Should First Trust Small Cap Growth AlphaDEX ETF (FYC) Be on Your Investing Radar?

The First Trust Small Cap Growth AlphaDEX ETF (FYC) has long been a staple in the portfolios of investors seeking exposure to high-growth small-cap stocks. However, in a market characterized by rapid innovation and volatility, evaluating FYC's risk-adjusted returns, expense structure, and sector concentration is critical. This article examines whether FYC merits a place in your portfolio, particularly for those prioritizing growth but wary of its trade-offs.

Risk-Adjusted Returns: A Double-Edged Sword

Small-cap growth stocks are inherently volatile, and FYC's portfolio reflects this reality. Over the past three years, the fund has delivered annualized returns of approximately 18%, outpacing the S&P 500's 13.8% during the same period. However, volatility tells a different story. FYC's standard deviation of 22% over this timeframe—compared to the S&P 500's 14%—underscores its heightened risk.

To assess whether FYC's returns justify the risk, the Sharpe ratio is a key metric. A Sharpe ratio of 1.2 for FYC over the past three years indicates decent risk-adjusted performance, but it lags behind peer funds like the iShares Russell 2000 Growth ETF (IWO), which boasts a Sharpe ratio of 1.5. This suggests that while FYC's returns are strong, it does not fully compensate investors for the additional volatility it carries.

The Sortino ratio, which focuses on downside risk, offers further clarity. FYC's Sortino ratio of 1.8 is slightly above average, but its heavy exposure to cyclical sectors like industrials and technology amplifies the likelihood of sharp drawdowns during market corrections. For risk-averse investors, this could be a red flag.

High Expense Ratio: A Costly Premium?

FYC's 0.65% expense ratio is 20 basis points higher than the average 0.45% for small-cap growth ETFs. While this may seem modest, the compounding effect over a decade can erode gains by 10-15%. For example, a $100,000 investment in FYC would yield $24,000 less in returns compared to a 0.45% ETF, assuming 10% annual returns.

The premium is justified by FYC's active screening process, which selects stocks based on growth metrics like revenue and earnings momentum. However, this strategy's success hinges on the accuracy of these screens. If the fund's holdings underperform, the higher fees may not be warranted. Investors must weigh the potential for outperformance against the drag of costs.

Sector Concentration: Growth vs. Vulnerability

FYC's top sectors—technology (30%), healthcare (20%), and industrials (18%)—account for nearly two-thirds of its portfolio. This concentration aligns with the growth narrative but exposes the fund to sector-specific risks. For instance, a regulatory crackdown on tech or a slowdown in healthcare innovation could disproportionately impact FYC.

Compare this to the Russell 2000 Growth Index, which is more diversified across sectors. While diversification may dilute growth potential, it also acts as a buffer during sector-specific downturns. FYC's approach suits investors confident in the resilience of its core sectors but may not be ideal for those seeking broad-based exposure.

Investment Advice: Who Should Consider FYC?

FYC is best suited for investors with a high-risk tolerance and a long-term horizon (5+ years). Its focus on high-growth small-cap stocks can deliver outsized returns in bull markets, but it requires patience to weather periods of underperformance. The fund is also appropriate for those who:
1. Prioritize Growth Over Stability: FYC's portfolio is designed for capital appreciation, not income.
2. Believe in Sector Innovation: Investors bullish on tech, healthcare, or industrials may find FYC's concentration appealing.
3. Can Tolerate Higher Fees for Active Management: The premium for FYC's screening process is a trade-off for potential outperformance.

Conversely, FYC may not be ideal for:
- Conservative Investors: Its volatility and sector concentration could lead to significant drawdowns.
- Short-Term Holders: The fund's performance is more cyclical than steady.
- Cost-Conscious Portfolios: Lower-fee alternatives like IWO or VSGX may offer better value.

Conclusion

FYC's allure lies in its aggressive pursuit of high-growth small-cap stocks, but this comes with elevated risk, costs, and sector concentration. While its risk-adjusted returns are respectable, they fall short of peer benchmarks. For investors who can stomach the volatility and align with the fund's strategic focus, FYC remains a compelling option. However, those seeking a more balanced or cost-effective approach may find better alternatives. As always, diversification and alignment with personal risk profiles are paramount.