FXD: Factor-Based Consumer Discretionary ETF You Should Avoid (NYSEARCA:FXD) #NewsETFs

Investment Thesis

The First Trust Consumer Discretionary AlphaDEX Fund ETF (NYSEARCA:FXD) is a well-established specialty fund selecting U.S. stocks of all sizes based on their growth and value features. Unfortunately, FXD has lagged behind most low-cost options since it debuted in May 2007, and my assessment of its current holdings indicates it’s highly risky. Furthermore, I have concerns about the portfolio’s quality, as FXD’s net and free cash flow margins are well below the category average. As a result, I recommend avoiding FXD, and I look forward to explaining why in further detail below.

FXD Overview

Strategy Discussion

FXD tracks the StrataQuant Consumer Discretionary Index, selecting Russell 1000 securities expected to outperform on a risk-adjusted basis. According to the fund’s prospectus and fact sheet, the selection process is as follows:

1. The eligible universe includes all Consumer Discretionary securities in the Russell 1000 Index meeting the Index’s share class and liquidity screens.

2. Each security receives a growth score based on three-, six-, and twelve-month price appreciation, sales to price, and one-year sales growth.

3. Each security also receives a value score based on book value to price, cash flow to price, and return on assets.

4. Based on a security’s style designation as determined by Russell, the Index uses its corresponding growth or value score. In cases where Russell designates a security as growth and value, the Index uses the better score.

5. The greater of the top 75% of the eligible universe or 40 securities form the Index. Securities are divided into quintiles based on their scores, with top-ranked stocks receiving a higher weight.

6. The Index is reconstituted and rebalanced quarterly.

I compared each stock’s weight in the iShares Russell 1000 Value ETF (IWD) and the iShares Russell 1000 Growth ETF (IWF) and found that FXD assigns 71.50% of the portfolio to value stocks and only 28.50% to growth stocks. I spot-checked these allocations over the last two years and found them to be remarkably consistent. In addition, Morningstar’s Factor Profile indicates the portfolio tilted closer to value over the last five years, which is good evidence that FXD is a value-oriented fund.

The Index’s weighting scheme is also much closer to equal weight, which significantly impacts value and growth. For example, if FXD were float-adjusted market-cap-weighted, it would trade at 23.50x forward earnings and feature 14.57% one-year estimated earnings per share growth. Instead, FXD’s method reduces those figures to 14.07x and 7.70%, respectively.

FXD Performance Analysis

Since its inception, FXD has delivered a 240.96% total return. Sadly, this pales in comparison to market-cap-weighted funds like The Consumer Discretionary Select Sector SPDR Fund ETF (XLY) and the Vanguard Consumer Discretionary Index Fund ETF Shares (VCR), which gained 481.81% and 512.89%, respectively.

The smaller 260.99% return for the Invesco S&P 500 Equal Weight Consumer Discretionary ETF (RSPD) illustrates a weighting scheme’s massive impact on performance. I see the approach as anti-momentum by design, as RSPD routinely decreases the weights of stocks like Amazon.com, Inc. (AMZN), Tesla, Inc. (TSLA), and The Home Depot, Inc. (HD) rather than letting these winners run. I understand valuation concerns can arise, but this approach also requires boosting the weights of poor-performing stocks, whose share prices have often declined for good reasons.

Still, even if alternative weighting schemes appeal to you, FXD’s return lagged RSPD by 20%. About 5% is attributed to the difference in expense ratios (0.61% vs. 0.40%), which I calculated using this calculator, assuming a 7.50% annual return over 17.33 years. The rest relates to strategy.

Portfolio Visualizer provides some additional information on risk, which is essential because FXD’s objective is to deliver stronger risk-adjusted returns than broad-market benchmarks like XLY and VCR. Unfortunately, this task is even more challenging because its selections tend to be volatile. As shown below and linked here, FXD’s annualized standard deviation since June 2007 was 22.99% compared to 19.86% and 20.94% for XLY and VCR. The result is poor risk-adjusted returns, as measured by the Sharpe and Sortino Ratios.

These results do not support FXD as a viable long-term investment and certainly not one worthy of a 0.61% fee. However, let’s look at the fund’s composition and fundamentals to see if a case can be made moving forward.

FXD Analysis

Composition Differences vs. Peers

FXD is well-diversified, both at the company and sub-industry levels. It holds 120 securities and allocates at least 3% to 15 unique GICS sub-industries compared to 9, 14, and 8 for XLY, VCR, and RSPD, respectively. Another distinction is that FXD follows the ICB framework, which includes several GICS-categorized stocks from the Communication Services, Consumer Staples, and Industrials sectors. These include Fox Corporation (FOXA), Costco Wholesale Corporation (COST), and Spotify Technology S.A. (SPOT), which are all in FXD’s top 15 holdings list shown below.

Relative to XLY and VCR, FXD’s primary underweights are Amazon, Tesla, and Home Depot by 21%, 14%, and 8% on average. In XLY’s case, these stocks comprise 48% of the fund, and at this point, it’s reasonable to question the benefits of owning an ETF and paying the annual fees. I think that’s why FXD has managed to get up to $1.43 billion in AUM despite a poor track record. However, owning neither of these funds is also an option, as you might already have a solid amount allocated to the sector already. For example, Consumer Discretionary accounts for 10% of the S&P 500 Index.

FXD Fundamentals vs. XLY, RSPD, VCR

The following table highlights selected fundamental metrics for FXD’s top 25 sub-industries, which total 94.75% of the portfolio. Homebuilding (7.84%), Automotive Retail (7.73%), and Restaurants (7.66%) are the top three sub-industries, represented by stocks like D.R. Horton, Inc. (DHI), Lithia Motors, Inc. (LAD), and CAVA Group, Inc. (CAVA). Furthermore, FXD’s $47.5 billion weighted average market cap is about 50% less than RSPD’s and more than 90% lower than XLY’s, showcasing the fund’s small and mid-cap lean.

This small and mid-cap lean is also responsible for the fund’s 1.44 five-year beta, the highest of the four. This statistic indicates higher volatility, mainly driven by the Hotels, Resorts & Cruise Lines and Casinos & Gaming sub-industries are the biggest drivers, which comprise about 10% of the fund. Several retail sub-industries also have betas above 1.50, so these types of sector ETFs are really only best to overweight when the economy is expanding. As I recently covered in my review of the Invesco Russell 1000® Dynamic Multifactor ETF (OMFL), that’s not the case now. The Conference Board expects GDP growth to slow in 2024.

If accurate, this is concerning for FXD shareholders. Its current selections are not as financially sound as RSPD’s, evidenced by lower net income margins (8.33% vs. 11.91%) and lower return on equity (23.24% vs. 28.20%). FXD’s selections also have a lower weighted average interest coverage ratio (17.76x vs. 21.75x), so while they would likely benefit more from declining interest rates, it’s contingent on a “soft landing.” FXD’s portfolio and strategy, which includes no quality or forward-looking screens, indicate it won’t necessarily rotate into safer stocks should conditions deteriorate.

FXD’s main advantage is its low valuation, which, I believe, will be a consistent feature moving forward. FXD trades at 14.07x forward earnings, which is about 35-40% cheaper than broad-market funds like XLY and VCR. It could help offset some volatility concerns mentioned above, and it’s worth highlighting that FXD outperformed XLY by about 15% in 2022, a year when many high P/E stocks like Amazon and Tesla declined substantially.

Still, even if avoiding those stocks is your main reason for considering FXD, RSPD arguably has just as strong of a value and growth combination. Although slightly more expensive at 15.54x forward earnings, its historical sales and earnings growth rates are better, as are its one-year estimated earnings growth rate (8.75% vs. 7.70%). With superior quality, a lower expense ratio, and a better track record, RSPD makes much more sense than FXD.

Investment Recommendation

I do not recommend investors add Consumer Discretionary ETFs at this point due to concerns about a slowing economy and the likelihood of substantial losses in a recession. While FXD trades at an attractive 14.07x forward earnings, its growth rates aren’t better than its peers, its five-year beta is above average, and the quality of its selections is relatively poor. I believe these features have led to FXD lagging behind peers like XLY, RSPD, and VCR since its May 2007 launch, and for those reasons, I have assigned it a “sell” rating. Thank you for reading.