This financials ETF is racing ahead of cheaper sector funds. Here's how it works

Published Tue, Feb 21 20233:43 PM EST

Jesse Pound @/in/jesse-pound @jesserpound

Financial stocks are off to a solid start to the year, but the performance of the First Trust Financials AlphaDEX Fund (FXO) is surpassing its rivals and attracting a wave of cash from investors. The FXO has pulled in more than $1 billion of inflows over the past month, according to FactSet, and is outperforming cheaper sector funds this year. The fund has a total return of more than 11% so far in 2023, compared with 6.4% for the Financial Select Sector SPDR Fund (XLF) and 7.7% for the Vanguard Financials ETF (VFH) . The First Trust fund has also has been a long-term winner, as its 10-year total return tops those of its rivals as well. The fund is built by scoring the financial stocks in the Russell 1000 on both value and momentum factors, explained Ryan Issakainen, senior vice president and ETF strategist at First Trust. The stocks are then ranked based on the top score of either of those two factor tests. The top 75% of the stocks make the cut for the fund. The FXO, which is rebalanced quarterly, uses a tiered weighting system. The top 20% of the stocks in the fund by factor score are given equal weight and account for a combined one-third of the portfolio, Issakainen said. The next 20% are given a smaller combined weight, and so on. Stocks that score poorly on both value and momentum tests are either put in the smallest group in the portfolio or left out entirely. The result is a portfolio with less exposure to the stocks with the biggest market caps. Its biggest holdings are OneMain and Ally Financial . This allows the fund to avoid a lot of the "stock-specific risk" in the more concentrated funds. Berkshire Hathaway , for example, has a large market cap and has underperformed the financial sector this year. "The portfolio is going to in general almost always underweighting some of the largest stocks, especially within sector funds, because those tend to be really top heavy. … If you just look at top 10 holdings, much lower exposure to those big, diversified financials," Issakainen said. A cheaper valuation could also be a reason that the FXO is outperforming some of its peers, Issakainen said. According to FactSet, the fund had a price to earnings ratio below 9 as of December. The Vanguard and SPDR products had ratios above 13 and 14, respectively. The fund, which launched in 2007, has been able to achieve long-term success despite an expense ratio of 0.62%, well above that of index funds tracking the same sector.