Investors looking ahead to eventual interest rate cuts or simply wanting to diversify their large-cap equity portfolios may want to consider small caps in the second half of the year. Liquidity risks within the space prove a hurdle for some, but the VictoryShares Small Cap Free Cash Flow ETF (SFLO) may provide an avenue that alleviates some of this concern.
Small-cap companies hold appeal for their outsized growth potential compared to large-cap peers. However, because the businesses are smaller1, liquidity risk is higher than in large caps.
Liquidity risk pertains to two different types of risk within smaller businesses. The first type is the funding (cash flow liquidity) risk of a company, or the ability to pay its debts. The second type is market liquidity risk – or the ability to easily enter and exit a position – and relates more to investors than the first type.
Solving for Liquidity Risk Within Small Caps
The Index SFLO tracks, the Victory U.S. Small Cap Free Cash Flow Index (the Index), is constructed in a way that potentially reduces exposure to both types of liquidity risk. The Index methodology minimizes liquidity constraints by beginning with a larger universe of 2,500 companies through the VettaFi US Equity Mid/Small-Cap 2500 Index. It also eliminates the bottom 10% of securities based on liquidity.
Many small-cap funds only screen from 2,000 companies via the Russell 2000 Index. Including an additional 500 companies in the Index allows for greater trading efficiency and liquidity.
Data as of 03/31/2024
Image source: VictoryShares
In addition to reducing constraints, the Index also focuses on quality companies trading at a discount and demonstrating high free cash flow (FCF) yield. FCF is the cash remaining to a company after it’s paid its expenses. Companies use this money to invest in paying dividends, paying down debt, or growing their business. It’s also considered one component of measuring a company’s health. FCF yield is a financial ratio that standardizes the FCF per share a company is expected to earn as compared to its market value per share.
The Index screens for both current FCF as well as anticipated FCF. Additionally, a growth screen helps to remove the slowest growing companies. By focusing on high FCF yielding companies with an attractive growth rate, SFLO may provide an attractive solution within small caps that can potentially minimize liquidity risk.
SFLO carries a net expense ratio of 0.49% (gross expense ratio of 0.76%).
Net expense ratios reflect the contractual waiver and or reimbursement of management fees through at least December 31, 2024.
The Russell 2000® Index is a market-capitalization-weighted index that measures the performance of the 2,000 smallest U.S. stocks by market capitalization in the Russell 3000® Index.
1/The Russell 2000 Index has an average market cap of $4.3 billion as of 04/30/24 while the Russell 2000 Value Index’s average market cap is $2.8 billion.
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VettaFi LLC (“VettaFi”) is the index provider for VFLO and SFLO, for which it receives an index licensing fee. However, VFLO and SFLO are 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 VFLO and 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
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.
Distributed by Foreside Fund Services, LLC (Foreside). Foreside is not affiliated with Victory Capital Management Inc., the Fund’s investment adviser.
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