FXO ETF: A Curated Financials Sector Fund

Let’s face it – Financials have never been the same since the Great Financial Crisis. Banks became more like utilities, and the group broadly hasn’t had stellar performance relative to hotter sectors like Tech. Having said that, I do think the sector has promise largely because I believe value will outperform growth in the years ahead, and Financials are a major component of that. If you agree with that idea, you may want to consider the First Trust Financials AlphaDEX® Fund (NYSEARCA:FXO).

This is a quantitatively oriented fund consisting of equal-weighted stocks which are selected using the AlphaDEX stock selection methodology. This approach ranks companies on growth and value factors (that is, a company’s potential for price appreciation; sales-to-price ratio; book value-to-price ratio; and return on assets) to construct a portfolio of companies with strong growth prospects and favorable valuations.

A Look At The Holdings

As this is a sector-specific fund, you’ll find companies ranging from banks, investment firms, insurance companies, reinsurance, and more. There are a total of 102 holdings which are equal weighted on rebalances. Currently, no position makes up more than 1.89% of the fund.

To give you a sense of the types of companies you see here, consider that Progressive Corporation is the nation’s third-largest property and casualty insurer, while KKR & Co is one of the leading global investment firms with multiple alternative asset classes, which includes private equity, credit and real assets, across multiple industries and geographies.

One of the big positives here is the valuation metrics these companies give the portfolio. With a Price to Earnings ratio of just 11.44x and a Price to Book of 1.48x, this fundamentally is cheap, and should have a nice valuation cushion should markets turn more volatile.

Sector Composition and Weightings

Banks, no surprise, make up the largest allocation at nearly a third of the fund, followed by more traditional investment banking and non-life insurance. It’s a fairly typical mix for a financial sector fund.

Stocks categorized as banks include commercial banks, savings institutions and other credit intermediaries that accept deposits and make loans to individuals and businesses. Investment Banking and Brokerage Services include firms that are involved in primary capital market activities, such as underwriting, trading and brokering securities, as well as providing advisory services in the areas of mergers, acquisitions and corporate restructurings. And Non-Life Insurance covers companies that provide insurance of goods not associated with life, such as auto, homeowners and commercial coverage.

Peer Comparison

One fund worth comparing this against is the Financial Select Sector SPDR ETF (XLF) which tracks the Financial Select Sector Index passively. When we look at the price ratio of FXO to XLF, we find that the two have recently been in lockstep with each other. Despite the methodology used, it’s not clear if there’s a sustainable hedge that translates into performance.

Investing in the Financials Sector: Pros and Cons

On the positive side, FXO encompasses a large sector of the economy. As such, an investment in FXO can provide some diversification benefits to your portfolio, since it covers many sub-industries, such as banks, insurance, investment services, etc. It can help to reduce concentration risk as well, given its equal weight methodology. It’s also worth noting that a feature of the financial sector is that many of these institutions have a tendency to pay out dividends.

The downside? The big one is regulatory changes which could significantly affect the profitability and operations of companies that comprise FXO’s portfolio. Stricter regulations or higher cost of compliance may adversely affect the performance of certain holdings. Financials also broadly depend on the strength of the global economy. In periods of economic downturns or recessions, when the risk of loan defaults for financial institutions increases and their activities slow, their profitability is likely to fall, thus FXO’s performance might suffer too.

Conclusion

Mixed feelings here. When I look at the methodology, it makes sense, and I think the sector is due for relative outperformance. Having said that, passive proxies like XLF are performing just fine for the same kind of exposure. I think if you like the fundamental focus here, FXO is worth considering. If you’re more of the mindset that fundamentals don’t matter much, then the passive XLF might be more your speed.

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