What is FXZ? (Pros, Cons, and Strategies)

When evaluating investment opportunities within the materials sector, the First Trust Materials AlphaDEX Fund, known as FXZ, stands out. FXZ has gained popularity among investors looking to gain diversified exposure to the materials sector with a tactical investment strategy. Today, we'll delve into what FXZ is, along with its advantages and disadvantages, and explore various investment strategies.

What is FXZ?

FXZ is an exchange-traded fund (ETF) that focuses on the materials sector within the U.S. stock market. The full name is the First Trust Materials AlphaDEX Fund. FXZ aims to track the StrataQuant® Materials Index, which uses a fundamentally weighted methodology.

Instead of merely following a traditional market capitalization index, FXZ uses a proprietary selection and weighting process designed to enhance returns by investing in materials companies with strong growth and value characteristics.

Key Features of FXZ

• Enhanced Indexing: FXZ follows the StrataQuant® Materials Index, which is designed to identify companies with strong growth and value characteristics.
• Diversified Exposure: FXZ provides exposure to a broad range of companies within the materials sector, including chemicals, construction materials, containers and packaging, metals and mining, and paper and forest products.
• Fundamentally Weighted: The selection process involves ranking stocks by multiple factors such as price-to-book ratio, price-to-sales ratio, and return on assets, rather than by market capitalization.

FXZ Composition

FXZ includes a variety of well-known companies in the materials sector. Examples include Linde PLC (LIN), Sherwin-Williams (SHW), Freeport-McMoRan (FCX), and Dow Inc. (DOW). This diverse portfolio is designed to provide a mix of growth and value within the materials sector.

Pros of FXZ

Diversified Sector Exposure

Unlike sector-specific investments that may focus on one sub-industry, FXZ provides diversified exposure across multiple sub-industries within the materials sector. This helps mitigate risks specific to any single industry.

Tactical Approach

The enhanced indexing methodology aims to outperform traditional market cap-weighted indices by focusing on stocks with strong fundamentals. This tactical approach can potentially lead to higher returns over time.

Increased Growth Potential

The focus on growth and value characteristics allows FXZ to potentially capitalize on companies that may be undervalued by the broader market. This increases the potential for significant capital appreciation.

Liquid and Accessible

As an ETF, FXZ offers the liquidity and accessibility that individual investors seek. It can be bought and sold during market hours, and its relatively low expense ratio (0.63% per year) makes it an attractive option for cost-conscious investors.

Cons of FXZ

Sector Concentration Risk

Since FXZ is concentrated within the materials sector, it is subject to sector-specific risks such as fluctuating commodity prices, regulatory changes, and economic cycles. This concentration can lead to higher volatility.

Higher Expense Ratio

Compared to passive funds and some sector ETFs, FXZ has a relatively higher expense ratio of 0.63% per year. While this is justified by its enhanced strategy, it could be a drawback for fee-sensitive investors.

Underperformance in Bear Markets

During periods of economic downturn, materials stocks tend to underperform due to reduced industrial activity and lower demand for raw materials. FXZ could experience significant declines during such periods.

FXZ Investment Strategies

FXZ offers a unique strategy focusing on the materials sector, which can play a significant role in a diversified investment portfolio. Here are some strategies to consider when investing in FXZ:

Long-term Sector Play

Investing in FXZ can be a prudent long-term strategy for those who believe in the sustained growth of the materials sector. The sector's relevance to various industrial and economic activities can make FXZ a valuable portfolio component.

Tactical Allocation

FXZ can be used as part of a tactical asset allocation strategy, where investors periodically adjust portfolio weights to take advantage of sector rotations. This requires a more hands-on approach and regular market monitoring.

Hedging against Inflation

Materials stocks often perform well during inflationary periods as the prices of raw materials rise. FXZ can serve as a hedge against inflation, protecting the portfolio's purchasing power.

Complementary Holding

FXZ could be used as a complementary holding alongside broader market or sector ETFs. This helps enhance exposure to the materials sector while reducing reliance on a single sector's performance.

Conclusion

FXZ offers an enhanced, diversified approach to investing in the materials sector, balancing growth and value through its unique indexing methodology. While it comes with certain risks, such as sector concentration and a higher expense ratio, its potential for higher returns and strategic benefits make it an intriguing option for informed investors. By employing strategies such as long-term holding, tactical allocation, or using it as an inflation hedge, investors can leverage FXZ to meet their specific investment goals.