FXO - FXO: Leverage The Equal-Weighted Strategy Amid Low Consumer Sentiment

2023-06-22 08:03:10 ET

Summary

• First Trust Financials AlphaDEX Fund ETF demonstrates strong long-term performance, with a total return of 55% in the past 3 years and 33% in the past 5 years.
• The fund suffers from higher volatility, turnover, and expenses compared to its peers, but its equal-weighted approach and broad portfolio can reduce concentration risk.
• The financial sector is grappling with lower consumer confidence following recent bank failures. However, the FDIC is actively implementing measures to rebuild this.

Strategy

Launched and managed by First Trust Advisors L.P. in 2007, First Trust Financials AlphaDEX Fund ETF ( FXO ) invests in stocks of companies operating across the financial services industry. FXO attempts to outperform the United States financials market, seeking to track and replicate the performance of the StrataQuant Financials Index. The fund invests in growth and value stocks of companies across diverse market capitalizations, including mid-cap and large-cap financial companies. The fund employs a quant-based strategy to screen and identify stocks poised for outperformance, and then it equal-weights the remaining outperforming stocks. The index is rebalanced and reconstituted on a quarterly basis.

Holding Analysis

As mentioned earlier, this ETF primarily targets US financial companies poised to outperform the broader market. The fund employs an equal-weighted approach that significantly reduces concentration risk in its portfolio. The top 10 holdings only constitute 19% of its entire portfolio, and the weightings of its top 10 holdings range from 1% to 2%. With a total of 101 holdings in its portfolio, the remaining 91 holdings constitute 81% of the portfolio. The fund largely focuses on mid-cap and large-cap stocks, with 41% dedicated to large-cap and 56% dedicated to mid-cap. The remaining 3% comprises small-cap stocks.

Performance Analysis

Over the past year, FXO's price return has closely correlated with that of the S&P 500. It has shown relatively the same volatility level as it follows every peak and trough of the S&P 500. Overall, FXO is currently up 2%, whereas the S&P 500 is up nearly 5%. However, both the index and the fund seem to be on a steady incline now, hopefully recovering from the drop in February 2023.

While the fund's price return closely follows the S&P 500, its total return tells a different story. Surprisingly, FXO was outperforming the S&P 500 near the end of 2022 and into the beginning of 2023, but the fund experienced a steep decline in February 2023, from which it has not been able to recover in comparison to the broader index's total return. This drop can also be seen in the fund's price return, which occurred at the same time. Both FXO and the S&P 500 experienced a steep decline in their price returns, but the S&P 500 did not see the same decline in its total return. Instead, the index's total return continued to increase and outperform.

FXO also shows a favorable return from a long-term standpoint. The fund is up 55% in its total return for the past 3 years, and it is also up 33% in the past 5 years. Both these values are significantly larger than the median of all ETFs. This adds to the fund's stability and resilience in its performance over the long term despite cyclical downturns. So while FXO has a 6-month return of -5%, I am confident that the fund is strong enough to swiftly recover from this in the near term.

High Volatility and Expenses

As mentioned earlier, FXO is extremely volatile despite its outperformance in the long term. Seeking Alpha gives the fund a risk grade of D, and many of its underlying metrics are also in the D range. Considering that the fund only allocates 19% to its top 10 holdings, one would think that this would help reduce concentration risk and consequently, volatility, but that is not the case with FXO. Its annualized volatility is currently 28%, whereas the median for all ETFs is 19%. Most notably, the fund has an especially high turnover rate at 64%, which is twice that of the median. The fund's high turnover rate can imply that the managers are frequently buying and selling securities within the fund, which can also increase costs. It's no surprise that the fund also has a high expense ratio at 0.62%, which is substantially higher than all of its peers. The fund that comes closest to FXO is [[RYF]], with an expense ratio of 0.40 and a turnover rate of 17%.

Opportunities

The financial services industry may face potential repercussions from the recent collapse of several banks, including Silicon Valley Bank and Signature Bank. Alongside this, there was also difficulty and turmoil surrounding the acquisitions of both Credit Suisse and First Republic Bank. These factors can leave many investors concerned for the health of the financial and banking sector as well as for the entire economy. However, as a result of this fear among consumers, the Federal Deposit Insurance Corporation (FDIC) has recently advocated boosting deposit insurance above $250,000 for some accounts. The FDIC hopes that by increasing insurance after the three recent bank failures, it can reduce the risk of further bank failures. This will also provide temporary unlimited deposit insurance to bank accounts that do not earn interest, a policy similar to one implemented during the Great Recession. It's also worth noting that more than 99% of accounts fell under the $250,000 cap as of December 2022, but the growth of these uninsured accounts has made banks riskier. Uninsured deposits accounted for 47% of deposited funds in 2021.

Threats

The financial services industry is continuously advancing and adapting to new technologies. The industry is increasingly relying on digital infrastructure and financial technology as society shifts towards a digital economic environment. However, the key threat to this transformation is also the growing number of cyberattacks that target financial companies. Cybercrime is growing at an exceptionally fast rate, and in 2022, cyberattacks rose over 38% from 2021. Overall, digital financial services offer a profitable opportunity for hackers, and without dedicated action, the US financial system will only become more vulnerable to cybercrime as innovation and technology continue to advance. Firms need to not only focus on developing their existing technologies but also prioritize improving their cybersecurity and stay one step ahead of cyber attackers.

Conclusion

Overall, FXO has demonstrated robust long-term performance, being up over 55% in the past 3 years and 33% in the past 5 years. The fund has also closely followed the performance of the S&P 500 in the past year. Despite this outperformance, the fund suffers from higher volatility, turnover, and expenses compared to its peers. While these factors can pose concerns, the fund's equal-weighted approach and broad portfolio can significantly reduce concentration risk. Moreover, the financial sector as a whole is not performing the best as recent concerns surrounding the health of the banking sector may reduce consumer sentiment, but opportunities lie in the Federal Reserve's potential boosting of deposit insurance. Although I do have faith in the fund's potential to grow in the long term, my ultimate rating for FXO is Hold, at least until consumers regain confidence in the financial sector.

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