With Fed Tightening Likely to Continue, Consider Investing in Free Cash Flow | ETF Trends

The market rally that began in the summer came to an end after Federal Reserve Chairman Jerome Powell confirmed that the Fed was to continue aggressively raising rates to combat inflation. After Powell said at the Jackson Hole symposium, “our responsibility to deliver price stability is unconditional,” investors sold off risky assets, realizing that the Fed had no intention of pivoting or easing up on its hawkish path.

“Ultimately, markets are still at an inflection point,” wrote John A. Forlines III, CIO of Donoghue Forlines. And while Forlines doesn’t “believe we will experience a deep recession in the next 12 months,” Forlines does think “there will continue to be volatility while the Fed and the market play chicken.”

“We expect both equities and bond yields to remain range bound until there is more progress made on inflation,” Forlines added. “Risks remain elevated and we are aggressively monitoring the chances of a deeper economic turmoil.”

With the Fed’s program of quantitative tightening likely to continue, this means that the liquidity squeeze already underway in markets will be amplified and exacerbated. So, investors may want to reinforce their portfolios by targeting companies with solid free cash flow characteristics.

Free cash flow is the cash left over after a company has paid expenses, interest, taxes, and long-term investments. It is used to buy back stocks, pay dividends, or participate in mergers and acquisitions.

Two exchange-traded funds that specialize in free cash flow include the FCF US Quality ETF (TTAC) and the FCF International Quality ETF (TTAI).

TTAC aims to outperform the Russell 3000 through a fundamentals-driven investment process that selects about 150 stocks based on free cash flow strength. Its holdings are then weighted by a modified market-cap log transformation, which allows for increased exposure to companies with the strongest proprietary free cash flow rankings.

TTAI, meanwhile, aims to outperform the MSCI All Country World Index ex the U.S. through an active investment process. A quant model is used to rank stocks based on proprietary measures of free cash flow. Highly leveraged firms, that incur debt to buy back shares, or don’t satisfy ESG criteria, are screened out. Roughly 150 of the highest-ranked stocks are selected and then weighted on a modified market-cap basis that factors in free cash flow and log transformation.

Both ETF portfolios will also be rated with an ESG score, excluding companies with low ESG ratings. Firms with an extreme rise in shares count and increase in leverage are excluded.

For more news, information, and strategy, visit the Free Cash Flow Channel.