The next step in the evolution of
indexing
Traditional indexing
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.
The problem with cap-weighted indexes
The market is extremely efficient at reflecting
the prices investors are currently willing to pay for a company based
on available information. However, the market is not immune to speculation
and changes in investor sentiment which can cause a company's price to
deviate significantly from its fundamental value. This scenario became
clearly evident during the internet and technology-driven bull market
that took place in the late 1990s and the subsequent bursting of the bubble
in 2000. This period of market speculation also exposed a potential flaw
inherent in capitalization-weighted indexes. Cap-weighted indexes, by
their very nature, were forced to overweight larger, potentially overvalued
companies and underweight smaller, potentially undervalued companies causing
a drag on an index investor's returns.
Fundamentals still matter
Because stock prices are subject to factors that
can make them deviate from a company's true value, fundamental indexing
has been gaining favor with investors. Unlike traditional capweighted
indexes which rely solely on the price that the market places on a company
to determine its weight in an index, fundamentally-weighted indexes employ
fundamental measures of evaluating a company such as price to book value,
price to cash flow, price to sales and return on assets to determine how
much weight it should represent within an index. Although it is not a
new concept, advances in technology and greater availability of information
are making fundamentally-weighted indexes more robust than ever before.
Fundamental weighting attempts to limit exposure
to over-priced stocks and increase exposure to those which are trading
at more attractive valuations. While different methods of indexing will
have inherent limitations at different times, we believe that fundamental
indexes have the potential to generate higher long-term returns, and often
times reduce volatility, compared to similar cap-weighted indexes.
|
Traditional
index |
Enhanced
index |
Index representation |
Own all stocks |
Own
a select group |
Weighting method |
Size |
Fundamentals |
Performance
objective |
Beta |
Alpha |
Sometimes it's okay to be average - just not when it
comes to investing
Because indexing has historically implied broad
market matching returns through passive investing, investors have commonly
turned to active management when seeking market outperformance. We believe
that the passive investing structure provided by indexing can be used
as an effective way to generate positive alpha. Alpha is a 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. For example, if an investment returns more
than what you'd expect given the market for the asset class it is invested
in, it has a positive alpha. Conversely, if an investment returns less
than the asset class, it has a negative alpha. Because of the additional
benefits provided by ETFs such as tax efficiency, exchange-traded liquidity,
and transparency, we believe ETFs may be a better alternative to active
management when seeking alpha.
Enhanced indexing
The goal of an enhanced index is to identify
those stocks from within a traditional broad-based index which exhibit
the fundamental characteristics that enable them to provide the
greatest potential for capital appreciation. The enhanced indexing
approach seeks to generate positive alpha relative to the broad-based
passive index from which it selects its stocks. Enhanced indexing
is itself inherently passive. No active judgement is made when evaluating
stocks and every step in the process is driven by a transparent,
repeatable quantitative process.
|
|
Not FDIC Insured Not Bank
Guaranteed May Lose Value |
You should consider a fund's investment objectives,
risks, and charges and expenses carefully before investing. Contact your
financial advisor or call First Trust Portfolios L.P. at 1-800-621-1675
to request a prospectus, which contains this and other information about
a fund. Read it carefully before you invest.
Risk considerations
A fund's shares will change in value, and you could
lose money by investing in a fund. An investment in a fund involves risks
similar to those of investing in any fund of equity securities traded
on exchanges. 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 and
the securities may be issued by companies concentrated in a particular
industry. A fund may invest in small capitalization and mid capitalization
companies. Such companies may experience greater price volatility than
larger, more established companies.
Investors buying or selling fund shares on the
secondary market may incur brokerage commissions. Investors who sell fund
shares may receive less than the share's net asset value. Unlike shares
of open-end mutual funds, investors are generally not able to purchase
ETF shares directly from the fund and individual ETF shares are not redeemable.
However, specified large blocks of shares called "creation units" can
be purchased from, or redeemed to, the fund.
|