ETFs are all the rage lately, as most of them follow well-known indexes, cost very little and are easy to trade. But a new variety is making a splash, so called smart-beta ETFs, which use algorithms to concoct asset mixes designed to beat the market. Let’s check out one of the hottest new entries and weigh its advantages (good performance) against its weaknesses (vulnerability to a drooping market).
The No. 1 ranked newly launched exchange traded fund over the past year in terms of attracting money is the First Trust Focus Five (FV). This ETF began trading on March 6, 2014, with just under $2 million. Today, the fund has approximately $3 billion in assets.
What causes a fund to collect $3 billion in about one year? 1) a great marketing organization – First Trust, the Focus Five sponsor, grew 68% last year and has total assets in excess of $100 billion with a 100-plus person nationwide sales team, 2) an easy to explain story, 3) convenience and 4) performance.
Focus Five is a portfolio constructed of top performing First Trust sector ETFs. It is an ETF of ETFs. It measures the relative strength of 20 First Trust sector ETFs and buys the five strongest. Dorsey Wright & Associates, an experienced manager runs the relative strength model (which gauges the sustainability of an investment’s advances versus its declines) to select positions.
This ETF currently owns biotechnology, health-care, Internet, consumer staples and consumer discretionary First Trust sector ETFs. It is a concentrated portfolio. It does not have the option to shift into defensive positions if the market turns down. An investor in the Focus Five should expect volatility greater than the Standard & Poor’s 500 index.
Convenience: By owning Focus Five, an investor does not have to pick sectors. The fund will do this automatically.
Performance: Since inception, Focus Five is up about 18% versus the S&P 500’s advance of about 13%. Much of the outperformance stems from the fund’s biotechnology exposure. Since the October 2014 lows, the biotechnology sector is up more than 40% relative to the S&P 500 advance of 14%.
Result: $3 billion of assets in one year.
Focus Five came to market at a good time. For the past five months, the S&P 500 has effectively traded sideways. Market momentum is stalling as S&P 500 earnings for the past two quarters have declined or stayed flat year-over-year.
With earnings down, Fed Chairwoman Janet Yellen pointed out recently that stock prices are “quite high” and risk is elevated. This is especially true if interest rates rise on a sustained basis. Since early February, the 10-year U.S. Treasury yield has climbed to around 2.4% from 1.7%.
With this backdrop, outsized performance can be blinding. As the investment becomes hotter, hot money flows faster. Caution is thrown to the wind. Investors might look past issues that would normally cause hesitation.
The attractive part of the Focus Five is a concentrated portfolio of the best performing sectors of an up market, which should deliver better than benchmark results during bullish cycles.
The negative is what might happen to a concentrated sector portfolio in a bear market. Actually, we saw a preview of this during the first month Focus Five traded. The ETF lost about 13% of its value compared to the S&P 500 index loss of about 3%, thanks to its high exposure to biotechnology. The losing streak lasted for only about a month until the biotech sector bounced back. The S&P 500 has generally been in a bull move since last March.
If the market were to roll over, there is no escape hatch for the ETF to rotate into. The onus of asset protection is on investors to sell their Focus Five position if downward momentum becomes unacceptable.
At our firm, we don’t own Focus Five, as we know there is no process to lower exposure to stocks in an extended equity market downturn. We have already seen high levels of negative volatility in the first year of trading and expect this characteristic may reappear.
On the other hand, we do like the upside potential of Focus Five. We intuitively are attracted to the concept of buying the best performing sectors of the economy, particularly during a time when overall economic growth is slow.
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Nicholas Atkeson and Andrew Houghton are the founding partners of Delta Investment Management, a registered investment advisory firm in San Francisco, and authors of the new book, Win by Not Losing: A Disciplined Approach To Building And Protecting Your Wealth In The Stock Market By Managing Your Risk. Additional market commentary and investment advice is available via their websites at www.deltaim.com and www.deltawealthaccelerator.com
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