This ETF is beating the S&P 500 - and it's completely different from the index

By Philip van Doorn

It is easy to add an exchange-traded fund to broaden your portfolio and possibly reduce your risk

Every day you can see headlines warning that the stock market is overvalued. These warnings for U.S. investors typically center on the S&P 500. You might find it interesting to look at an example of an index fund that holds shares of medium-sized companies, with a quality approach that has helped it to outperform the indexes.

The $4.6 billion Invesco S&P MidCap Quality ETF XMHQ appears to be a solid alternative for investors who think the S&P 500 SPX is overvalued. Nick Kalivas, who heads Invesco's factor strategy for the firm's exchange-traded funds explained the stock-selection approach during an interview with MarketWatch.

He said that inflows of new money into the fund totaled $1.1 billion so far in 2024 and signaled growing interest from investors in the midcap category and quality strategies.

XMHQ tracks an index designed to include about 80 stocks in the S&P MidCap 400 Index MID. The full midcap list is pared using three factors:

Highest returns on equity. These can vary by industry, which means it may not be "fair" to compare ROE for companies with different business models. "Companies with high ROE tend to outperform those with low ROE," in the stock market, Kalivas said. Lowest balance-sheet accruals. Kalivas explained that this was tied to the levels of cash companies generate relative to profits. A company can "recognize revenue but not perform the service yet," he said. "That would be an example of a high accrual." So the selection methodology helps focus the funds on companies whose cash flow figures are relatively close to their reported profits.Low debt/equity. A lower level of debt reduces the risk of rising interest rates when loans are renewed or when bonds mature and are replaced with new ones. It also reduces credit risk if borrowing conditions have changed. For example, if a company has been borrowing against the value of its property, and commercial-property values have declined, it may be unable to renew a loan or might have to pay a higher interest rate or pledge more collateral. Higher leverage means a higher risk that one of these elements might lead to a reduction in profitability and a lower return for a stock.

The index underlying the Invesco S&P MidCap Quality ETF is reconstituted twice a year, on the third Fridays of June and December. The index and the fund's portfolio are weighted by the index provider's quality score, multiplied by the companies' market valuations.

Some investors might be afraid the S&P 500 is trading too high because its forward price-to-earnings ratio (its market capitalization divided by weighted rolling consensus profit estimates for the following 12 months) has increased to 20.9 from 18.3 over the past year. The index's weighted price has increased more quickly than expected profits have increased.

Meanwhile, the forward P/E for the Invesco S&P MidCap Quality ETF has risen to 17.2 from 12.8 over the past year, and the forward P/E for the S&P MidCap 400 Index has risen to 15.7 from 13.4.

So even though XMHQ's forward P/E has risen so much, it trades significantly lower by this measure than the S&P 500 does. And for investors nervous about large-cap stocks, this ETF is fully differentiated - it doesn't hold any stocks in the S&P 500.

The Invesco S&P MidCap Quality ETF changed its strategy to the current one in June 2019. Before that, it tracked the Russel Midcap equal-weight Index.

Let's look at a performance comparison for several periods for XMHQ, the SPDR S&P MidCap 400 ETF Trust MDY, which tracks the S&P 400 MidCap 400 Index and the SPDR S&P 500 ETF Trust SPY, which tracks the large-cap benchmark. The longest we will look back is five years, because of XMHQ's strategy change in 2019.

   Exchange-traded fund              Ticker  2024 through April 3  One year  Three years  Five years 
   Invesco S&P MidCap Quality ETF    XMHQ                     23%       49%          47%        133% 
   SPDR S&P Midcap 400 ETF Trust     MDY                       8%       21%          18%         67% 
   SPDR S&P 500 ETF Trust            SPY                      10%       28%          36%         97% 
                                                                                     Source: FactSet 

These total returns include reinvested dividends and are after expenses, which come to 0.33% of assets under management annually for XMHQ. The expense ratio for MDY is 0.24% and the expense ratio for SPY is 0.0945%.

The Invesco S&P MidCap Quality ETF has a five-star rating (the highest rating) within Morningstar's "U.S. Fund Mid-Cap Blend" category.

Here are the fund's largest 10 holdings:

   Company                          Ticker   % of Invesco S&P MidCap Quality ETF 
   Williams-Sonoma Inc.              WSM                                    3.9% 
   Manhattan Associates Inc.         MANH                                   3.8% 
   Reliance Inc.                      RS                                    2.9% 
   Carlisle Cos. Inc.                CSL                                    2.9% 
   Emcor Group Inc.                  EME                                    2.7% 
   Celsius Holdings Inc.             CELH                                   2.6% 
   Medpace Holdings Inc.             MEDP                                   2.3% 
   Advanced Drainage Systems Inc.    WMS                                    2.1% 
   Owens Corning                      OC                                    2.1% 
   Kinsale Capital Group Inc.        KNSL                                   2.1% 
                                                                 Source: FactSet 

Click the tickers for more about each company, including corporate profiles, financials, ratings, estimates and price ratios.

Click here for Tomi Kilgore's detailed guide to the wealth of information available for free on the MarketWatch quote page.

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-Philip van Doorn

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04-06-24 0540ET

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