FEX: A Mediocre High-Fee Large-Cap Fund You Should Avoid (NASDAQ:FEX)

investment thesis

First ETF Trust Large Cap Core AlphaDEX Fund (NASDAQ:FEX) is a well-established large-cap mutual fund with $1.25 billion in assets under management and a track record dating back to May 8, 2007. Selecting 375 of the largest U.S. stocks with attractive growth and value characteristics, FEX is fundamentally sound except for one crucial area: quality. My analysis reveals that FEX’s quality metrics are no better than what funds of equal weight offer, and its value factor advantage is offset by the fund’s excessive 0.60% expense ratio. I recommend avoiding it, but I look forward to explaining the FEX strategy below and comparing it to other ETFs that might be a better fit for you.

FEX overview

Strategy talk

FEX tracks the Nasdaq AlphaDEX Large Cap Core Index, selecting stocks from the Nasdaq US 500 Large Cap Index that meet specific growth and value criteria. right methodological documentthe selection factors are:

• 3, 6 and 12 month price appreciation (increase)
• sales/price ratio (growth)
• one year sales growth (growth)
• ratio of book value to price (value)
• cash flow to price (value) ratio
• return on assets (value)

Nasdaq ranks each stock as either growth or value, and based on that classification, they are assigned growth or value scores. The top 375 securities comprise the index and are divided into quintiles based on their scores, with the top quintile receiving 33.3% of the index weight. Quartiles 2–5 receive weights of 26.7%, 20.0%, 13.3%, and 6.7%, respectively. Finally, the index is reconstituted quarterly to prevent style drift. This step means that shareholders consistently benefit from exposure to the six factors listed above.

In my view, price appreciation metrics are momentum screens, while return on assets is a common way to measure quality, not value. I am also surprised that a company’s earnings per share is not rated and that the remaining growth criteria are trailing one-year values. Typically, factor-based strategies use three- or five-year growth rates to smooth results, but this approach promotes frequent changes based on the past year’s results. FEX’s annual report confirms this feature, as portfolio turnover has been between 87-104% per year since 2019.

Performance analysis

Since June 2007, the FEX has gained 8.56% annually, compared to 8.99% and 9.91% for the Invesco S&P 500 Equal Weight ETF (RSP) and the SPDR S&P 500 ETF (SPY). The difference of 0.43% to RSP is explained by the differences in the expense ratios of the two funds (0.60% vs. 0.20%).

However, the difference with SPY is substantial over the long term. The total return difference was 97.95% over these 14 years (410.44% vs. 312.49%), and SPY proved to be the less volatile product as measured by standard deviation.

More recently, the Goldman Sachs Equal Weight US Large Cap ETF (GSEW) has emerged as a viable and lower-cost alternative to RSP, with an expense ratio of 0.09%. Additionally, the JPMorgan US Quality Factor ETF (JQUA) has delivered an impressive annualized return of 14.35% since December 2017, proving that market-like returns are possible without such an extreme concentration of Magnificent Seven stocks.

For those who prefer more established funds, I want to highlight how FEX’s total returns over the past decade rank 45th/53rd among large-cap mixed ETFs with sufficient history. FEX has ranked 91/133 over the past five years, which strongly suggests that better options are available. 0.60% is a tough sell given the solid historical returns and strong fundamentals of low-cost index funds.

FEX analysis

Sectoral allocations

From a sector allocation perspective, FEX and GSEW have many similarities. The three of them the biggest allocations are for financials, industrials and technology, and allocations differ by 2-3% in most cases. The only exception is in healthcare, where FEX has 4.22% less exposure. There is no specific action that would cause this, but notably, FEX avoids many prominent companies such as AbbVie (ABBV) and UnitedHealth Group (UNH).

Meanwhile, JQUA is more similar to SPY. These ETFs have 31-32% allocated to technology, but JQUA has maximum security allocations of around 2%, so while it’s not quite an equal weight fund, it does a good job of spreading the risk. Magnificent Seven’s exposure is only 9.44%, compared to 31.00% for SPY.

FEX Fundamental Analysis

The following table highlights selected fundamentals for FEX’s top 25 sub-industries, totaling 52.22% of the portfolio. We’ve also listed summary values ​​for GSEW, JQUA and SPY at the bottom.

Here are three observations to consider:

1. FEX and GSEW have 52% allocated to the top 25 sub-industries. They also have nearly identical five-year betas (1.05 vs. 1.06) and weighted average market caps ($118 vs. $104 billion), so structurally they are very similar. The main differences we noted were 1.48% more exposure to property and casualty insurance stocks, with the main offset being 1.61% lower than the Life Sciences Instruments & Services sub-industry.

2. FEX trades at 16.74 times forward earnings or about two points cheaper than GSEW. This is a pleasant surprise for me, as the earnings assessment is not part of the screening process. There is a similar discount to last-minute price cash flow (10.58x vs. 12.73x), accompanied by slightly better estimated one-year sales and earnings growth rates, so the mix is ​​likely superior to GSEW. The only downside is that FEX constituents have a lower five-year historical sales growth rate (8.84% vs. 9.36%), so the upside is minimal. We observed a sector-adjusted growth score of 5.13/10 using Seeking Alpha Factor Notes, compared to 5.09/10 for GSEW.

3. The quality values ​​of FEX are probably worse than those of GSEW. While it has the edge in trailing net margins (14.24% vs. 13.44%), it lags behind in free cash flow margins (10.74% vs. 12.65%) and return on total equity (10.41 % versus 10.55%). The differences are relatively small, but the JQUA and SPY metrics demonstrate how much quality investors sacrifice when “smart beta” ETFs focus on other factors like growth and value.

In the last decade, not the focus on quality has not he paid According to the table below, quality was the only factor that was in the green in the last three, five and ten years. This heat map, which reflects the performance of equity “risk premium” factors, illustrates what I think most investors know intuitively: quality stocks ultimately do well.

Unfortunately, smart beta strategies often sacrifice too much quality. To illustrate, the average large-cap mix ETF following a plain vanilla strategy holds stocks with net margins of 20.95%, compared to 15.34% for those following “fundamental” or “multifactor” strategies. Factor investing can work, but only if you focus on the right factors and it doesn’t look like FEX has enough quality to warrant an investment.

Investment recommendation

FEX has many qualities of equal-weight funds like GSEW, including a five-year beta of 1.05-1.06 and limited exposure to Magnificent Seven stocks. Its main advantage is in terms of value, highlighted by its forward P/E of 16.74x and trailing cash flow ratio of 10.58x, which is about two points cheaper. However, this advantage is negated by the fund’s excessive 0.60% expense ratio. FEX is sacrificing too much quality in pursuit of better value and higher growth, which I think is a crucial mistake. As a result, I do not recommend that readers buy FEX, and I look forward to answering any questions you may have in the comments below. Thank you for reading.