Fed Chairman Jerome Powell delivered on Friday some sobering news. Investors intuitively knew things would be tricky, but many hoped that the Fed could engineer a soft landing. Friday saw those hopes dashed with Powell's commitment to attack inflation the only way the Fed knows how, regardless of the harm to the economy.
In fact, he warned, "reducing inflation is likely to require a sustained period of below trend growth.... While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses."
Where can exchange-traded fund investors look to in this situation? I'm going to go back to basics to take a look at two "long-only" consumer staples funds. The first fund uses the original smart beta approach that helped turn First Trust into the ETF juggernaut it is today, the First Trust Consumer Staples AlphaDEX Fund (FXG) . The second is the actively managed Consumer Staples Select Sector SPDR Fund (XLP) .
For anyone wondering what I am talking about when I call XLP an active fund, I'd remind readers that all the Select Sector ETFs are based on the S&P 500 Index. If you read through the index methodology guide, SPX is an index that has no set rebalance schedule, and final security selection (including the decision to fast-track IPOs for inclusion) is based on the subjective decision of the S&P Selection Committee. If that's not the definition of active management, I don't know what is.
OK, back to the fund comparison.
As you can see in the table below, FXG has had a good year to date through Aug. 29, relatively speaking, against both XLP and the SPDR S&P 500 ETF Trust (SPY) . Even in the current quarter-to-date period ending Aug. 29, it is still 1.04% over XLP, posting 4.02% compared to XLP's 2.98% returns. While FXGs 64 basis point (bps) expense ratio is clearly higher than XLPs 10 bps, you can see that over time, shareholders can make up that difference in returns.
Source: Factset, All You Can ETF
I covered the methodology for XLP above except to add that Select Sector Indexes use a float-adjusted market capitalization weighting approach. Let's take a quick look at the methodology for AlphaDEX product indexes, identified as StrataQuant by index provider ICE Data Services. This approach was first developed in the mid-2000s and the first AlphaDex products were launched in 2007. The strategy uses the Russell 1000 Index as the base universe. From there, constituents in a given sector are evaluated using the following growth, and value factors:
3-Month Price Appreciation
6-Month Price Appreciation
12-Month Price Appreciation
Price to Sales
1-Year Sales Growth
Price to Book Value
Price to Cash Flow
Return on Assets
Once all names have been scored and ranked, the top 75% of names are selected and grouped in quintiles based on rank. The constituent target is 40 names. The top quintile group is assigned an allocation of 33.33% (5/[1+2+3+4+5]), the second quintile is allocated 26.67% (4/[1+2+3+4+5]), and so on down the line. Constituents are equally weighted within each quintile.
I mentioned some returns above, but looking at some attribution is the best way to figure out what these funds are doing differently. First off, we have a 58% overlap between FXG's 40 holdings and XLP's 33 holdings, meaning that 58% of the names held in FXG are also in XLP. Not to confuse anyone, but from XLP's perspective, that figure is 68%. Suffice it to say that there are some material differences in security selection between these two funds. Another material difference comes from each fund's weighting methodology with XLPs float-adjusted market capitalization going up against FXGs modified equal-weight approach using the equal-weighted ranked quintile approach.
I ran some attribution for each fund from June 30 to Aug. 29 and found that while only one name was in both funds' Top 10 contributors to return over the period (Archer-Daniels Midland (ADM) ), a full eight names were held in common in the bottom 10 contributors to return. While anecdotal, these results seem to give a systematic selection and non-market capitalization-weighted approach to sector investing some advantage.
As you can see from the below below, FXG has done a good job over the years on a cumulative basis at least, outperforming both XLP and SPY.
Source: Factset, All You Can ETF
There are periods where the tables are flipped of course, but if you have a mid-to-long-term view that consumer staples has a place in your allocation, then perhaps FXG is worth a closer look.