XLG - USMC: Should You Buy This Low-Cost Concentrated Mega-Cap ETF?

2023-05-22 18:05:48 ET

Summary

• USMC selects stocks from the top 50th percentile by market value of the S&P 500, re-weighting the vast majority by a proprietary measure of financial strength. Fees are just 0.12%.
• Despite suggestions otherwise, USMC is not a low-volatility ETF by any stretch. Its 0.99 five-year beta and slightly lower standard deviation compared to SPY are our first clues.
• Still, USMC has favorable growth, valuation, and profitability scores. The key downside is concentration. USMC's top 25 holdings total 76% of the portfolio, and there are only 41 in total.
• Investors may also consider XLG and MGC, two other mega-cap ETFs with similar risk and return profiles. Along with SPY, this article compares the four fundamentally.
• Given USMC's similarities to more established low-cost passive funds and the risks of high concentration, I struggle to see its value. Therefore, I rate USMC as a hold only.

Investment Thesis

The Principal U.S. Mega-Cap ETF ( USMC ) is a low-cost actively-managed mega-cap fund currently holding 41 S&P 500 companies. USMC's proprietary approach re-weights 90% of its mega-cap universe based on financial strength, effectively improving portfolio metrics like volatility, growth, and valuation. However, the differences are negligible compared to low-cost passive alternatives. In addition, USMC is already too concentrated and likely to become even less diversified when the index reconstitutes next. In short, USMC is a solid ETF, but it's not worth replacing, so I have decided to limit my rating to only a hold.

USMC Overview

Strategy Discussion

USMC is actively managed by Jeffrey Schwarte and Aaron Siebel, two CFA Charterholders with nearly 50 years of combined experience. Though they follow a proprietary strategy, USMC's prospectus highlights the following:

• mega-caps are those with market capitalizations in the top 50th percentile of the S&P 500
• the proprietary quantitative model applies higher weight to securities expected to be less volatile
• selections are not constrained to a particular style (growth or value)
• rebalancing occurs as needed but at least annually

The framework divides the starting universe of stocks into two subcategories by aggregate market capitalization: the top 10% and the bottom 90%. The S&P 500 has an aggregate market capitalization of $37.2 trillion, so the top 50% would be $18.6 trillion, the sum of the largest 35 stocks. Currently, USMC has 41 holdings, so if the Index were to rebalance today, it would become even less diversified.

From this $18.6 trillion, the top 10% is $1.86 trillion, and from here, it gets complicated because Apple ( AAPL ) has a $2.76 trillion market capitalization. Based on Apple's relatively low weighting compared to an S&P Top 50 ETF, I believe its market capitalization is prorated. In effect, roughly two-thirds fall into the top 10% subcategory, with the remainder in the bottom 90%, which re-weights based on financial strength.

I reviewed USMC in April 2022 , naming it a low-volatility ETF to consider in a recession. At the time, its five-year beta was 0.89, reasonably low for a mega-cap fund. However, a strategy change in June 2022 moved USMC's beta closer to 1.00, like the benchmark S&P 500 Index. Therefore, attempts to frame USMC as a low-volatility ETF are unsupported. Instead, it's a simple fundamental re-weighting of a select group of mega-cap stocks offered for a reasonable 0.12% expense ratio, and this becomes clear in my later analysis.

Sector Exposures and Top Ten Holdings

The following table highlights sector exposures for USMC alongside the SPDR S&P 500 ETF ( SPY ), the Vanguard Mega Cap ETF ( MGC ), and the Invesco S&P Top 50 ETF ( XLG ). XLG is a close comparator, as it has approximately the same number of holdings as USMC but re-weights most based on fundamentals.

As a result, USMC is more balanced than XLG across sectors. It underweights Consumer Discretionary, Technology, and Communication Services, distributing the weight primarily to Financials and Health Care. Still, both have the same concentration in their top 25 holdings, while SPY and MGC are more diversified.

USMC's top ten holdings are below, totaling 40%. Several prominent mega-cap stocks include Apple, Microsoft ( MSFT ), and Alphabet ( GOOGL ). Still, each has approximately half the weight as in XLG.

Performance History

Since September 2017, USMC has underperformed XLG, MGC, and SPY by 1.47%, 0.51%, and 0.03% per year. However, it was less volatile, leading to the same or better risk-adjusted returns (Sharpe Ratio) with MGC and SPY.

However, these results may not be helpful, given how the "objective and strategy" changed on June 10, 2022. The disclaimer is below, sourced from this link .

Instead, consider the following performance chart since June 2022. The results were slightly better, but USMC still trailed XLG, leaving us wondering if Principal's re-weighting of 90% of mega-cap stocks based on fundamentals is beneficial. So far, it doesn't look like it, but it's too early to tell.

USMC Fundamentals

The following table highlights selected fundamental metrics for USMC's top 25 holdings, totaling 76% of the portfolio. As discussed, this concentration level is similar to XLG. Still, its $708 billion weighted average market capitalization is close to MGC's $697 billion, so it's another suitable alternative.

The primary benefit of mega-cap investing is that high profitability is virtually guaranteed. USMC's top 25 holdings have perfect "A+" Seeking Alpha Profitability Grades, which I've normalized on a ten-point scale in the table above. The same is true for its three comparators. However, MGC and SPY have lower net scores because they are more diversified. Some examples of stocks with less-than-perfect profitability scores that USMC excludes include Advanced Micro Devices ( AMD ), NIKE ( NKE ), Intel ( INTC ), S&P Global ( SPGI ), and Morgan Stanley ( MS ).

Highly profitable companies make great long-term investments. There is always a valuation risk, and we saw that in 2022, many mega-cap stocks declined more than average. However, they also tend to bounce back quickly.

USMC is less volatile than XLG and has slightly better estimated EBITDA and EPS growth rates. In addition, it trades at a 3-point discount on forward earnings (25.37x vs. 28.33) and a 2-point discount on trailing cash flow (21.59x vs. 23.41x). My fundamental screens differ from what Principal uses, giving me some confidence in the process. I would choose USMC over XLG today. XLG's recent outperformance is likely due to a slightly better last quarter earnings surprise figure (9.09% vs. 7.55%) and a stronger earnings revision score (6.48/10 vs. 6.29/10). The extra alpha is because Apple, Microsoft, and Alphabet are having excellent years. XLG benefits because it overweights these three stocks by 15%. You can read more about how mega-caps are outperforming in my Q1 2023 earnings season recap here .

USMC's fundamentals also look strong compared to MGC and SPY. Without considering concentration, I also favor it. However, a 41-stock portfolio is not sufficient on its own. USMC touches 27 industries compared to 30, 86, and 126 for XLG, MGC, and SPY. You may choose to replace SPY with USMC, but you will still have a diversification problem. Besides, so may decrease some of the profitability, growth, and valuation benefits USMC offers.

Investment Recommendation

USMC has slightly better fundamentals than XLG, so I favor it based on lower volatility, superior estimated growth, and a cheaper valuation. However, USMC is too concentrated to replace MGC or SPY, and if the Index reconstitutes now, its diversification problem would only deepen. As this article demonstrated, it's easy to construct a concentrated portfolio of high-quality mega-cap stocks, as all of the top 25 holdings have "A+" Seeking Alpha Profitability Grades. The question is if an investor is willing to sacrifice a substantial amount of diversification for only slight improvements elsewhere. I struggle to see how it would fit in my portfolio, so I have rated USMC as a hold only. Thank you for reading, and I look forward to the discussion in the comments section below.

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