XLG: Pursue Quality, Examine Expenditure First (NYSEARCA: XLG)
Investors who don’t compromise on quality have a plethora of options to choose from when it comes to ETFs. Funds targeting profitability with particular methodologies are plentiful, appealing to both cash flow and profit-oriented investors, so figure out which one is right for you. best is a time consuming task.
However, there is a simpler alternative to delve into dozens of ETFs that involve sophisticated measures of earnings and capital efficiency to narrow down their lists to the most capable companies. Stock valuations contain immeasurable amounts of data, and the key question I would like to focus on today is the correlation between size and quality.
Another way of saying this is that large and especially mega-cap funds mostly have significantly higher quality than their smaller counterparts as a by-product of their strategies. Invesco S&P 500 Top 50 ETF (NYSEARCA:XLG) is a good example.
By tracking the annually rebalanced S&P 500 Top 50 Index, it selects the most valuable players in the S&P 500 using a buffer rule described in the methodology document. It’s a beautifully minimalist yet powerful strategy.
As my analysis presented below revealed, XLG could be used as a solid substitute for the iShares Core S&P 500 (IVV) ETF for investors looking for simpler, quality portfolios, sometimes with a slight tilt ( through market capitalization weighting). I will expand on this using Seeking Alpha Quant data and a few select profitability metrics.
However, there are drawbacks. First, differences in expense ratios could become a dealbreaker. IVV is a classic vanilla fund with only 3 basis points of fees, while XLG comes with an expense ratio of 20 basis points. Second, XLG has a problem with peak heaviness given that the top ten stocks in its basket are over 52%, making it likely to drop further if the IT giants’ rally falters after a month in July. euphoric and bullish first week of August. In the wake of the new inflation data, I think this is relatively unlikely as the bulls have a strong case to bid multiple again, but the risk of this rally losing momentum exists and should not. be forgotten. And third, XLG has all the upper echelon stock valuation issues.
Is XLG really better than IVV in terms of quality?
XLG is significantly overweight in IT, with 39% of net assets allocated to the sector at the time of writing, around 11% more than IVV. The other sectors which have seen their weight increase significantly are consumer discretionary and communication. Those who have seen their weightings sharply reduced are industrials and financials, while real estate and utilities have been eliminated entirely.
Of course, XLG investors enjoy much greater exposure to Apple (AAPL) and Microsoft (MSFT) than those who opted for the 500 cohort. that MSFT has a weight of 11.2%. In IVV, these indicators have, although significant, only one-digit weights.
Did it tilt the fund towards only the most profitable companies in the world? It made.
I’ve talked about the correlation between size and quality constantly in my Seeking Alpha articles, and the XLG Wallet offers a unique opportunity to illustrate this once again.
There are a few methods that can be applied here. This time, I would like to compare the quantitative characteristics of XLG’s holdings to IVV, and then compare the asset returns and EBITDA margins of their holdings outside of the financial sector.
When it comes to quantitative profitability ratings, XLG easily beats IVV. Within its portfolio, there is not even a single stock with a rating lower than A-. While also displaying strong profitability characteristics, the S&P 500 ETF is exposed to those with some issues, exemplified by a D+ or worse rating of around 1.2%. In the case of Stanley Black & Decker (SWK), this is negative operating and free cash flow while DuPont de Nemours (DD) could not organically hedge LTM investments and provide an asset turnover rate acceptable.
Now, comparison of ROA and EBITDA margins.
The scatter plot clearly shows that cohort 50 not only has components with negative EBITDA or net income (the nominator of ROA), but also most of its holdings (over 69%, to be precise) have an ROA above 10%, which is a solid result that deserves to be appreciated. We find that asset returns are particularly strong among the fund’s IT investments, with 12 out of 14 posting an ROA of at least 11%. Two outliers with single digit numbers are Advanced Micro Devices (AMD) and Salesforce (CRM). On the other hand, healthcare players cannot boast a similar level of efficiency, but their EBITDA margins are clearly impressive since the industry median is only 4.5%, while 11 out of 12 Sector holdings have a margin of no less than 29%.
Does XLG have a growth advantage over IVV?
Unfortunately no. Growth rates are slightly lower. For example, only 19.2% of XLG’s holdings have a growth rating of B- or better compared to 22.5% for IVV.
Either way, the forecast growth rates for EPS and revenue from its holdings are still quite robust, as shown in the chart below.
Is XLG’s wallet more expensive than IVV?
As quality generally invites higher multiples, XLG comes with a larger share of overvalued stocks. For example, 71.8% of its holdings are rated D+ or worse, compared to 68.3% for IVV.
Its portfolio is inherently more expensive than the S&P 500, so investors who choose it should consider whether they are comfortable with higher growth and quality premiums and whether they can tolerate periods when those premiums decline. .
What can historical returns tell us?
The main conclusion from the analysis of returns from the period June 2005 to July 2022 is that XLG tends to provide almost similar results to IVV.
For example, their risk-adjusted returns were nearly identical as both have a Sharpe ratio of 0.61, although XLG was a bit ahead at 0.92 compared to IVV’s 0.90. If we look at a shorter period, for example, a 10-year period, the results are also similar, as the S&P 500 ETF delivered the Sortino ratio of 1.51 versus 1.52 for XLG.
The chart below provides a better view of historical returns, with green cells indicating XLG’s alpha months and years.
XLG was a clear winner in the late 2010s and early 2020s, with the coronavirus market rally certainly contributing to its strong 2020 alpha of around 5.4%. We also find that his growth and technology-focused portfolio was more susceptible to the growth premia issue this year as investors began to adjust valuations to a new era of higher interest rates, so his total return in the first seven months was slightly weaker, although it outperformed in July.
Final thoughts: Pursue alpha with profitability in mind
Although indirectly, XLG follows a hybrid momentum/quality strategy, investing in some of the most expensive companies in the world.
It sums up beautifully how a simple strategy can dramatically increase a portfolio’s exposure to the quality factor.
Certainly, any factor should be pursued with profitability in mind. Even though XLG could offer better short-term returns if bulls continue to bid on multiples, longer-term, lower-cost alternatives like IVV have an edge over it. XLG is a plug.