ETFs
XMHQ ETF: Winning Streak May Continue
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Even if we want to diversify beyond large-cap stocks, the options are limited. Small caps (IWM) are an area of interest, but their frustrating underperformance shows no signs of slowing down. Mid-cap stocks might have more potential, but they would still perform poorly relative to the broader market. However, the Invesco S&P MidCap Quality ETF (NYSEARCA:XMHQ) uses fundamental “quality” analysis and shows impressive performance over the past 18 months.
XMHQ Overview
XMHQ was launched by Invesco in 2006. It is a passively managed ETF with $4.8 billion in assets under management that seeks to track the S&P MidCap 400® Quality Index. This underlying index uses fundamental analysis to select quality stocks, making it very different from the majority of passively managed funds. Very often we see ETFs selecting stocks and weighting them based on market capitalization, GICS classification, or metrics such as volatility or momentum. A measure of quality is something different, but more difficult to define. So, what exactly constitutes “quality”?
In short, according to prospectus, “companies that seek to generate higher revenues and cash flow than their peers through prudent use of assets and finances.” This is determined by three factors –
(1) return on equity (calculated as the company’s trailing 12-month earnings per share divided by the company’s latest book value per share)
(2) accrual ratio (calculated using the change in the company’s net operating assets over the last year divided by the company’s average total assets over the last two years)
(3) financial leverage ratio (calculated as the company’s total latest debt divided by the company’s book value)
These fundamental ratios are then converted to Z-scores and averaged to provide a quality score. 80 stocks with the highest scores from the S&P Midcap 400 Index, which generally represents the U.S. mid-cap stock market, are selected for the index. They are weighted by a combination of market capitalization and quality score.
The weighting process imposes limits on individual stocks and sectors to ensure diversification.
The minimum weight of each component stock is 0.05% and the maximum weight is the lesser of 5% or 20 times its market capitalization weight in the parent index. No single sector (according to GICS®) represents more than 40% of the underlying index.
The underlying index is rebalanced semi-annually after the market closes on the third Friday in June and December.
All of this leads to a sector exposure that looks like this:
Sector exposure (seeking alpha)
Industrials is by far the fund’s largest sector, which is a good sign as the sector has performed well over the past year. That said, this is a case of the tail wagging the dog: quality scores should improve stocks in well-performing sectors.
Although we cannot accurately track changes in sector exposure, we can look back at previous Alpha Article Search. Industrial stocks were still at the top of the allocation a year ago, but financial stocks rose to the detriment of consumer discretionary.
Exhibition April 2023 (in search of Alpha)
This is again an encouraging sign as the financial sectors (XLF) and industrialists (XLII) significantly outperformed consumer discretionary goods (XLY) over the past year.
Sector comparisons (SPDR sectors)
Currently, the top 10 stocks look like this:
Top 10 Stocks (Looking for Alpha)
This composition makes XMHQ quite concentrated in its 10 main titles, at least compared to other mid-cap funds, which tend to be much more diversified than funds containing mega-cap stocks.
% in the Top 10 (Etfdb,com)
This focus can be beneficial when the top 10 performs well.
XMHQ Performance
XMHQ significantly outperformed the benchmark, the Vanguard Mid Cap ETF (VO) over the past year.
This outperformance extends to most funds are in the mid-cap sector.
Performance table (Etfdb.com)
XMHQ also comes in second place in Seeking Alpha’s quantitative ratings in its subclass.
Quantitative Notes (In Search of Alpha)
Its long-term performance is less impressive, but still compares well to VO. It outperformed 6 years out of the 11 presented.
XMHQ vs. VO (Portfolio Viewer)
The cumulative performance is much better thanks to the gains of the last two years.
XMHQ vs. VO (Portfolio Viewer)
The big question is whether these good performances will continue. Due to the fund’s rotation from poorly performing sectors to higher quality sectors and stocks, I think there is a good chance that this will be the case, but of course it is not guaranteed.
Other measures
XMHQ has a dividend yield of 0.6% TTM. This is not the fund or space to seek yield. The 0.25% expense ratio is high, but can be justified as long as the fund performs well. Liquidity is excellent and I don’t see any other red flags.
Risks
The risks come from the relatively high concentration of industrial stocks and the top 10 stocks. Due to the semi-annual rebalancing, if the sector or top 10 began to perform poorly, the fund would take time to adjust and could outperform other funds in the sector.
Mid-cap stocks generally have higher risk than large-cap stocks. Quality control should insulate XMHQ from very high-risk companies, but the subclass as a whole is generally more volatile.
Conclusions
XMHQ offers an alternative to large-cap stocks and ETFs and a welcome change from the common selection process employed by majority funds. By using fundamental analysis to select quality stocks, he has managed to significantly outperform over the past 18 months. The selection process doesn’t always work, but changes in portfolio composition over the past year suggest that XMHQ tends to pick winning stocks and sectors.