XMHQ ETF: Winning streak could continue

As much as we may want to diversify, when looking at large-cap stocks, the options are limited. Small caps (IWM) are an interesting area, but their frustratingly poor performance shows no sign of abating. Mid-cap stocks may have more potential, but they still don’t Poor performance compared to the broader market. However, the Invesco S&P MidCap Quality ETF (NYSEARCA:XMHQ) uses a basic “quality” check and has shown great performance over the past 18 months.

Introducing XMHQ

XMHQ was launched by Invesco in 2006. It is a passively managed ETF with $4.8 billion in assets under management which seeks to trace Standard & Poor’s Midcap 400®Quality index. This fundamental index uses fundamental scans to select high-quality stocks, and this makes it very different from the majority of passively managed funds. We often see ETFs pick stocks and weight them based on market cap, GEX rating, or… Measures such as volatility or momentum. The quality measure is something different, but difficult to define. So what exactly constitutes “quality”?

In short, according to the prospectus, “companies that seek to achieve higher revenues and cash flows than their peers through the prudent use of assets and funds.” This is determined by three factors –

(1) Return on equity (calculated as follows: A company’s trailing 12-month earnings divided by the company’s earnings Latest book value per share)

(2) Accrual ratio (calculated using the change Of the company’s net operating assets during the past year divided by Average total assets of the company over the past two years)

(3) Finance Leverage ratio (calculated as a company’s total recent debt divided by… Book value of the company)

These key ratios are then converted into Z-scores and averaged to provide a Quality Score. The 80 stocks with the highest scores from the S&P Midcap 400 Index, which broadly represents the U.S. midcap stock market, were selected for the index. They are weighted by a combination of market value and quality score.

The weighting process sets limits for individual stocks and sectors to ensure diversification.

minimum The weight of each component stock is 0.05%, and the maximum weight is Less than 5% or 20 times the weight of its market capitalization in the main index. No sector (according to GICS®) includes more than 40% of the basis index.

The underlying index is rebalanced semi-annually after the market closes at tThe third Friday of June and December.

All this leads to a sector exposure that looks like this –

Industrials is the largest sector in the fund, which is a good sign as the sector has performed well over the past year. However, this is a case of wagging the dog’s tail – quality points He should Pick up stocks in well-performing sectors.

Although we cannot precisely track changes in sector exposure, we can refer to previous “Seeking Alpha” articles. Industrials still led allocations a year ago, but the financial sector rose at the expense of consumer estimates.

This is once again an encouraging sign as the financials (XLF) and industrials (XLI) sectors have significantly outperformed consumer estimates (XLY) over the past year.

Currently, the top 10 properties look like this –

This combination leaves XMHQ highly concentrated in its 10 largest holdings, at least compared to other mid-cap funds, which tend to be much more diversified than funds with mega-cap stocks.

This focus can be useful when the top ten perform well.

XMHQ performance

XMHQ has significantly outperformed the benchmark Vanguard Mid Cap ETF (VO) over the past year.

This outperformance extends across most funds in the mid-cap space.

XMHQ also comes in second place on Alpha’s Quant Reviews search in its subcategory.

Its long-term performance is less impressive, but it still compares well with VO. It has outperformed for 6 of the 11 years offered.

The cumulative performance is much better thanks to the gains of the past two years.

The big question is whether the good performance will continue. As the fund shifts from underperforming sectors to better sectors and stocks, I think there is a good chance of doing so, but this is of course not guaranteed.

Other metrics

XMHQ has a dividend yield of 0.6% TTM. This is not the fund or space to look for yield. An expense ratio of 0.25% is high, but can be justified as long as the fund is performing well. Liquidity is excellent and I don’t see any other red flags.

Risks

The risks come from the relatively high concentration in industrial companies and top ten stocks. Due to the semi-annual rebalancing process, if a sector, or top 10, starts to underperform, the fund will be slow to adapt and could outperform other funds in that space.

Mid-cap stocks are usually higher risk than large-cap stocks. A quality check should isolate XMHQ from very high-risk companies, but the subcategory as a whole is typically more volatile.

Conclusions

XMHQ provides an alternative to large-cap stocks and ETFs and a welcome change from the common selection process used by majority funds. By using fundamental screening processes to pick high-quality stocks, I’ve been able to outperform significantly over the past 18 months. The selection process may not always work, but changes in portfolio composition over the past year suggest that XMHQ tends to pick winning stocks and sectors.