Breaking Down the New Free Cash Flow ETF

Victory Capital Solutions' Lance Humphrey discusses the firm's new fund. 

Lance Humphrey, a senior portfolio manager at Victory Capital Solutions, a diversified global asset management firm with $154.8 billion in assets under management, sits down with etf.com's Senior Analyst Sumit Roy to discuss the firm's brand-new VictoryShares Free Cash Flow ETF (VFLO). What differentiates this fund from other ETFs on the market? Tune in to hear the answer and much more.

Sumit Roy: Hi, this is etf.com's Exchange Traded Friday's podcast, a weekly podcast covering developments in the ETF industry. My name is Sumit Roy, and I'm senior ETF analyst for ETF.com.

This week I'm talking with Lance Humphrey, a senior portfolio manager at Victory Capital Solutions, a diversified global asset management firm with $155 billion in assets under management. Lance, welcome to the show.

Lance Humphrey: Great to be here.

Roy: Lance, I want to start off by asking you about your newest ETF, the Victory Shares Free Cash Flow ETF (VFLO). We've seen here etf.com that funds that buy high quality stocks or those with things like low leverage, stable earnings and high profitability have been in vogue since 2022.

Can you tell us about this fund and what differentiates it versus other ETFs that target high quality stocks?

Humphrey: Sure, and I think you actually just mentioned a couple of the key elements. If we think about many of the quality ETFs that are on the marketplace today, they do focus exactly on those metrics that you mentioned: profitability; how consistent are the earnings; is it a strong or weak balance sheet; what are the levels of debt?

And I think what's important is that really, in my opinion, that’s only one part of the equation. When we think about the quality of a company, all of those metrics we just mentioned, the one thing that's missing from each of them is they don't include the price or the market value associated with those metrics.

So if we were to think about a simple example of, let's say, a rental property that we were going to look at for an investment, and I told you that the property produces, let's say, $20,000 per year in income and it's in a great city with a great school district, corner lot with great neighbors, that's going to be a high quality property.

But if we were to determine if that's an investment that we would want to make, we would certainly ask, well, how much is the property? If it was $100,000 and we were earning $20,000 a year, that would likely be a tremendous value. But at the same time, if that property was valued at $1 million, well, now, maybe not so much.

And so when we think about VFLO, which is the ETF you referenced, we're really trying to bring both of those elements together. And so, specifically what we're doing is we're evaluating the amount of free cash flow that a company generates relative to the total value of the company or the enterprise value.

So if we think about what is free cash flow, in its most simple version, it's all of the cash that a company has left after paying all of its expenses and making all of its capital expenditures for the year.

Again, you could think of it as how much cash do I have in the bank today relative to how much cash should I start the period with?

And we think that's a really important metric in investments and in finance, because, No. 1, it's less susceptible to some of the accounting adjustments that we see with net income. So for instance, one-time write-offs, depreciation amortization, some of these things at times can somewhat distort traditional net income measures as opposed to free cash flow. It tends to be a little bit more of a pure value metric than some of the others.

So again, in this product, we're looking at what is the total amount of free cash flow that a company generates relative to the total value of the company.

One other thing, if we just think about some of the origins of value investing, really it was centered around this idea of a company's value relative to its book value or the value of its assets. And if we go back to the 1970s and 1980s, that wasn't so bad of an idea when the economy was comprised of railroads and manufacturing plants and supermarkets.

But if we think about the composition of the new economy today, many of the companies in our universe are companies like Apple or Google, Microsoft, Facebook; these types of companies where a lot of their value is not necessarily derived from the assets that they have, but more so, things such as their intangible value or the value of their customer relationships or the value of their future ideas.

And free cash flow is a measure that oftentimes can incorporate that new economy back into the value of a given security. So we're not the first to come to market with a product that focuses on free cash flow. There are a few out there today, but I think it's important for the listeners to know a few of the key points of differentiation between VFLO and some of the other products in the market.

As I mentioned, we're certainly focusing on companies with great free cash flow relative to their enterprise value. But the first thing that we do that I think differentiates us is we incorporate forward-looking measures of profitability.

So I think when we think about investing, oftentimes products might look at simply the last year or the last 12 months of information when making an evaluation of a company. But today we have a lot of information that allows us to look at all of the sell-side analysts that might cover a given company. What are their expectations over the next 12 or 24 months of a company's free cash flow or profitability, and can we incorporate that into our process?

I think a good example of that might be if we think about a stock like Moderna, going back to 2021, coming out of COVID, they had tremendous amounts of free cash flow because, of course, they were administering the vaccine and doing other things, where it had, for that one-year period, significantly increased their level of free cash flow.

But at the time, any analyst who followed the stock knew that that level of free cash flow is likely going to decline over the next 12 to 24 months.

In our product, we look to incorporate that information into our decision-making process, where we're looking at not only past information but we're incorporating forward-looking measures of profitability as well to determine what the total free cash flow of a company would be.

The second part that I think is really unique is we incorporate an element of what we call a growth filter. So with our product today, we start with 400 profitable stocks that have positive free cash flow as our universe. Then we select the 75 with the highest free cash flow yields based off that forward and trailing measure I mentioned before.

What's important is when you get down to a portfolio of high-free-cash-flow-yielding companies, a lot of times there are companies in there that may be cheap for a good reason. There could be stocks that currently have high free cash flows but their growth prospects looking forward or in the past might be quite poor.

So what we do when we have those 75 high-free-cash-flow yielders, we actually remove the 25 with the weakest forward and trailing growth prospects, leaving us with a portfolio of 50 stocks.

In summary, those key differentiators are, we're 1) incorporating that forward-looking information into all elements of our process; and 2), we're looking to make the product more all-weather by removing those low growth prospect companies, leaving us with the 50 highest-free-cash-flow yielders.

Roy: That's great. I appreciate that comprehensive answer. So you mentioned all-weather type of fund. Does that mean that this type of portfolio isn't necessarily just a type of fund that would work in the 2022 environment? It's something that could work in any market environment: high interest rate, low interest rate, etc.?

Humphrey: Well, certainly we built it in a way that we would like to see it be able to generate good returns in a variety of environments. Certainly with any product, it's not going to work in every environment.

What we find with strategies like this, most importantly, is they tend to be pretty reliable in value-oriented markets, meaning the percentage of time that a free-cash-flow-oriented strategy outperforms in a “value-oriented market.” They tend to do pretty well in that market.

But one of the drawbacks is that oftentimes they perform relatively poorly in growth-oriented markets. And so by incorporating the steps I mentioned, what we find is that, historically, we continue to provide strong returns in those value-oriented markets, but keeping up more effectively in the growth-oriented environments.

So, we're trying to create more of a balance between those value and growth environments, but again, that doesn't mean it's going to outperform in each of those environments at all times. But that's what we're attempting to accomplish by adding in those additional steps: to allow it to participate more in the growth-dominated environments.

Roy: That makes a lot of sense. So, Lance, I want to turn now to another one of your ETFs, and in particular, your largest ETF. The VictoryShares US EQ Income Enhanced Volatility Wtd ETF (CDC) has $1.6 billion in assets under management. This fund has been having a tough year. It's down 7% versus a 15% gain for the S&P 500. But last year it actually outperformed; it was only down 8% versus 18% for the S&P 500.

Can you explain how this fund works? As I understand it, the fund shifts from stocks into cash depending on what the market's doing. Can you get into that?

Humphrey: Absolutely. I think that's a great question, and I'll start off by talking a little bit about how the fund is designed and what it's looking to accomplish.

CDC is a large cap value product that seeks to provide investors really with three primary sources of defense, and those would be dividends, diversification and dynamic allocation.

So the first being dividends. The portfolio is going to be 100 of the highest-dividend-yielding profitable companies within the United States. So you're getting a 100-stock portfolio, high-dividend-yielding profitable companies.

Number two is the diversification. So many products in the market today might weight stocks, let's say, on their market cap or how large they are. We believe it's really important to create an element of diversification within the product, where with those 100 stocks, we actually weight them based off of their volatility, where each stock is designed to contribute an equal amount of risk to the portfolio.

So stocks with a high volatility get a slightly lower weight, and stocks with a lower volatility get a slightly higher weight, creating what we believe to be a more diversified approach.

And then lastly, and importantly, would be the dynamic allocation element of the strategy. So in CDC, we're able to systematically allocate between stocks and cash depending on the market environment. So the fund has the ability to shift from stocks to cash as market conditions deteriorate.

The way we evaluate that is we look at where is the underlying index at any given time relative to its all-time high. And so at the end of every month, we evaluate the index level, and if it's fallen, let's say 8% is the first trigger, 8% from its all-time high. The strategy will systematically move to 75% cash and then remain 25% invested.

We have a series of triggers that go down where, as the markets continue to fall, we will systematically reallocate back into the market. And we think that's a really important piece, where what we find is a lot of times, markets may fall and a lot of tactical strategies or strategies shift between stocks and bonds.

One of the drawbacks might be they don't have a way to reenter the market, particularly if the market has seen a significant sell-off. So in CDC in particular, once the markets are down 32% relative to their all-time high, the fund will actually go back to being 100% invested.

So I think a couple of key takeaways about the strategy would be it's a defensive strategy that has the ability to sidestep those more volatile markets as those triggers turn on within the product.

But we really seek to be invested or fully invested a majority of the time. So if we look at the strategy, historically, 88% of all months the strategy has simply been fully invested in 100 profitable high-dividend-paying stocks.

But again, 12% of the time when we have had those more volatile markets, it has the ability again to then move into cash. I think your question then on the performance this year is really then a function of that design.

I think you highlighted a couple of key points, where, if we think back to last year, a very volatile market environment, most equity markets were down on the year, and the strategy did as we would expect it to do, which is to provide that downside protection.

If we were to fast-forward then to this year, so far, we've seen a very strong equity market with the S&P 500 as of the time of this taping, up almost 15% over the first almost six months.

And so in those types of environments, the fund may struggle relative to something like the SP 500. And if we think about this year, it really comes down to two primary elements.

No. 1, I mentioned the portfolio is designed to provide 100 high-dividend-paying stocks. But dividend-paying stocks have had a quite challenging year so far in 2023. For instance, if we look at the Russell 1000 Value, which is the fund's benchmark, the stocks in the Russell 1000 Value that do not pay a dividend at all are up over 22% year to date.

While if we look at the stocks that are in the highest quartile or the highest 25% of dividend yields within the Russell 1000 Value, that same cohort of stocks is down more than 2% on the year. So almost a 25% difference between stocks that pay dividends and stocks that don't pay dividends.

As I mentioned, for CDC, a stock that does not pay a dividend is not eligible for inclusion. So that's been a headwind to the strategy.

And then I think the second would be talking about the diversification. If we just look at something as simple as the S&P 500, it’s up almost 15% year to date.

But if we take those same exact stocks in the S&P 500 and simply equal weight them, the S&P 500 Equal Weighted, that index is up around 5%. So there's been about 1000 basis point difference simply based off how a portfolio is weighted. The more diversified a portfolio or the less concentrated a portfolio has been this year has also been a headwind.

So again, those are two of the primary elements of CDC: the dividends and the diversification. And again, in a year like 2023, so far those have been headwinds to the strategy. I think that importantly, again, a strategy like this is designed to be really evaluated over a full market cycle.

CDC's inception was July 2014. So we've seen several different market environments over that period.

And if we look at its Morningstar category, which is placed in the large cap value strategy, it actually rates in the second percentile in terms of alpha generation and Sharpe ratio within the large cap category as of May 31. And that's out of 1,038 funds in that category.

So when we think about over a full market cycle, having that ability to sidestep markets that are trending down but participate in markets as they're moving up has created a nice return profile over a full market cycle.

Roy: That makes a lot of sense. Lance, we've talked a lot about stocks, but I want to touch a little bit on fixed income, because obviously this is still a very big story within the broader financial markets. At the last Fed meeting, the Fed paused interest rates hikes.

But depending on how things evolved with inflation in the economy, Powell is indicating we could get another hike or two. What's your outlook for interest rates and bonds?

Humphrey: Sure, I think the markets pricing in at this point about one to two more rate hikes between now and the end of the year.

I think investors might be focusing sometimes on the wrong thing, where we think a lot about what the Fed might be doing at the short end of the curve.

But if we think about, let's say, the 10-year bond, which a lot of fixed income products tend to be more in that intermediate-term bucket of duration, has been relatively well anchored throughout the year. It's really kind of ranged between 3.4 and 3.8%. And what that's ultimately led to is a pretty sharp inversion of the yield curve.

So as the Fed has raised interest rates and if they were to continue to raise interest rates a couple more times this year, that's really impacting the very short end of the curve. But we're seeing that more intermediate-term part of the curve being relatively stable.

I think we'll continue to see a declining amount of volatility in that intermediate-term area of the market. And so I think we'll see just less volatility within interest rates throughout the year within the corporate bond market.

We look closely at the spread level. So how much extra yield are you earning for taking on corporate bond risk or high yield risk? And when we look today, those spreads are relatively tight, meaning you're not getting well compensated for taking on that additional risk.

So, in our asset allocation portfolios, we are pretty underweight high yield bonds, and we've been focusing on somewhat of a more defensive posturing within our fixed income portfolios.

Roy: Well, I'm glad you touched on intermediate-term bonds, Lance, because I want to talk about one of your fixed income ETFs, the Victory Shares Core Intermediate Bond ETF (UITB). It has about $1.5 billion in assets under management.

What do you think, are intermediate-term bonds less risky? Now that the Fed is close to the end of its rate hiking campaign, should investors start adding duration to their portfolios?

Humphrey: Sure. And to the last point I made, that given that a lot of the volatility in the bond market is behind us, I do think it could be a good opportunity for investors to consider adding duration back to their portfolios.

I know that over the course of the year, I've spoken to many advisors who had shifted significant portions of their portfolios into things like money markets or ultra-short-type products.

And now that I think interest rate volatility is likely to subside, I do think that it's a good time for investors to look to use this as an entry point to begin to lengthen duration and focus more on the intermediate portion of the curve.

As I mentioned, in our portfolios, we're still slightly less duration than our benchmarks, but where we're really focusing is on the traditional kind of short-term fixed income along with intermediate-term core fixed income.

UITB really falls right into that intermediate-term core portion of the fixed income markets and one that we've been actively allocating to. We think it makes a lot of sense in many advisor portfolios to quickly touch on that ETF itself.

UITB is an actively managed intermediate core bond fund. And while I think there's many applications where we in our own portfolios use passive investments within fixed income, we actually strongly prefer our core fixed income to be actively managed.

We think there's a lot of inefficiencies within benchmark-oriented fixed income products, and so we really like the attributes and benefits of having an active manager within our core fixed income space.

And UITB in particular is managed by a team here at Victory called Victory Income Investors. Just to give you a couple of quick highlights on that team, really I think about them in terms of their experience. It's a 35-member team with over 23 years’ average experience within the fixed income markets. They have a very extensive focus on their research process.

So within UITB and all of the products that that team manages, they rely on an independent credit rating system. Instead of relying on the three large credit rating agencies when selecting bonds, they're doing all of that credit research internally and again, have been doing that process for many decades now.

Lastly, the size, their team and the amount of AUM that they manage, they're not too big and they're not too small. That means they're big enough that they're able to get access to all of the best deals in the fixed income market, access to the best tools and resources and brokers across the industry, but they're not too big that they can't select positions that make an impact.

There are several fixed income managers out there today that have simply become so large that they are forced to use synthetic instruments or derivatives to build their portfolios. And if they were to invest in some of these smaller corporate issues, they're not able to really make a difference in the portfolio.

But given the size of the team, they're able to do that independent credit rating research, pick individual bonds that are all able to make contributions to the final portfolio.

Roy: That's great. So Lance, we've touched on a few of your ETFs. Are there any other ETFs you want to talk about that are either seeing demand from investors or you think investors should take a look at?

Humphrey: There's one in particular that comes to mind that we've been seeing a lot of interest on recently and it's the VictoryShares WestEnd U.S. Sector ETF (MODL).

It's an actively managed ETF by one of our franchises here at Victory Capital called West End Advisors, which was an acquisition that we made back in 2021.

What they do is look to actually allocate to sectors within the S&P 500. So they're looking at the macroeconomic environment and then taking that macroeconomic information and utilizing that to make individual sector positions within the portfolio.

So we think about, what are the sources of active return for an investor? If you were investing in U.S. large cap stocks, for instance, you could choose between value and growth or you could choose between large companies or small companies.

But what we find if you look at the typical dispersion or the difference between growth in value or small cap and large cap, we find that actually looking at if you look every year at the difference between the best and worst performing sectors, you tend to see a large spread there. That means there's great opportunity if you can identify those sectors that are likely to outperform and avoid those sectors that are likely to underperform. There's a great alpha opportunity by looking at that from a sector perspective.

And so with MODL, we have a team that has a significant amount of experience. The strategy that's utilized in MODL has actually been available as an institutional-level product across many of the large wirehouses across the United States in an SMA format.

So what we're excited to do with MODL is we've been able to bring that strategy that has had a very long-term track record and bring that into the ETF format that now allows that institutional-caliber team and process to be available to all investors within the ETF wrapper. So that's one that I'm particularly excited about.

And we've seen a lot of our advisors and clients begin making allocations to that product.

Roy: Fantastic. VFLO, the one we talked about at the beginning of the show, that's your newest ETF. What kind of new products do you expect VictoryShares will launch in the future?

Humphrey: The ETFs we've talked about today give a glimpse into our product evolution and the way we think about products.

I'd say, No. 1, we tend to be very deliberate. So unlike some other ETF providers, we don't launch a lot of ETFs every year to see what sticks. We really think very selectively about how we want to bring products to market.

And while I can't comment on any specific products, I could tell you that our philosophy is really about a couple of things I would highlight. No. 1 is, at Victory Capital, we have 12 investment franchises that we utilize, meaning we have tremendous investment talent that we're able to access across our company.

So MODL was actually a great example where WestEnd Advisors was one of the franchises here at Victory. And we're able to then take that product that they've been managing and offer it into the ETF format.

When we think about our other investment franchises, there's always opportunities to take existing strategies or existing ideas that aren't available today in the ETF wrapper and perhaps look at those into the future.

Secondarily, if we think about VFLO, there's a commonality there between that and some of our products where what we look to do is when there's ideas that we think can be successful in the market, we can use our internal experience and expertise in these investment types of strategies.

Can we bring something that's a little bit different to the market? For instance, today we have a dividend growth ETF where we do a couple of things different than some of the products on the market, or we have a low volatility strategy that has a similar theme and we try to do things a little bit differently.

I would say, when we think about new products, it's usually where there's something that we think is very effective in the market, but we might have a way of modifying that or attempting to improve on it. Or No. 2, bring out strategies that have existing track records into the ETF format.

Roy: And before I let you go, Lance, is there anything else you want to add?

Humphrey: The only thing I'll add is when I think about the investment landscape today, I think this will kind of reverberate through some of the topics we've talked about.

And the other questions is, I think a lot about the concentration today that we see in many of the broad market indexes, such as the S&P 500, where it's really five or 10 stocks that have been driving a significant portion of the return of those indexes so far this year. We've seen similar trends in prior years where that concentration has led to significant returns for those markets.

But if we look historically, what we find is that, generally speaking, a more diversified approach has oftentimes produced better results to investing. So when you think about our products in the VictoryShares lineup, in particular, many of our products really think deeply about that more diversified approach.

I talked about the way we weight our securities and CDC; that's something that you're going to see across many of our strategies, where we want to invest in given names, but we want to make sure that we're not doing so where a high level of concentration is simply coming from two, three or four names.

So I think that for any investors out there who share those concerns, I'd welcome them to take a look at the VictoryShares lineup, where many of our products are designed in such a way to avoid the concentration that we see in many traditional market-cap-weighted indexes.

Roy: Fantastic. Well, we're going to have to leave it there. Lance, it's been an absolute pleasure having you on the show. Thanks so much for your time.

Humphrey: It was a pleasure to meet great.

Roy: Listeners, I hope you enjoyed this episode. You can find this and all other Exchange Traded Fridays episodes on etf.com or on any major podcast platform. See you next week.