Investors should recognize at least two things about funds that purport to be defensive or low volatility.
First, as an investment factor, low volatility is often conflated with quality, but these are distinct, standalone factors. Second, traditional low volatility strategies are designed to not capture all of the upside in overt bull markets. Indeed, investors face choices when embracing low volatility, but adding some quality to the mix can enhance returns while providing more offense than is found with standard minimum volatility strategies.
Enter the First Trust Capital Strength ETF (FTCS). FTCS, which just turned 15 years old, follows the Capital Strength Index (NQCAPST), and it's an index that provides the foundation for what's an attractive factor-based strategy.
Where quality matters
Enhancing the allure of FTCS is its underlying index, which doesn't force investors to choose between defense and offense. This is a relevant point because that's often the choice investors are making when embracing traditional “low vol” funds.
“The index methodology that NQCAPST employs is not limited to any single style, such as value or growth, so it has the capacity to allocate to growth, a traditional offensive style, so long as the components meet the selection criteria, which is based on profitability, leverage, and cash reserves,” according to Nasdaq Investment Intelligence. “Second, the index has many defensive qualities, namely, the fact that it incorporates a low volatility screen.”
In the case of any passive ETF, index methodology matters, but that's particularly true with FTCS. While there are similarities between NQCAPST and the MSCI USA Minimum Volatility (USD) Index, a widely followed gauge of low volatility equities, these two benchmarks aren't even distant relatives.
Thirty-four FTCS holdings reside in the ETF that tracks the MSCI USA Minimum Volatility (USD) Index, but the overlap by weight between the two funds is just 21%, according to ETF Research Center data. Over longer holding periods, the differences are material as highlighted by FTCS beating the other ETF by nearly 700 basis points over the past three years.
That's a testament to the quality overlay featured in NQCAPST. Members of the index and thereby FTCS components are required to have at least $1 billion in cash or cash equivalents, return on equity in excess of 15% and a long-term debt-to-equity ratio of less than 30%.
Stringent as those requirements are, FTCS isn't exceptionally boring at the sector. Industrial and consumer discretionary stocks combine for over 45% of the fund's weight and its largest defensive exposure – healthcare at 20.58% – is a sector rich in quality stocks.
Durable long-term idea
Admittedly, FTCS isn't the sexiest idea out there, but what it lacks in pizzazz, it makes up for in durability.
“Based on the data, the index (NQCAPST total return) has outperformed the broader market over an extended period, specifically over the 10-year period, and although it is trailing over shorter-term periods, the index has exhibited lower volatility since November 2006,” notes Nasdaq.
Additionally, NQCAPST's drawdowns over the past 15 years when the broader market swooned at least 10% have been less severe. In other words, the low volatility and quality marriage is a potentially fruitful one for long-term investors.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.