As part of the Wealth Advisor’s ongoing coverage of innovation in the exchange-traded funds (ETFs) market, Managing Editor Scott Martin sat down with Sean O’Hara, President, ETF Distributors, to discuss how Pacer’s unique approach to ETF construction is providing advisors with superior tools for navigating complex and long-standing challenges in values-based investing.
Established nine years ago and based in Malvern, Pennsylvania, Pacer ETFs has carved out a niche in the values-based ETF market by focusing on innovative, disruptive, and unique strategies. To illustrate their approach, O’Hara focuses on the Pacer US Cash Cows 100 ETF (ticker: COWZ), the firm’s flagship large-cap ETF.
The critical metric driving Pacer ETFs’ strategies is free cash flow (FCF) yield, he explains. Unlike traditional value investing metrics, Pacer emphasizes FCF yield to capture a more accurate picture of a company’s financial health.
Traditionally, value investing has been associated with low price-to-book stocks. However, Pacer’s research reveals that the value premium, which refers to the excess return generated by investing in value stocks, has diminished over time.
This change is largely a result of the evolving composition of companies’ assets. Historically, companies such as Kodak and Borders had substantial tangible assets. However, the digital revolution and the rise of technology giants have shifted value toward intangible assets, making metrics such as book value less indicative of a company’s true worth.
Free cash flow represents the cash a company generates after accounting for capital expenditures. The FCF yield is calculated by dividing this free cash flow by the company’s total enterprise value (the sum of its equity and debt, minus cash).
This metric offers a clearer insight into a company’s profitability and efficiency, especially in a market where intangible assets increasingly drive value. By focusing on FCF yield, Pacer aims to identify stocks that offer higher cash returns for the same investible dollars.
Pacer’s research, dating back to its inception, identified the shift toward the importance of intangible assets and prompted the company to adopt FCF yield as a core valuation factor. This approach has proven successful, as evidenced by the performance of the Pacer US Cash Cows 100 ETF, which has consistently delivered excess returns compared to traditional indices such as the S&P 500.
COWZ focuses on large-cap stocks with high FCF yields, providing investors with exposure to financially healthy companies. The fund offers several differentiating factors that make it a potentially attractive option for investors and their advisors.
First, COWZ provides exposure to stocks with higher FCF yield, indicating better cash returns. This strategy can be particularly appealing in a low-yield environment where advisors are searching for income-generating opportunities.
Second, COWZ offers true diversification by incorporating a different value metric compared to traditional price-to-book-based value strategies. By combining COWZ with other value-focused ETFs, advisors can construct portfolios that capture different aspects of the value premium, potentially enhancing overall performance.
O’Hara emphasizes that the COWZ strategy is not about chasing high-risk, high-reward stocks but rather about identifying companies that generate substantial free cash flow and are undervalued relative to their enterprise value.
Financial advisors can integrate COWZ or other Pacer value-based ETFs into their portfolios to complement traditional value positions. By adding ETFs that focus on FCF yield, advisors can achieve true diversification. This approach not only provides exposure to different sectors but also enhances the portfolio’s overall return potential.
Pacer’s approach to sector allocation is driven by the FCF yield metric, which often leads to significant overweight positions in certain sectors. For instance, energy has been a strong performer in Pacer’s portfolio, not by design but because the sector has offered high FCF yields. Similarly, although the tech sector is included, the focus is on companies that produce strong cash flows, such as chip makers and device manufacturers, rather than more speculative stocks driven by interest in artificial intelligence (AI).
The Pacer ETFs methodology also results in limited exposure to sectors such as financials, where FCF yield is not a suitable metric. Traditional value portfolios are typically overweight in financials, utilities, and real estate, sectors that Pacer’s strategies often avoid, O’Hara notes. This exclusion enhances the complementarity of Pacer’s ETFs when paired with conventional value investments.
O’Hara highlights a critical advantage of using FCF yield-focused ETFs: the ability to lower a portfolio’s price-to-earnings (P/E) ratio. With such major indices as the S&P 500 and Nasdaq trading at elevated P/E ratios, many investors and advisors are concerned about sustainability and potential market corrections. Pacer’s ETFs are designed to offer a way to maintain equity exposure while mitigating these risks.
For example, over the past five years, COWZ has outperformed the S&P 500, achieving higher returns with a significantly lower average P/E ratio. This disparity demonstrates that value investing, when measured with the right metrics, can still deliver substantial returns in a market dominated by high-growth, high-valuation stocks.
Although Pacer’s value-based ETFs have demonstrated strong performance, O’Hara highlights the importance of patience when investing in value stocks. Value investing requires a long-term perspective, as the market may take time to recognize the true value of these stocks. However, over time, the FCF yield approach has the potential to deliver consistent excess returns.
Pacer ETFs continues to track emerging trends in the market, such as the role of utilities in the AI revolution, says O’Hara. Although utilities are traditionally seen as stable, low-growth sectors, the rise of data centers and increased demand for computing power are changing this perception. Utilities providing energy to these data centers may see significant increases in cash flow, potentially transforming them into growth stocks.
Not all utilities will benefit equally, he notes, but those in key locations or with unique business models may become attractive investments. This potential development underscores the importance of using metrics such as FCF yield to identify opportunities in evolving sectors.
O’Hara reinforces the importance of adapting to market changes. Traditional value metrics may no longer suffice in a world where intangible assets dominate. Pacer ETFs’ focus on FCF yield provides a robust framework for identifying undervalued companies with strong cash flows, offering a reliable path for advisors and their clients to enhance their portfolios.
For advisors, the takeaway is clear: integrating innovative ETF strategies such as COWZ can offer clients diversified, high-quality equity exposure while addressing concerns about market valuations and sustainability. As the market continues to evolve, staying ahead requires not just new ideas but better solutions to old problems, a philosophy that Pacer embodies through its commitment to innovation and disruption.
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Disclosures
This content is intended for financial advisors only.
Before investing you should carefully consider the Fund’s investment objectives, risks, charges, and expenses. This and other information is in the prospectus. A copy may be obtained by visiting www.paceretfs.com or calling 1-877-577-2000. Please read the prospectus carefully before investing.
An investment in the Funds is subject to investment risk, including the possible loss of principal. Pacer ETF shares may be bought and sold on an exchange through a brokerage account. Brokerage commissions and ETF expenses will reduce investment returns. There can be no assurance that an active trading market for ETF shares will be developed or maintained. The risks associated with this fund are detailed in the prospectus and could include factors such as calculation methodology risk, concentration risk, derivatives risk, equity market risk, ETF risks, futures contracts risk, high portfolio turnover risk, large- and mid-capitalization investing risk, passive investment risk, tracking risk, sector risk, style risk, and/or special risks of exchange traded funds.
NOT FDIC INSURED | MAY LOSE VALUE | NOT BANK GUARANTEED
Distributor: Pacer Financial, Inc., member FINRA, SIPC, an affiliate of Pacer Advisors, Inc.
Pacer Cash Cows ETFsTM and Cash Cows Index® are registered trademarks of Index Design Group, LLC.
