FTGS: This well-rounded large-cap growth ETF comes with a catch

investment thesis

The first ETF Trust Growth Strength (NASDAQ:FTGS) gives investors equal large-cap exposure to 50 stocks that have grown earnings per share more than 21% annually over the past three years. Trading at 19.17x forward earnings, it is a The GARP investor’s dream, but there’s a catch. Unlike most growth ETFs, analysts expect FTGS’s growth rate to slow over the next year, and this relatively weak earnings momentum could become a short-term headwind. So my advice today is to avoid him, but I’m still looking forward to evaluating his strategy and comparing it to four alternatives in more detail below.

FTGS overview

Strategy talk

FTGS tracks the growth force index, selecting 50 stocks based on available cash, debt ratios, and earnings and cash flow growth. The methodology paper is linked here, but I’ve summarized the key screens below:

1. Average daily trading volume of at least $5 million over three months.
2. Rank in the top 500 by free-float market capitalization.
3. Minimum $1 billion in cash or short-term investments.
4. Maximum 30% long term debt to market capitalization ratio.
5. Return on equity of at least 15%.

Securities that pass these screens receive two ranks based on three-year cash flow percentage growth and three-year earnings percentage growth, and the two ranks are combined to obtain a single combined rank. The top 15 titles with the best combined rank in each ICB industry are selected for the final stage, and then the 50 titles with the best combined ranks are chosen. This process is repeated quarterly, with the reset taking effect after the third Friday in January, April, July and October. Each title receives an equal weight (2%) in this data.

In my view, there is also the potential for a few low growth stocks to creep into the index as the cash flow and earnings growth screens only need to be positive from three years ago. In bull markets, it is an easy target to hit, and since all screens are retrospective, there is nothing to prevent the Index from selecting stocks whose growth rates have outperformed. In addition, the index should be well diversified due to the maximum allocation of 30% per sector (15 stocks per sector / 2% per share). That could give it an edge over large-cap growth ETFs that overweight the tech sector and many Magnificent Seven stocks, but as we’ve seen over the past year, betting against them doesn’t always work, especially over the long term .

Performance snapshot

FTGS was only released on October 25, 2022and since when is close to when mega-caps began significantly outperforming, its track record is disappointing compared to the Invesco Nasdaq 100 ETF (QQQM). By September 4, 2024, FTGS remained 14% (50.75% vs. 64.36%).

However, FTGS beat the First Trust NASDAQ-100 Equal Weighted ETF (QQEW) with 11.60%, which is perhaps its closest competitor. FTGS also outperformed the Monarch Blue Chips Core ETF (CCBM), which is also equally weighted and slightly edged by the Sofi Select 500 ETF (SFY), which I labeled as “grow light”. previous reviews.

The Portfolio Visualizer provides some additional information about risk and returns. Since November 2022, FTGS has been less volatile, as measured by standard deviation, and had the smallest maximum discount. It also managed to gain 0.80% in the last two months of 2022, while QQQM fell by 3.98%. Had the ETF launched earlier, there’s a good chance its returns would have been much more competitive with QQQM, which fell 32.52% in 2022.

Finding other large-cap growth ETFs with better results is relatively easy. However, much can be explained by the outstanding performance of a select few stocks. For example, the Roundhill Magnificent Seven ETF (MAG) is up 43.49% over the past year, and other top performers such as the Schwab US Large-Cap Growth ETF (SCHG), allocate over 50% to these stocks. Of course, SCHG and similar ETFs could become underperforming ETFs if these stocks were to decline, which is why I welcome more diversified options like FTGS.

FTGS analysis

Sectoral allocations

The following table highlights the sector allocation differences between FTGS, QQEW, MBCC, SFY and QQQM. At 30%, FTGS exposure to the Technology sector is maximum, with the difference distributed mainly to the financial sector. Meanwhile, QQEW and SFY have 35-37% allocated to technology, while QQQM is the outlier at 50.89%.

Fundamental Analysis: Top 25 Holdings

The following table highlights selected fundamentals for FTGS’s top 25 stocks, which total 53.84% of the portfolio. My first observation is that FTGS includes several mid-cap funds such as RenaissanceRe Holdings ( RNR ) and Enphase Energy ( ENPH ). With a market cap of about $15 billion or less, I’m surprised these stocks were eligible, but it does open the door for it to function more like a full-cap fund.

FTGS is a high-quality fund, highlighted by a return score of 9.41/10, which we obtained from Seeking Alpha Factor Grades. I attribute this to the initial set of debt and return on equity screens. FTGS selections have also increased sales by 15.57% per year over the past three years, an impressive but unsurprising finding given that this is one of the factors its index uses to rank securities. I don’t have cash flow growth numbers, but his picks have also grown earnings per share by 21.12% annualized over the last three years, by far the most in this sample. Many financial actions, including Visa (V) and LPL Financial Holdings (LPLA), contribute to these strong results.

However, the problem is that FTGS’s estimated one-year EPS growth rate is almost 5% lower at 16.48%. Please note, this is not normal for large-cap growth ETFs, and the difference between the two numbers is the third largest among the 69 funds I track in that category. The only two ETFs with larger gaps are the Pacer US Cash Cows Growth ETF ( BUL ) and the Invesco S&P 500 GARP ETF ( SPGP ), which is to be expected since these ETFs actually use value screens. In contrast, FTGS does not use value screens, and while its forward P/E of 19.17x is quite attractive from a growth perspective at a reasonable price, I fear that this will not be the case after the upcoming rebuild. Based on the index’s methodology document, there is nothing preventing the index from selecting high P/E stocks with high historical earnings growth rates but poor projected growth rates.

Part of the expected slowdown in FTGS growth is attributed to the relatively weak earnings surprise and revision numbers. Its picks delivered an earnings surprise of 4.83% last quarter and have an EPS revision score of 5.98/10. Meanwhile, the average figures for the category are 7.23% and 6.46/10 respectively, so FTGS is quite behind. In other words, FTGS’s cheaper valuation is likely the result of its picks delivering disappointing results, giving Wall Street analysts little reason to upgrade earnings expectations. We placed these statistics under the broader “sentiment” category, and unfortunately, FTGS ranks 65/69 on this factor among high-growth ETFs.

Investment recommendation

FTGS delivered solid results compared to equally weighted growth alternatives such as QQEW and MBCC. Additionally, it trades at just 19.17 times forward earnings and has a three-year historical EPS growth of 21.12%, which is incredible from a GARP perspective. However, I am concerned that FTGS’s attractive valuation is because its growth rate is slowing, and I am even more concerned that this is an unintended consequence of a flawed strategy. With frequent quarterly restocks, I won’t have to wait too long to test this hypothesis, but out of an abundance of caution, I’m limiting my rating on FTGS to a neutral “hold” for now. Thanks for reading and I look forward to answering any questions in the comments below.