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.

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.

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.