XLG: A Focused Way To Access The S&P 500's Core Stock Group

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By Somya Sharma

Summary

We rate the Invesco S&P 500® Top 50 ETF (NYSEARCA:XLG) a Hold, more because we are fans of its focused structure and access to market leaders. As with just about any Buy rating on an equity ETF in the current market climate, we acknowledge the potential for macro market factors to drop the price of any ETF that owns equities significantly. That said, we continue to consider it a tactical position for our tactical model portfolios for the reasons noted below.

Strategy

XLG tracks the performance of the 50 largest stocks within the S&P 500 Index. This passively managed fund is market cap weighted, which means index components with a higher market capitalization will receive a higher weighting, and vice-versa.

As per S&P Global, this index is reconstituted annually. Additionally, a “buffer rule” is applied to the annual selection process to reduce portfolio turnover. It works like this: first, the 45 largest companies are automatically included in the index, and any current constituent companies remaining within the top 55 are re-selected for inclusion in the index.

Proprietary ETF Grades

  • Offense/Defense: Offense

  • Segment: Broad Equity

  • Sub-Segment: Large Cap

  • Correlation (vs. S&P 500): Very High

  • Expected Volatility (vs. S&P 500): Moderate

Holding Analysis

The fund currently holds 53 stocks. While the index is technically a 50-stock set, the aforementioned buffer rule resulted in one additional holding at the last index reconstitution. The fund is highly-concentrated in that the top 10 holdings make up more than half of the assets, and the top 25 stocks comprise more than 75% of XLG. That focused approach can be helpful or risky, depending on how an investor decides to use this ETF.

Strengths

XLG’s focus on the largest companies gives it a strong fundamental picture, at least when doing a backward-looking analysis. Mega-cap stocks tend to have relatively low debt, generate solid cash flow, and are more globally diversified than smaller companies. For this reason, we consider XLG a competitive alternative to small caps and mid-caps, as it may offer similar returns but from a much more familiar set of companies to many investors.

Also, with more than 3/4 of assets invested in 25 stocks, XLG simulates a portfolio of individual stocks much more than the typical, over-diversified ETF. Thus, it can be an excellent transition vehicle for investors who want the diversification of an ETF without having to own and track the entire stock market or even the full S&P 500. In addition, XLG is quite liquid, with a daily average dollar trading volume of around $30mm.

Weaknesses

That focused, less-diversified portfolio can be a strength but might also be a weakness in the eyes of some. While owning 50 stocks is less subject to single-stock risk, with individual weightings of some holdings being north of 5%, there can be temporary setbacks when one or more of those top names misses earnings or has an adverse market reaction for some other reason.

The chart below shows that XLG will often track the S&P 500 very closely. In fact, there is an argument to be made that with these top 50 stocks having a historical beta of 0.96 to the S&P 500, it is almost like the bottom 450 stocks don’t matter much. This was not always the case, but it has resulted from a period of years where a small number of now-iconic U.S. companies just kept getting bigger and more dominant.

And, with XLG’s expense ratio at 0.20%, those who hyper-focus on that aspect of an ETF might decide that the difference in performance is not likely to be big enough to warrant paying more than it costs to own an S&P Index fund (SPY’s expense ratio is 0.09%).

Opportunities

For someone looking to invest in the so-called FAANG stocks while diversifying individual stock risk, XLG can be a good option. FAANG stocks currently comprise about 40% of the fund, with just 3 holdings accounting for 30% of the total fund. Specifically, Apple Inc. (AAPL) occupies about 13% of the ETF, Microsoft (MSFT) about 11%, and Amazon (AMZN) about 6%.

It’s been a tough year for the market this year. Even the big names couldn’t hide from the effects. All the FAANG stocks have declined significantly this year, and such a drop allows investors to buy quality stocks. It remains to be seen if they are “cheap” or simply discounted from their all-time highs.

This chart shows that at a distance, XLG looks like a clone of the S&P 500.

XLG vs SPY past 10 years (Ycharts.com)

However, the last few years have shown that XLG can be a good choice for tactical investors, as it has outperformed the S&P 500 by a comfortable margin at times.

XLG vs SPY past 3 years (Ycharts.com)

Threats

With its current portfolio selling at over 19 times trailing earnings per share, XLG sells at a premium multiple to the S&P 500. That’s due to the market’s sustained confidence in the FAANG stocks and a few other mega-caps. Should that confidence continue to fade as it has throughout much of 2022, XLG could head much lower. That, in turn, could also produce more turnover in the portfolio than we’ve seen in some time, due to a Dot-Com Bubble era “changing of the guard” at the top of the S&P 500 Index.

Proprietary Technical Ratings

  • Short-Term Rating (next 3 months): Hold

  • Long-Term Rating (next 12 months): Buy

Conclusions

ETF Quality Opinion

We are big fans of concentrated ETF investing, and XLG is one of a relatively small set of funds that are both concentrated and diversified across the industries of the S&P 500 Index. That’s why we have and expect to continue to, maintain it on our “short list” of equity ETFs to consider owning.

ETF Investment Opinion

That said, we are hard-pressed to be enthusiastic about the prospects for any equity ETF over the next several months. The bear market is not over; until it is, even our favorite equity ETFs like XLG are considered “tactical buys only.” Thus our official rating for longer-term investing is Hold, until such time as we feel the equity bear market has “cleared.”

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