FYC: Smart Or Speculative Small-Cap Growth ETF? (NASDAQ:FYC) #NewsETFs

Investment Thesis

There are very few fundamentals-based small-cap growth ETFs on the market, but the First Trust Small Cap Growth AlphaDEX Fund ETF (NASDAQ:FYC) is one I’d like to explore today. I found its total returns to be competitive with low-cost peers like the SPDR S&P 600 Small Cap Growth ETF (SLEEP), and its high-growth profile provides investors with the opportunity for substantial gains under the right conditions. While the fund’s 0.70% expense ratio is excessive and its underlying portfolio has some quality deficiencies, FYC offers a different look at the small-cap growth universe, and I look forward to explaining how its strategy works in more detail below.

FYC Overview

Strategy Discussion

FYC tracks the Nasdaq AlphaDEX Small Cap Growth Index, selecting U.S. securities based on specific size, liquidity, and fundamental criteria. I’ve listed the main points of the strategy below.

1. Securities must be included in the Nasdaq US 700 Small Cap Growth Index.

2. Securities must have a minimum $500,000 five-day average daily traded value for each of the 60 days leading up to the Reconstitution Reference Dates, which are the last trading days of December, March, June, and September. Reconstitutions are effective on the sixth business day of the following month.

3. Based on Nasdaq’s designation of each security as either growth or value-oriented, only growth stocks are eligible for selection.

4. Each security receives a growth score based on three-, six-, and twelve-month price appreciation, sales-to-price ratio, and one-year sales growth. Higher values are preferable in all cases, and the Index selects the top 262 securities for inclusion.

5. Based on rank, securities are divided into quintiles, and the securities within each quintile are assigned an equal weight. Quintiles 1-5 receive total weights of 33.3%, 26.7%, 20.0%, 13.3%, and 6.7%, respectively.

I have two takeaways based on these screens. First, the growth screens are all short-term (i.e., less than one year), and I expect a significant overlap between the price appreciation and price-sales ratio screens. Therefore, I expect FYC to have excellent momentum features. Second, the weighting scheme amplifies this, and since the Index uses no forward-looking screens, the potential for selecting stocks after they’ve already outperformed is high.

Performance Analysis

FYC has delivered a 259.17% total return since its inception on April 19, 2011. These returns trailed SLYG by about 25% and were better than the iShares Russell 2000 Growth ETF (IWO) and the Vanguard Small-Cap Growth ETF (VBK) by 42% and 30%, respectively.

From a risk perspective, FYC’s total volatility was about the same as IWO’s based on its 19.87% annualized standard deviation figure. However, SLYG’s volatility was the lowest at 18.58%, and because its 10.09% annualized returns were also the best, its risk-adjusted returns (Sharpe and Sortino Ratios) were the highest. Given these results and the fund’s low 0.15% expense ratio, SLYG should be the bar FYC needs to cross to earn a buy rating.

FYC Analysis

Sector Allocations and Top Ten Holdings

The following table highlights the sector allocation differences between FYC, SLYG, IWO, and VBK. I first noticed that IWO was the least diversified of the four, allocating more than two-thirds of its assets to just three sectors (Health Care, Industrials, and Technology). FYC is well-balanced but does overweight Health Care compared to SLYG.

The reason is that the S&P SmallCap 600 Index requires new entrants to have positive earnings over the last year and the previous quarter. This screen eliminates many high-potential but speculative biotechnology stocks. FYC’s 9.70% overallocation to this sub-industry (12.41% vs. 2.71%) explains the sector variance, while IWO’s 14.27% allocation to biotechnology stocks is even higher. You should decide whether you want that much speculation in your portfolio or prefer more consistent returns through SLYG.

FYC’s top ten holdings are below and include Summit Therapeutics (SMMT), ADMA Biologics (ADMA), and Zeta Global Holdings (ZETA). SMMT has surged recently after “unprecedented” Phase III trial results for its drug designed for lung cancer patients. It’s an example of the incredible potential of small-cap stocks, but approximately one-third of FYC’s portfolio reported a net loss over the last twelve months. By comparison, this is only valid for 6.76% of SYLG’s constituents by weight.

FYC Fundamentals By Sub-Industry

The following table highlights selected fundamental metrics for FYC’s top 25 sub-industries, which total 63.93% of the portfolio. This concentration level is in line with its peers, and FYC also has a similar $3-4 billion weighted average market cap as SLYG and IWO. Meanwhile, VBK is an outlier at $9.4 billion, indicating it also holds several mid-cap stocks.

Here are three other observations to consider:

1. FYC’s strong momentum features are on display, evidenced by its weighted average 66.64% one-year price return based on current holdings and weights. However, FYC is only up 18.01% over the last year, indicating its holdings entered the Index only after they achieved significant gains. It’s how momentum investing works, and while it’s also true for the other three ETFs, it’s not nearly to the same degree.

Moreover, FYC’s price return is driven primarily by Biotechnology stocks, which are up 247.22% on a weighted average basis. Led by Summit Therapeutics, these stocks are often subject to significant losses, evidenced by the following table highlighting drawdowns for the SPDR S&P Biotech ETF (XBI) and the Virtus LifeSci Biotech Clinical Trials ETF (BBC).

2. Although it’s not part of the selection process, I’m pleased that FYC offers excellent estimated one-year sales and earnings per share growth. At 14.66% and 19.87%, these growth rates are twice as much as SLYG and 3-5% higher than IWO. Interestingly, its valuation ratios (18.14x forward earnings, 1.80x trailing sales) are between SLYG and IWO, so it’s a good deal from a GARP perspective. By dividing each ETF’s estimated earnings growth rate into its forward P/E, we get these PEG ratios:

• FYC: 18.14x / 19.87% / 100 = 0.91
• SLAY: 15.54x / 9.14% / 100 = 1.70
• IWO: 19.02x / 14.65% / 100 = 1.30
• VBK: 24.29x / 14.92% / 100 = 1.63

Often, an ETF achieves an attractive PEG ratio by being undiversified. I’ve stated in other articles how it’s easy for an ETF to look attractive fundamentally when it’s only “forced” to select a few stocks. However, that’s not the case with FYC. It’s well-diversified with 262 holdings, and its concentration by sub-industries is similar to broad-market ETFs.

3. Evaluating the quality attributes of small-cap growth ETFs is challenging, but I noticed that FYC’s weighted average asset turnover ratio of 0.70 was the lowest of the four. This metric indicates an inefficient use of assets to generate sales. For some added context, the ratio is about 0.85 for the S&P SmallCap 600, S&P MidCap 400, and S&P 500 Growth Indexes, so FYC’s ratio is disappointing. Combined with its higher P/E, I see it as borderline speculative.

Investment Recommendation

FYC selects 262 small-cap growth stocks based on three short-term historical metrics: 3-12 month price appreciation, sales-to-price ratio, and one-year sales growth. Although I categorized the first two as momentum screens, the result is a portfolio featuring 19.87% estimated EPS growth for just 18.14x forward earnings. This combination was the best of the four ETFs I analyzed. To be sure, I am concerned about FYC’s poor quality, particularly its low asset turnover ratio and high allocation to biotechnology stocks. However, putting its 0.70% expense ratio aside, the portfolio is well constructed for aggressive small-cap growth investors, so I’ve assigned it a solid “hold” rating. Thank you for reading, and I look forward to your comments below.