Exchange-traded funds (ETFs) can be great performers for your portfolio. In general, they let you invest in an index without some of the disadvantages of traditional mutual funds, such as steeper fees and occasionally hefty minimum investment amounts. In recent years, the folks at First Trust have introduced a line of index-based ETFs with a very promising twist -- the AlphaDEX funds.

Each AlphaDEX fund is based on an index such as the S&P 500. But while a conventional index fund will simply hold the same companies as the index, usually weighting them by market capitalization, the AlphaDEX fund does a little tweaking. It evaluates and scores each of the stocks in the index on a handful of measures, then discards the worst-scoring stocks, and weights the remaining ones by their score. Thus, it ends up holding the more promising companies in the index, and devoting a bigger percentage of its holdings to its best picks.

These funds are only a few years old, but their initial results suggest that First Trust may be on to something. Perhaps that's because investors are getting the best of both worlds -- passive index investing coupled with a little active management (in a relatively passive, quantitative, formula-driven manner). Let's take a closer look at one of the funds, shall we?

Big and better?
The First Trust Large Cap Core AlphaDEX (NYSE: FEX) is based on the S&P 500 index, so we might compare it with the SPDR S&P 500 ETF. Whereas the regular ETF holds stock in all 500 index components, the AlphaDEX variant holds around 370, having winnowed out the 25% it deems least promising.

For their winnowing and weighting, the AlphaDex funds that are focused on "value" stocks consider three main ratios: book value-to-price, cash flow-to-price, and return on assets. The "growth"-oriented ones consider price appreciation over the past three, six, and 12 months, sales growth over the past year, and the price-to-sales ratio. The "core" funds, such as our specimen, consider all these factors and focus on the higher-scoring ones.

So how has the fund fared, compared to the SPDR ETF? See for yourself:





3-Year Avg. Annual Return

First Trust Large Cap Core AlphaDEX (38.7%) 36.8% 20.7% 5.7%
SPDR S&P 500 (36.7%) 26.3% 15.0% 1.7%

Source: Morningstar.

That's an impressive difference. It's worth noting that the AlphaDEX fund carries a much higher expense ratio (annual fee) of 0.70%, versus just 0.09% for the SPDR ETF. That's still well below the typical stock mutual fund fee of around 1% or more.

Holding differences
The AlphaDEX methodology explains why the results will differ. Here's how they differ, in terms of sector representation:


First Trust Large Cap Core AlphaDEX

S&P 500

Utilities 10% 3%
Financial Services 8% 15%
Consumer Cyclical 16% 9%
Consumer Defensive 7% 11%

Source: Morningstar, as of April 29, 2011.

The variance makes sense. The S&P 500 holds the same stocks, no matter what the economy is doing. The AlphaDEX fund is able to load up more on defensive companies when the country is in a recession, and in cyclical companies when they seem to be taking off again as the economy recovers. According to the measures it examines, the AlphaDEX system considers utilities more attractive than financial companies right now, so it invests accordingly -- with no financial company in sight in its top 25 holdings.

While some of the S&P 500's top holdings did well over the past year, contributing to an overall 17% increase for the S&P ETF, others did not. Philip Morris International (NYSE: PM) soared 48%, but financial companies such as Wells Fargo and Bank of America (NYSE: BAC) sank 11% and 31%, respectively. The latter two companies each make up 1% or more of S&P's index. Even Berkshire Hathaway (NYSE: BRK-B), a financial company complemented by many other businesses, advanced only 8%.

Meanwhile, the AlphaDEX fund's recent top holdings, Marathon Oil (NYSE: MRO) and JDS Uniphase (Nasdaq: JDSU), soared 73% and 60%, respectively, giving the fund a nice push. These kinds of companies benefit from recovering economies, as manufacturing picks up and industry demands more materials. Once Marathon spins off its refining business in June, it will focus attractively on oil exploration and production. JDS Uniphase has been blowing away expectations recently, and demand for its fiber-optic networking equipment likely won't ebb anytime soon.

While the world may not urgently need new and different ETFs, this intriguing trend nonetheless deserves your closer attention.

For some great ETF investing ideas, take a look at The Motley Fool's special free report, " 3 ETFs Set to Soar During the Recovery ."