Investors who like momentum stocks in their portfolio now have a way to really get the ball rolling.

First Trust has launched a new ETF — the First Trust Dorsey Wright Focus 5 ETF (FV) — that uses relative strength and price momentum to determine the holdings in the fund. The fund seeks to replicate an index that identifies the five best sector and industry funds offered by First Trust using Dorsey Wright Associates’ (DWA) relative strength ranking system.

First Trust is known for developing some very unique ETFs, and FV is no different. Investors in momentum stocks will definitely be interested in this particular offering … though it does come with some pitfalls.

First Trust Dorsey Wright Focus 5 ETF (FV): The Basics

FV is a fund-of-funds that pulls from the First Trust universe.

Using the DWA relative strength ranking system, the index compares the price momentum of each of First Trust’s 23 sector and industry ETFs relative to other ETFs in the selection universe. The top five First Trust ETFs go into the index at equal weightings of 20% each. Relative strength analysis is carried out weekly, and rebalancing occurs when one or more of the ETFs loses price momentum and is no longer ranked in the top five in terms of relative strength. When this happens, the new ETF is thrown in and the funds are re-weighted equally.

The five ETFs included in the initial portfolio are:

1. First Trust Consumer Discretionary AlphaDex Fund (FXD)
2. First Trust Consumer Staples AlphaDex Fund (FXG)
3. First Trust Dow Jones Internet Index Fund (FDN)
4. First Trust Health Care AlphaDex Fund (FXH)
5. First Trust NYSE Arca Biotechnology Index Fund (FBT)

While FV doesn’t have a track record, the five holdings in the fund do. Over the past five years, these five ETFs achieved an average annualized total return of 32.3% — 980 basis points higher than the SPDR S&P 500 ETF (SPY). A $50,000 investment made five years ago would be worth $202,661 as of March 12 — almost $65,000 more than the SPY.

It’s an impressive record. Unfortunately, it’s unlikely that these five momentum plays will go on another five-year run, but you never know. 

FV charges a total of 0.95% annually, which includes a management fee of 0.3% plus annual expenses from the five individual ETFs.

Now, a look at the pros and cons:

Pros: Momentum Stocks Can Make You Money

In a March 5 Money Magazine article, the author highlights research done by the Leuthold Group that examines seven major asset classes: blue-chip U.S. stocks, small caps, foreign stocks, government bonds, commodities, gold and real estate investment trusts.

The asset manager went back over 40 years and looked at an asset class the year after delivering the best performance among the seven classes. Researchers found that although the best performer beat the S&P 500 by more than 3 percentage points the year after, it did so with extreme volatility. Interestingly, the second-best performer beat the index by more than 5 percentage points the year after, with volatility not much higher than the index.

So, what does this mean?

Investing in momentum stocks, when carried out within the context of a diversified portfolio, can be the difference between mediocre and exceptional performance. The five ETFs currently held by FV are included because their relative strength is off the charts.

While this can change, it’s good to have exposure to fast-moving stocks — and FV certainly accomplishes this.

Cons of First Trust ETF

Chasing performance is a mug’s game. Yet that’s exactly what momentum stocks are all about.

Jacob Sagi is an associate professor of finance at the University of North Carolina at Chapel Hill and an expert on financial economics and decision theory. He believes that momentum investing is “more prevalent or profitable when it’s restricted to smaller firms, growth firms, firms with lower operating leverage, firms with higher sales volatility, firms with lower credit quality.”

In other words, it shouldn’t be blindly applied to every stock or sector.

The other problem with momentum investing: It isn’t a long-term investment strategy. Turnover is often high requiring frequent rebalancing leading to higher transaction costs. In addition, momentum strategies involve volatility that’s significantly higher than the average buy-and-hold portfolio, exposing the average investor’s capital to greater risk.

Unless you are a professional who knows what you’re doing, momentum investing can lead to extraordinary losses.

As they say on TV, “Don’t try this at home!”

Bottom Line: FV Is for Someone, But Not Everyone

I’m torn on FV.

I have a problem recommending any ETF whose expense ratio is north of 0.75%. I believe the average investor can get some excellent ETFs at bargain basement management fees.

Moreover, the KISS (keep it simple stupid) rule applies to about 90% of the investing population. Just ask Warren Buffett, who believes most of us should own the Vanguard 500 Index Fund (VOO) or some other large-cap index fund. Playing around with esoteric ideas like this one can burn you.

On the other hand, if you only put 10% of your portfolio into the FV, which itself is five funds invested in 306 stocks, your level of diversification is really quite high with a manageable level of risk. Add in an ETF like the Vanguard Total Stock Market ETF (VTI), which holds more than 3,600 stocks, and you’re good to go.

My recommendation is this: If you hate fees, FV is not the fund for you. But if you’re only mildly concerned choosing to focus on the ultimate performance, this First Trust fund is definitely worth considering.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

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