2023-05-01 10:31:43 ET
Summary
- XSLV is an ETF with an aura of relative safety as it targets small-size, and, therefore, potentially better-valued U.S. stocks that exhibit low volatility characteristics.
- XSLV has lackluster past performance as it trailed both IVV and IJR since its inception.
- There are quality concerns coupled with massive exposure to the financial sector (almost 41% of net assets) that is yet again under bearish pressure.
- Valuation has mostly been a disappointment despite the lion's share of its holdings being small caps that tend to trade at attractive discounts.
- Assuming financials might surprise to the upside from here, which would be one of the principal risks to a theoretical bearish thesis, I believe XSLV is a Hold.
The Invesco S&P SmallCap Low Volatility ETF ( XSLV ) is an exchange-traded fund with an aura of relative safety as it targets small-size, and, therefore, potentially better-valued U.S. stocks that exhibit low volatility characteristics. At first glance, this is an ideal combination to prepare for a looming recession. However, I would argue against a Buy rating for XSLV at this point for a few reasons.
- First, this investment vehicle has lackluster past performance as it trailed both the iShares Core S&P 500 ETF ( IVV ) and iShares Core S&P Small-Cap ETF ( IJR ) since its inception, even despite 2021 and 2022 being bright spots.
- Second, there are quality concerns coupled with massive exposure to the financial sector (almost 41% of net assets) that is yet again under bearish pressure amid the First Republic Bank ( FRC ) saga . More specifically, the median one-month return for financials in the XSLV basket is -9.7%, as per my estimates, while the median for the overall basket is -4.9%. Unfortunately, the S&P 600's profitability screen did little to bolster the fund's overall quality, even though the share of companies that reported a net loss in the last twelve months in its portfolio is comparatively small (~7.7%).
- Third, valuation is mostly a disappointment despite the lion's share of its holdings being small caps that tend to trade at attractive discounts.
Obviously, the fund has a few advantages not to overlook (more on that below); however, I believe they do not outweigh its drawbacks. Hence, while I see no substantial reason to short this vehicle, a Hold rating in light of existing risks should be the golden mean.
XSLV: what is the fund's strategy?
According to the fund's website , its investment strategy is based on the quarterly rebalanced and reconstituted S&P SmallCap 600 Low Volatility Index, which is
... compiled, maintained and calculated by Standard & Poor's, consisting of 120 out of 600 small-capitalization securities from the S&P SmallCap 600 ® Index with the lowest realized volatility over the past 12 months.
Investors might consider reading the fact sheet on the S&P Global website for more details on the constituent selection and weighting process.
What bears say
Sluggish past performance despite some bright spots
The essential advantage of less volatile names is that they tend to perform better than other stocks during market downturns. Perhaps the best example from the not-so-distant past is 2022, when IVV and IJR had much deeper one-year drawdowns than the iShares MSCI USA Min Vol Factor ETF ( USMV ), Invesco S&P 500 Low Volatility ETF ( SPLV ), and XSLV.
As a consequence, even though low-volatility funds finished in the red, their losses were not that steep compared to the S&P 500- and S&P 600-tracking ETFs.
ETF | 2022 total return |
SPLV | -4.89% |
USMV | -9.42% |
XSLV | -11.84% |
IJR | -16.19% |
IVV | -18.16% |
Created by the author using data from Portfolio Visualizer
But the primary downside here is their inability to catch up with the market during recoveries. For example, from April 1, 2020 to December 31, 2020, the period after the March 2020 coronavirus-driven sell-off, IJR surged by an astounding 76%, IVV rose by over 52%, but XSLV advanced by just 32.5%.
Uncoincidentally, the longer-term returns leave a lot to be desired. Incepted on February 12, 2013, during the March 2013 - April 2023 period, XSLV underperformed both IJR and IVV, delivering a CAGR of just 7.1%, while also having a standard deviation above the one for the S&P 500 ETF's. Besides, the risk-adjusted returns (the Sharpe, Sortino ratios) were the weakest.
Portfolio | XSLV | IJR | IVV |
Initial Balance | $10,000 | $10,000 | $10,000 |
Final Balance | $20,115 | $25,865 | $33,314 |
CAGR | 7.12% | 9.80% | 12.57% |
Stdev | 17.17% | 19.28% | 14.76% |
Best Year | 31.44% | 31.69% | 31.25% |
Worst Year | -17.81% | -16.19% | -18.16% |
Max. Drawdown | -33.79% | -36.12% | -23.93% |
Sharpe Ratio | 0.44 | 0.54 | 0.82 |
Sortino Ratio | 0.61 | 0.8 | 1.27 |
Market Correlation | 0.8 | 0.89 | 1 |
Created by the author using data from Portfolio Visualizer
Quality issues: critically low share of high-profitability names
As of April 28, XSLV had a portfolio of 117 common stocks and REITs, with about 11.5% allocated to the key ten names and Insight Enterprises ( NSIT ) being its top holding (1.3%). The weighted-average market cap stood at $1.8 billion, as of my calculations, with only about 36% allocated to mid caps. However, even assuming small caps in most cases have softer profitability than their larger counterparts, I was still surprised by XSLV's exposure to companies with utterly lackluster quality. More specifically, only ~26.2% of its holdings had a B- and higher Quant Profitability grade (as of April 30), a dangerously low level. Over 15% were D+ rated and worse, with eight stocks (6%) from that group being financials like Horace Mann Educators ( HMN ), an insurance holding company. Next, the WA Return on Equity was at ~10.5%, with Return on Assets at just 3.6%, an extremely weak result. Besides, since it seems the banking crisis is still rippling through the sector, the ETF with ~40.7% of net assets allocated to financials is in fairness a risky place to be.
Lackluster growth characteristics
It is also worth noting that its weighted-average forward earnings per share growth rate stands at only 5.3%, with forward revenue growth at just 6.6%, as per my calculations. To provide some context on the EPS rate, one of the essential reasons for such a weak figure is that 35 companies in the XSLV portfolio that account for almost 27% of net assets are forecast to deliver lower EPS going forward, with the majority of them being financials.
Valuation might look attractive, but there are nuances
At first glance, with a weighted-average earnings yield of ~6.5%, as per my calculations, XSLV might appeal to investors trying to tilt their portfolios to better-valued names and slightly reduce the risks inherent to expensive stocks amid a potential recession. However, the following facts illustrate XSLV's basket is not as cheap as it might seem.
- First, the S&P 600 index has a much higher earnings yield of close to 8.9% (an 11.3x P/E), according to the data from the SPDR S&P 600 Small Cap ETF ( SLY ).
- Second, the 14.4x median EV/EBITDA ratio for non-financial stocks, as per my calculations, looks fairly expensive.
- Third, just about 28% of the holdings have a B- Quant Valuation grade or better, even despite the fact the fund lost ~8.4% in the first four months of 2023.
- Fourth, we see around 37.6% of the portfolio priced at a premium to their respective sectors, which is manifested in a D+ Valuation grade and lower. One of the examples is California Water Service Group ( CWT ), an F-rated utility company with a ~0.9% weight in XSLV.
A few positives: e xpense ratio and liquidity
The factors discussed above do not speak in favor of XSLV. However, this vehicle has a few advantages, mostly related to its adequate expenses and liquidity. More specifically, the expense ratio of 25 bps is substantially below the median of 47 bps for all other rated ETFs, while its relatively large AUM and average daily volumes secure a B- Liquidity rating.
Investor takeaway
With the potential recession being a growing concern, investors might consider boosting exposure to stocks that tend to perform better than the overall market during downturns, with those from the defensive league (e.g., consumer staples) and low-volatility names on the list.
However, I believe XSLV should be crossed off that list. Its past performance was mostly soft, despite 2021 and 2022 being bright spots. Its portfolio currently has too much exposure to low-quality small caps, with a substantial share of them being financials. Growth is sluggish, while valuation is questionable. In sum, assuming financials might surprise to the upside from here, which would be one of the principal risks to a theoretical bearish thesis, I believe XSLV is a Hold.
For further details see:
XSLV: Mind Quality Risks When Seeking Low Volatility In Small Caps