The universe includes all NYSE, AMEX & NASDAQ stocks. Stocks are equallyweighted. Past performance is no guarantee of future results.An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    9. 9. Active, Passive or Happy Medium  Active Management  Passive Indexing  AlphaDEX®An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    10. 10. What is AlphaDEX®?  “Merit-based” approach through quantitative screening  Overweight stocks based on investment potential – seek to go beyond merely avoiding pitfalls of cap-weighting  Use the findings available in the academic literature  Seek to earn alpha through a disciplined empirical approachAn Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    11. 11. What are AlphaDEX® Funds? ETFs based on a group of custom enhanced indexes  Dual Lenses – Separate Growth and Value Factors  Simple – Only 3 Growth & 3 Value Factors  Transparent – No “Black Box” MystiqueAn Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    12. 12. Factors Used in the AlphaDEX® ModelAn Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    13. 13. AlphaDEX® Methodology Stock A Stock B 33.3% Weight Stock C Stock D Stock E Stock F Stock G Stock H 26.7% Weight Stock I Stock J Stock K Stock L Stock M Stock N Broad- 20.0% Weight Stock O Stock P Based Stock Q Stock R Index Stock S Stock T 13.3% Weight Stock U Stock V Stock W Stock X Stock Y Stock Z 6.7% Weight Stock AA Stock BB Stock CC Stock DD Stock EE Rebalance & Reconstitute Stock FF Stock GG Stock HHThis example is for illustrative purposes and does not represent any actual investment. Stock II An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    14. 14. AlphaDEX® - A Smart Alternative to Active Management  Lower Expense Ratio*  General Tax Efficiency  Transparent  Trading Flexibility *Compared to the average expense ratio of all domestic stock funds tracked by Morningstar.An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    15. 15. Risk Considerations A fund’s shares will change in value, and you could lose money by investing in a fund. One of the principal risks of investing in a fund is market risk. Market risk is the risk that a particular stock owned by a fund, fund shares or stocks in general may fall in value. You should anticipate that the value of the shares will decline, more or less, in correlation with any decline in the value of the index. A fund’s return may not match the return of the index. A fund may not be fully invested at times. Securities held by a fund will generally not be bought or sold in response to market fluctuations. Investors buying or selling fund shares on the secondary market may incur customary brokerage commissions. Investors who sell fund shares may receive less than the share’ s net asset value. Shares may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from the fund by authorized participants, in very large creation/redemption units. An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    16. 16. Additional Risk Considerations The funds are classified as “non-diversified.” A non-diversified fund generally may invest a larger percentage of its assets in the securities of a smaller number of issuers. As a result, the fund may be more susceptible to the risks associated with these particular companies, or to a single economic, political or regulatory occurrence affecting these companies. The funds may invest in small and mid capitalization companies. Such companies may experience greater price volatility than larger, more established companies. An investment in a fund containing equity securities of foreign issuers is subject to additional risks, including currency fluctuations, political risks, withholding, the lack of adequate financial information, and exchange control restrictions impacting foreign issuers. These risks may be heightened for securities of companies located in, or with significant operations in, emerging market countries. The information contained in this presentation does not constitute tax advice. Please consult your tax advisor for specific information about your tax situation. An Enhanced Indexing Approach to Investing AlphaDEX® ETFs
    17. 17. Talk to your financial advisor for more information. Or, visit our website at: www.ftportfolios.com“AlphaDEX®” is a registered trademark of First Trust Portfolios L.P.A patent application with respect to the AlphaDEX® stock selection methodology is pending at the United States Patent and Trademark Office.An Enhanced Indexing Approach to Investing AlphaDEX® ETFs

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