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The First Trust RBA American Industrial Renaissance ETF (NASDAQ:AIRR) is a solid passively managed fund to target the U.S. industrial revival investment theme via small- and mid-cap stocks. Compared to the iShares Core S&P 500 ETF (IVV), AIRR appeared to be almost immune to the pressure stemming from rising interest rates and declining growth premia, performing strongly last year, with a negative total return of about 2% while IVV dropped by 18.2%. However, there are a few meaningful disadvantages uncovered upon deeper inspection, namely in terms of value and quality, which I would like to address below in the article.
The investment strategy and portfolio discussion
AIRR tracks the Richard Bernstein Advisors American Industrial Renaissance Index which draws its components from the Russell 2500. The idea here is to whittle the list down to a cohort of mid- and small-cap companies that contribute to the industrial revival in the U.S. by either being directly involved in manufacturing in the country or by providing financial infrastructure and capital to bolster that process. As for banks, they must operate in the states deemed traditional manufacturing hubs, specifically, Pennsylvania, Wisconsin, Michigan, Ohio, Illinois, Indiana, and Iowa. A few nice examples from AIRR’s current portfolio are Evansville, Indiana-based Old National Bancorp (ONB) and Newark, Ohio-based Park National Corporation (PRK). An essential remark is that bank stocks cannot exceed 10% of the index. Companies that generate a quarter of sales or more outside of the U.S. are filtered out. The index uses a proprietary weighting schema, with a caveat that the maximum weight a position could have at rebalance is about 4%.
At this point, AIRR has a portfolio of 49 equities, with about 9.2% of the net assets allocated to 18 stocks from the GICS financial sector and the rest deployed to industrials. The weighted-average market capitalization stands at about $4.1 billion, with the median at $2.3 billion, as per my estimates. This should be a tailwind for valuation, but likely a detractor from quality, as we will see below.
The most sizeable position currently is Atkore (ATKR), with a weight of slightly above 4%. Illinois-based ATKR manufactures and sells electrical, safety, and infrastructure products like wire basket cable tray & fittings and PVC & metal trunking. According to page 5 of the most recent Form 10-K, 91% of its net sales in fiscal 2022 were generated in the U.S.; the share was 90% in FY2021 and 89% in FY2020, so there is no coincidence it easily qualified for the AIRR portfolio. Despite doing incredibly well in a higher interest rate environment, delivering a one-year price return of 6.8%, the stock remains attractively valued, with an EV/EBITDA of 3.79x, which partly reflects a somewhat bleak forward EBITDA growth rate of below 1%.
Looking at the holdings’ valuation and quality, there are a few facts I suppose are worth addressing. First, the weighted-average earnings yield the U.S. Industrial Renaissance fund is offering at the moment is 5.6% (or 17.9x Price/Earnings ratio), as per my calculations, which is a bit higher compared to the S&P 500 index with its 5.3% yield. On the flip side, it seems this equity mix is priced at a meaningful premium to the S&P 400, a mid-cap universe barometer, which has a 12.78x P/E.
Nevertheless, focusing on the P/E ratio would be somewhat myopic. The bigger picture is that only 20% of the fund has a Quant Valuation grade of B- or higher, while more than 40% have a D+ rating and worse. For a mid-cap mix, this is a red flag not to ignore. To make the picture a bit gloomier I should add that this valuation issue coincides with a rather soft quality. The fact is, just two stocks in AIRR have negative earnings yields, namely Astec Industries (ASTE) and Array Technologies (ARRY), together accounting for around 6.2% of the net assets, but the share of companies that earned no less than a B- Quant Profitability grade is only 34.4%, a worrisomely low level. Meanwhile, around 13.4% clearly have issues with margins and capital efficiency as comes from their D+ grade and worse. Another way of saying, the AIRR equity mix trails the industrials (mostly) and financials sectors in terms of profitability despite being priced at a premium.
What returns the strategy was capable of delivering in the past?
AIRR was incepted on 10 March 2014. The period we will be looking at is April 2014 – December 2022. The funds I would like to compare its results to are IVV, iShares Core S&P Mid-Cap ETF (IJH), and Industrial Select Sector SPDR ETF (XLI).
| Portfolio | AIRR | IVV | IJH | XLI |
| Initial Balance | $10,000 | $10,000 | $10,000 | $10,000 |
| Final Balance | $22,982 | $24,144 | $20,120 | $22,197 |
| CAGR | 9.98% | 10.60% | 8.32% | 9.54% |
| Stdev | 23.67% | 15.34% | 18.14% | 18.55% |
| Best Year | 43.37% | 31.25% | 26.10% | 29.09% |
| Worst Year | -20.57% | -18.16% | -13.10% | -13.24% |
| Max. Drawdown | -31.09% | -23.93% | -29.70% | -27.13% |
| Sharpe Ratio | 0.48 | 0.68 | 0.49 | 0.54 |
| Sortino Ratio | 0.75 | 1.03 | 0.7 | 0.83 |
| Market Correlation | 0.85 | 1 | 0.95 | 0.93 |
Created by the author using data from Portfolio Visualizer
As we can see, AIRR did not outperform IVV, yet it managed to deliver a higher CAGR than the mid-cap and industrials ETFs. The downside is the highest standard deviation in the group. It is also worth noting that AIRR performed especially strongly in 2016 when it achieved an impressive 43.4% total return, then in 2019 and also 2021 during the vaccines-induced capital rotation. Its weakest year to date was 2018 when it was down by 20.6%. Speaking of 2022, as I said above, it declined only marginally, about 2% vs. XLI’s negative total return of 5.6% and IVV’s of 18.2%.
Did simpler portfolios perform better?
One of the disadvantages of AIRR leveraging a sophisticated proprietary strategy is its expense ratio of 70 bps, which begs a question about whether a similar investment theme could be targeted with simpler and cheaper passively managed vehicles.
The most obvious solution that comes to mind here is to mix XLI and Financial Select Sector SPDR ETF (XLF) either equally or to lower the share of the latter to 10% in line with what AIRR’s underlying index does, also rebalancing the two-ETF portfolios quarterly. Another solution is to substitute the SPDR S&P Regional Banking ETF (KRE) for XLF. Just for context, almost all AIRR financial sector holdings are present in KRE except for German American Bancorp (GABC) and CNB Financial Corporation (CCNE).
Now let us look at what returns the theoretical portfolios could deliver during the April 2014 – December 2022 period.
| Portfolio | XLF and XLI, 50/50 | AIRR |
| Initial Balance | $10,000 | $10,000 |
| Final Balance | $22,490 | $22,982 |
| CAGR | 9.71% | 9.98% |
| Stdev | 18.48% | 23.67% |
| Best Year | 30.64% | 43.37% |
| Worst Year | -13.08% | -20.57% |
| Max. Drawdown | -29.36% | -31.09% |
| Sharpe Ratio | 0.55 | 0.48 |
| Sortino Ratio | 0.83 | 0.75 |
| Market Correlation | 0.93 | 0.85 |
Created by the author using data from Portfolio Visualizer
The fact is, the total return that the 50/50 XLI, XLF portfolio tracking the market-cap weighted indices delivered is fairly close to AIRR’s, with a few remarkable caveats. First, the 50/50 portfolio had lower volatility and higher risk-adjusted returns. Second, it was ahead of the First Trust ETF during most of the period measured, yet AIRR performed much stronger in the second half of 2022, and the 27 bps higher CAGR is mostly the consequence of that.
Two other theoretical portfolio versions delivered akin results, also lagging AIRR, but only slightly, and with much lower volatility.
| Portfolio | XLI and XLF, 90/10 | AIRR |
| Initial Balance | $10,000 | $10,000 |
| Final Balance | $22,288 | $22,982 |
| CAGR | 9.59% | 9.98% |
| Stdev | 18.45% | 23.67% |
| Best Year | 29.42% | 43.37% |
| Worst Year | -13.20% | -20.57% |
| Max. Drawdown | -27.46% | -31.09% |
| Sharpe Ratio | 0.54 | 0.48 |
| Sortino Ratio | 0.83 | 0.75 |
| Market Correlation | 0.93 | 0.85 |
Created by the author using data from Portfolio Visualizer
| Portfolio | XLI and KRE, 90/10 | AIRR |
| Initial Balance | $10,000 | $10,000 |
| Final Balance | $21,966 | $22,982 |
| CAGR | 9.41% | 9.98% |
| Stdev | 18.63% | 23.67% |
| Best Year | 28.96% | 43.37% |
| Worst Year | -13.76% | -20.57% |
| Max. Drawdown | -28.62% | -31.09% |
| Sharpe Ratio | 0.53 | 0.48 |
| Sortino Ratio | 0.81 | 0.75 |
| Market Correlation | 0.93 | 0.85 |
Created by the author using data from Portfolio Visualizer
The Verdict
AIRR offers an opportunity to benefit from the U.S. industrial revival by investing in a basket of small- and mid-cap manufacturing and financial players that facilitate that trend.
With all due respect paid to the prospects of the U.S. manufacturing renaissance and a plethora of investment opportunities it begets, the issue here is the inadequate balance of value and quality AIRR has at this juncture, which makes me feel more skeptical about the vehicle despite its comparatively strong performance last year. On this account, assigning it a Buy rating would be unjustified.
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