Quality has increasingly played an important role in portfolios in recent years.
Over the last two years, clients have been adding quality to serve as a more defensive position in portfolios but also to add a third factor beyond just value and growth, Michael Mack, associate portfolio manager for VictoryShares, said during a webcast on Sept. 5.
Quality exposure becomes increasingly important in small-cap investing. That’s particularly so now, as a strong case exists for adding small-cap quality exposure from a valuation perspective.
Investors may still be trying to determine if the great rotation trade into small caps is a compelling opportunity. From a long-term valuation standpoint, Mack thinks the opportunity is excellent.
There is currently a substantial valuation gap between small-cap value and large-cap growth. Notably, small-cap value outperformed in the last three periods in which the valuation gap was this wide.
“I think most of our client base is trying to figure out, is small-cap a buy-and-hold strategy right now, or is it just a trade?” Mack said. “We think small-cap is a strategic allocation. But we do think it’s very important for your small-cap allocation, from a strategic perspective, to be a quality small cap.”
Consider Quality When Adding Small-Cap Exposure
There’s a wide amount of disparity within small caps, Mack said. Therefore, it’s important to be up in quality.
A potential solution is the VictoryShares Small Cap Free Cash Flow ETF (SFLO ). The Fund is designed to offer quality within small caps through the lens of free cash flow.
Free cash flow represents the cash a company generates after accounting for cash payments to support operations and maintain its capital assets. It allows companies to reinvest cash, pay dividends, or pay off debt. Free cash flow is a valuable metric, as companies that succeed in generating high free cash flow tend to exhibit higher quality and lower valuations.
Liquidity and Risk
Additionally, when considering adding exposure to a small-cap ETF, it’s pertinent that the Fund spreads out risk as well as screens for liquidity, ensuring the most liquid small-cap portfolio possible.
Small-cap free cash flow funds tend to have higher turnover, making it necessary that risk and liquidity are adequately managed. In short, the funds must own enough names and rigorously screen for liquidity.
The starting universe for the Index underpinning SFLO is the VettaFi US Equity Mid/Small-Cap 2500 Index. The top 200 names are selected from there based on free cash flow yield and future growth potential. Mack noted that this effectively spread out the risk.
Additionally, the 10% least liquid names included in the starting universe are excluded.
“Liquidity is also a factor in our weighting scheme,” Mack added. “Names that maybe aren’t as high on liquidity, we will own, but will own a smaller weight.”
SFLO may be used to enhance a portfolio’s small-cap exposure by considering quality, liquidity, and risk.
For more news, information, and analysis, visit the Free Cash Flow Channel
VettaFi LLC (“VettaFi”) is the index provider for SFLO, for which it receives an index licensing fee. However, SFLO is not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of SFLO.
Disclosure Information
Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. To obtain a prospectus or summary prospectus containing this and other important information, visit http://www.vcm.com/prospectus. Read it carefully before investing. All investing involves risk, including the potential loss of principal.
All investing involves risk, including the potential loss of principal. Please note that the Fund is a new ETF with a limited history. The Fund has the same risks as the underlying securities traded on the exchange throughout the day. Redemptions are limited, and commissions are often charged on each trade. ETFs may trade at a premium or discount to their net asset value. The Fund invests in securities included in, or representative of securities included in, the Index, regardless of their investment merits. The performance of the Fund may diverge from that of the Index. Investments in smaller companies typically exhibit higher volatility. Investing in companies with high free cash flows could lead to underperformance when such investments are unpopular or during periods of industry disruptions.
The Fund could also be affected by company-specific factors that could jeopardize the generation of free cash flow. Derivatives may not work as intended and may result in losses. Large shareholders, including other funds advised by the Adviser, may own a substantial amount of the Fund’s shares. The actions of large shareholders, including large inflows or outflows, may adversely affect other shareholders, including potentially increasing capital gains. Investments in mid-cap companies typically exhibit higher volatility. The value of your investment is also subject to geopolitical risks such as wars, terrorism, environmental disasters, and public health crises; the risk of technology malfunctions or disruptions; and the responses to such events by governments and/or individual companies.
Additional Information
Small-Capitalization Stock Risk—Investments in small-capitalization companies involve greater risks than those associated with larger, more established companies. Free Cash Flow Risk—Investing in companies with high free cash flows could lead to underperformance during periods when such investments are unpopular, and fluctuations in market conditions, industry disruptions, or company-specific factors may jeopardize the generation of free cash flow. Fund holdings and sector allocations are subject to change, may differ from the Index, and should not be considered investment advice.
The Victory U.S. Small Cap Free Cash Flow Index aims to select high quality companies from its starting universe by applying profitability screens. It then selects companies with the strongest free cash flow yield that exhibit higher growth. The Index is rebalanced and reconstituted quarterly. This Index calculates free cash flow yield by dividing expected free cash flow by enterprise value. Expected free cash flow is the average of trailing 12-month FCF and next 12-month forward free cash flow. Enterprise value (EV) measures a company’s total value, often used as a more comprehensive alternative to equity market capitalization.
The Russell 2000 Value Index is a market-capitalization-weighted index that measures the performance of those companies in the Russell 2000® Index with lower price-to-book ratios and lower forecasted growth values.
Distributed by Foreside Fund Services, LLC (Foreside). Foreside is not affiliated with Victory Capital Management Inc., the Fund’s investment adviser.
©2024 Victory Capital Management Inc.
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