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Is This ETF Really Good Through 2018?

Morningstar has just selected the (XLG) Rydex Russell Top 50 ETF (XLG) as its Best ETF for 2018, but there may be cracks in that reasoning.

The general idea behind the award is that the companies in the fund have staying power, so-called wide economic moats, will be around in 2018. Also, a criterion is that many of the names in the fund are cheap based on Morningstar's valuation methodology, so the award is partially based on a bottom-up analysis of the holdings' fundamentals right now.

XLG owns shares in the 50 largest U.S. companies, weighted by market cap, and charges a reasonable 0.20% expense fee. This fund owns the biggest of the big, the largest 50 stocks in the S&P 500 but with larger weightings. Exxon Mobil (XOM) has an 8.19% weight in XLG, for example, but only a 3.69% weight in the S&P 500 SPDR.

The fund itself is fine. It captures the large-cap space very adequately, and offers the chance for outperformance when the megacaps lead the market, which often happens at the end of a stock market cycle.

But I'm skeptical that XLG is the "Best ETF for 2018."

Ten years is a long time in terms of normal market cycles. In fact, it makes sense to think that over the next ten years there could be at least two complete bull/bear market cycles (cyclical bulls usually run 3.5 to 5 years and cyclical bears usually last 9 to 18 months).

If we have a couple of "normal" cycles during that time, we will see the mantle of market leadership change several times over the period. In most cycles, small-cap tends to outperform large-cap (and megacap) until the cycle matures, when leadership transfers to the large caps. Think about this bull market -- it was very typical. Small-cap trounced large-cap until 2007, when large-cap took the lead. Of course, now the cycle appears to be ending.

Additionally, the duration of small-cap leadership is usually longer than the duration of large-cap leadership.

Another issue is the composition of the fund, which owns the largest 50 stocks and it rebalances annually. The fund will have different looks -- potentially very different -- as the next ten years unfolds. I compared the current holdings to the holdings from 2005 (via a phone call to Rydex) and the bottom fives from then to now were different.

If XLG had existed at the height of the tech bubble, it would have been dominated by $150 billion-market-cap Internet companies with very little in the way of earnings. While the tech bubble is in the rear-view mirror, one sector growing to 30% of the market is clearly possible; it happened to energy in the early 1980s, as well. This sort of lopsidedness would be a reason to sell the fund, not own it.

There is, of course, no way to know if a sector will grow that large again. More succinctly, there are too many variables in the equation for this to add any value.

From a slightly bigger picture, ETFs mimic indexes. Using bottoms-up analysis with factors like P/E ratios and other valuation tools has mixed results, at best, in predicting where indexes go. An index can stay expensive for a long time or cheap for a long time.

Most of the 2003 rally in the S&P 500, the largest by far this decade, occurred with the P/E ratio well above 30, which is high. During the 2007 muddling, the P/E ratio was below 18 for most of the year, a level which some consider cheap.

I have been critical of Morningstar's coverage and analysis of ETFs because I feel the firm tries to apply the wrong type of analysis to ETFs. I have had several discussions with Morningstar, most recently here , about exploring different methods of analysis, but nothing has come of the talks up to now.

In my experience, understanding how cycles work is a far more reliable way to assess which parts of the market to overweight or underweight, because of the fundamental way cyclicality affects the flow of capital, as opposed to buying something that "should go up because it is cheap." Analysis that relies too much on "should" is far from ideal, and it's only logical that different sectors lead at different times. I don't believe there is any fund that will be the best for all market conditions that come in the next ten years.

At the time of publication, Nusbaum had no positions in any of the aforementioned securities, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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