FXZ - FXZ: Looks Strong But Exposed To Bear Market Risks

Summary

• FXZ is an ETF that focuses on the basic materials sector.
• End-user market diversification and large-cap stock exposure make this ETF attractive.
• FXZ's volatility could increase risk exposure to the downtrend in market.

The First Trust Materials AlphaDEX ETF's ( FXZ ) selection criteria involves highly quantitative methods that result in the careful selection of holdings, which I find impressive. FXZ has a few unexpected advantages, such as high trading volumes, greater assets under management, and diversification - despite it being a sector-specific fund. I like the performance and future outlook of the high-weighted holdings, and that makes me believe their growth will positively impact the fund's performance. However, volatility is a concern and creates uncertainty as to whether the fund will stand strong or stumble if the bear market hits hard. As such, I rate FXZ a hold.

Strategy

This is an ETF that aims to track the gains of the Strata Quant Materials Index, which was created by selecting companies from the materials sector based on specific selection criteria from the Russell 1000 Index. These criteria involve a highly sophisticated quantitative system to assign weights and rankings to holdings based on a set of growth and value factors.

Holding Analysis

FXZ has about 40 holdings spread across four industries, with concentration at the top roughly 54% in chemicals, followed by the rest as shown below:

With a little more than 45% of FXZ's total assets in the top 10 holdings and no major difference (greater than 2%) between any two holdings among the top 10, this fund looks well-balanced. Although the holdings belong to one sector, basic materials, the clients of those companies aren't individuals. They are often other businesses that belong to various other sectors. Therefore, FXZ is exposed to sector diversification in terms of end-use markets, and the demand-specific risk and concentration risk are mitigated to some extent.

The top two holdings are steel giants and supply steel to various types of businesses throughout America. One of those top holdings is Nucor Corp. ( NUE ), which happens to be the world's 15th largest steel producer, is over 80 years old, and is a strong and stabilized business in this sector.

Strengths

The constituents of FXZ are selected from the basic materials sector in the Russell 1000 Index. This means that all of FXZ's holdings are large-cap companies. Having that kind of large-cap exposure acts as a support for price volatility when compared to much smaller stocks. This can reduce the effect of market risks, as these stocks are more stable and mature than their smaller peers. This is also the reason why FXZ has viable liquidity and assets under management of over $1.7B. Supplementing that is the daily dollar volume (of three months) at $11.8M. That's much higher than the ETF median ($1.8M) and is uncommon, especially in the sector-specific ETFs category.

As mentioned above, end-user market diversification is one of the biggest strengths of this fund. The chemical industry that makes up more than half of the fund has balanced risk itself, as not all of the sectors (from which the chemical industry draws its demand) are affected the same by economic conditions. The fund also has some exposure in the precious metals industry, which acts as a hedge for industrial metals and chemicals, as they are negatively correlated. When demand for houses and cars goes down, it inversely increases for gold and silver, and companies like Royal Gold, Inc. ( RGLD ), Newmont Corp. ( NEM ), and SSR Mining, Inc. ( SSRM ) (all FXZ holdings) benefit from this.

Weaknesses

FXZ has a high expense ratio of 0.61% compared to all related ETFs, where the median lies at 0.48%. When compared to peers who have a similar style of investing, this fund has the highest expense ratio among all of them. Related peers are shown in the table below:

This ETF does not have global diversification as it focuses on U.S. equities only. While these are mostly large-cap stocks and offer stability, one downside is that they cannot capture the growth opportunities coming from mid- and small-cap stocks. Lack of sector diversification makes FXZ susceptible to risks faced by the basic materials sector arising from bottlenecks and disruptions in the supply chain, high labor costs, and the negative impact of economic conditions like inflation, high interest rates, and recession.

Opportunities

In the current economic scenario, where inflation is rising and so are interest rates, the precious metals industry is seeing new growth opportunities. There often exists a direct relationship between interest rates and gold - when rates increase people prefer investing in tangible commodities like gold, whose value is perceived to appreciate over the long term. The performance of a couple of major holdings - such as Westlake Chemical Corp. ( WLK ), which accounts for approximately 5% of assets, and Albemarle Corp. ( ALB ), at close to 3% of assets - has been exceptionally strong during the last year, helping this ETF outperform the S&P 500.

Moreover, the future is optimistic for both chemical companies, as Westlake has incoming demand from infrastructure spending on projects like municipal water systems, agricultural irrigation, and global transportation. Also, FXZ will greatly benefit from the high demand for EVs, as all electric vehicles run on lithium batteries. 41% of Albemarle's revenue comes from the production of lithium, making it the largest provider of this material.

Threats

As FXZ focuses on growth and value stocks, the dividend payout is lower. This fund has a yield of roughly 1.4%, while that of S&P 500 is 2%. This does not fare well for investors hoping to benefit from quarterly distributions.

Meanwhile, the standard deviation for this ETF has been close to 40%, while the median stands at about 24%. A beta of 1.35 combined with the maximum drawdown (in five years) of 49% looks alarming, other than for very risk-tolerant investors or those who strictly limit their position size allocation to FXZ within a broader portfolio.

Conclusions

ETF Quality Opinion

There is a lot to like about this ETF, especially the factors mentioned above that make it unique and interesting. FXZ's end-user market diversity and exposure to large-cap, stable stocks make it a compelling choice for me to track going forward. The ample liquidity of this fund only serves to increase my interest in it.

I'm curious to see if the opportunities mentioned above outweigh the threats. For those reasons, I am including FXZ on my watchlist.

ETF Investment Opinion

Although I believe FXZ has a lot of positives, one negative makes me uncertain of the future performance. The high volatility increases FXZ's risk when it comes to current market downtrends; that's the only reason I rate this fund a hold for the time being.

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