VFLO: 5 Reasons I'm Buying This Dividend ETF For My Retirement Portfolio (NASDAQ:VFLO) (2024)

My ZEUS family fund is one-third equity ETFs, so I must stay on top of the best ETF opportunities.

I've long been a fan of the Pacer 100 Cash Cows (COWZ) ETF, the first free cash flow yield-based ETF that combines deep value and quality.

When the VictoryShares Free Cash Flow ETF (NASDAQ:VFLO) came out in June of 2023, I was intrigued by what I believed might be a better approach.

However, as a brand new strategy ETF, I knew that more data was necessary before I could grant VFLO a complete seal of approval or even buy it for my family fund.

Let me share an update on VFLO, since my update in 2023, and why I think there's enough data to recommend it and add some to my family fund.

Strategy Vs. Core ETFs: The Important Differences

ETFs like the Vanguard Dividend Appreciation ETF (VIG) or the Schwab US Dividend Equity ETF (SCHD) are very popular and great examples of core ETFs.

They have low turnover (usually 15% or less) and low expense ratios of 3 to 20 basis points.

• A basis point is 0.01%.

For example, a 10% turnover ETF will, on average, hold a stock for a decade before it is rebalanced.

So with a core ETF like VIG, SCHD, or my personal favorite growth ETF, the iShares Russell Top 200 Growth ETF (IWY), you pretty much know what companies you own via the ETF, though the weightings can change at the margins.

Strategy ETFs used to be called "smart beta" or "alpha factor" ETFs. They have higher expense ratios but claim higher fees (0.4% to 0.75% typically), which are worth it because they use rules-based strategies, or even AI algorithms, to generate superior returns following a strategy.

ETFs like ARKK, Cathie Woods' flagship, are actively managing ETFs. She or her team decides daily whether to buy or sell, at their discretion, not on a rules-based system.

ETFs like COWZ SPGP or SCHD are index-based ETFs.

• SCHD is both a strategy ETF and low volatility. Its strategy results in stable, core holdings (six-year average ownership in the ETF).

The indexes are very specific, rules-based, and usually rebalance once per quarter, twice per year, or once per year.

The difference between ARKK and COWZ is that while both can have high turnover, COWZ can't decide to buy or sell a company out of the portfolio between rebalances.

The index is the index, even though the index is very specialized and created for a very specific strategy.

I like strategy ETFs like COWZ and SPGP because they avoid the "key person risk" of a "hot manager" going cold.

According to S&P Dow Jones Data, over the long-term, 10+ year periods, just 7% to 8% of fund managers can match their benchmark marks, never mind beat them.

For certain kinds of funds, like large-cap value, it's easier, with about one-third of managers beating over five years, but by year 20, that alpha tends to disappear.

• Imagine a one-in-a-billion-dollar investor like Buffett managing a fund and then retiring.

Actively managed ETFs like Cambria Shareholder Yield ETF (SYLD) and Meb Faber's ETF try to minimize this risk by using rules-based approaches even with active management.

How can a prudent investor navigate the complexity of a world with over 3,200 ETFs available in the US alone?

Focus On Design And Strategy, Not Necessarily Returns

Let's use poker as an example of the way to think about investing probability.

A straight flush (five consecutive cards, all in the same suite) is very unlikely. It happens once every 41,667 hands.

Imagine you're at the World Series of Poker, with millions on the line at the final table, and you have a straight flush.

You're down to one opponent, and they are betting aggressively. What's the optimal strategy? The odds say there is just one hand that can beat yours, the Royal Flush, A ♦ K ♦ Q ♦ J ♦ 10 is a royal flush, though it can be any suit.

The probability of you losing is 1/649,740, the probability of your opponent having a Royal Flush.

You go all in, forcing them to do the same. How risky is this move? Are you being reckless? Gambling everything on a single hand of Poker? Not at all; when you have the second-strongest hand possible, and the chances of your opponent beating you are this small, the right move is to go all in, forcing an all-or-none outcome.

The tournament will end with this hand, and you will almost certainly win.

But imagine that your opponent almost miraculously has a Royal Flush. You just lost the World Series of Poker.

And you did everything right. You played the odds to perfection. There was no flaw in your strategy. There was an almost 1 in a million chance of failure, which was one of those times.

That's the nature of probability, and on Wall Street, probability curves rule all. There are no guarantees of any kind.

Not even AAA-rated Microsoft (MSFT) and Johnson & Johnson (JNJ) bondholders can be 100% safe from default.

• AAA = 0.07% risk of default over 30 years.
• According to rating agencies, there is a 1 in 1,429 chance MSFT or JNJ will go bankrupt over 30 years and shareholders will get wiped out.

This is the same for stock returns over time.

In the short term, defined as six years or less, the majority of returns is momentum, sentiment, or luck.

It takes seven years before fundamentals explain the majority of returns, and even over 30, 40, or 50 years, Buffett-level time horizons, 3% of returns are still attributable to luck.

How confident can we be that US stocks are a good asset? Based on 220 years of data, I'm 97% confident.

However, there's a 3% chance that Buffett just had luck, and so did the US stock market for centuries.

There's a 3% chance that Buffett has no edge at all, that the US economy isn't actually special, and that our stock markets don't always go up in the long term, despite all evidence so far to the contrary.

I like strategy ETFs. Paradoxically, historical returns are necessary to determine whether they work.

"I've Never Seen A Back Test I Didn't Like" - Wall Street Aphorism

To launch an ETF and attract an average of $50 million, it costs in assets to keep it open ($250,000 per year SEC registration and exchange fees). ETFs need to have something to market.

This is where backtesting a strategy using historical data and a rules-based approach is useful.

From 1991 to 2023, rebalancing a portfolio quarterly using FCF/EV, or free cash flow yield (the inverse), resulted in the best stock returns with the lowest volatility.

One reason this metric works so well might be that only one in seven fund managers knows about it.

For a third of a century, this was by far the best investing strategy: A single-metric, deep-value approach utilizing Buffett's "owner earnings."

• Free cash flow is what's left over after running the business, investing in sustaining the moat, and growing the company.
• What can be taken out of the business to pay dividends, buybacks, pay down debt, acquire other companies, etc?

Enterprise value is market cap + net debt, the true cost to buy the entire company.

EV/EBITDA is a popular private equity valuation metric (the most popular in fact).

EV/FCF is historically the most powerful because there is no more pure valuation metric.

EV/FCF Multiple: The true cost of acquiring the business is divided by the money I can take out of the business and spend on anything I want.

But that's the theory, at least. The backtest is magnificent, with 17% average annual returns! Less than 16% average yearly volatility! A shape ratio of more than 1% (volatility-adjusted returns, what hedge funds try to optimize).

Compared to the Russell 1000 (largest 1000 US companies), this metric was more than two times as good at delivering average annual returns per unit of volatility.

But as Howard Marks likes to say, "A six-foot man can drown in a river that's five feet deep, on average."

The Importance of Historical Returns When Investing in Strategy ETFs

When analyzing an ETF like COWZ, you start with how it works and what is the theory behind it.

We just saw that FCF yield is brilliant, in theory. In fact, since 1991, it would have beaten the Nasdaq, the single best-performing index in history.

• 13.5% annual returns for 38 years.

Historical Returns Since 2017

In seven years, COWZ's portfolio has changed about six times. What it owned in 2017 is entirely different from what it owns today.

The managers? They don't matter. The ETF is completely rules-based, tracking a rules-based index. We see pure strategy results: EV/FCF-based investing and quarterly rebalancing.

While the average annual rolling returns aren't matching the 17% backtest results, 13% to 15% average annual returns over time are slightly better than the S&P in a roaring FANG/Mag 7-led bull market that left value (and every other factor) in the dust.

Compared to Vanguard's value ETF (VTV), COWZ is a champion.

And its not just VTV that COWZ beat.

• Top 1% of value funds over the last five years.
• Top 1% of value funds over the last three years.
• Top 14% of value funds in the last 12 months.
• Top 20% of value funds year-to-date.

COWZ is a fantastic strategy ETF because of how well constructed and managed it is.

The Secret Sauce Of COWZ: Excellent Benchmark Design

But how does COWZ take this time-tested investing principle and actually make it beat the market and 99% of value funds?

Pacer's index starts with the Russell 1000 and then, based on trailing 12-month FCF yield, selects 100 companies with the highest yield (and thus deepest value but high quality) and weights them by FCF yield with a 2% risk cap.

It's a very simple approach, but as we've seen over seven years, it's highly effective, beating 99% of its peers and the S&P.

But what are the limitations? The weaknesses?

The Downsides of COWZ

No ETF will be perfect, and no strategy works all of the time. If value were the No. 1 strategy, everyone would always use it, and it would stop working.

COWZ and many strategy ETFs, especially with quarterly rebalancing, have high turnover, though they use tax-loss harvesting algos to minimize tax bills.

• 13.55% historical total return since inception
• 12.76% after-tax
• 0.74% annual tax expense ratio (average)

Even adjusting for taxes, COWZ is a standout deep-value ETF.

• Top 2% of value funds over the last five years.
• Top 1% of value funds over the last three years.
• Top 11% of value funds in the last 12 months.
• Top 18% of value funds YTD.

But here's the downside of high turnover: You sometimes have to lose companies you love and accept ownership of companies you don't like.

Some people don't like that Altria (MO) is now in COWZ's top 10. I don't like that 3M (MMM) is in the top 10.

ABBV and QCOM are great companies with such strong rallies that they are out of the ETF entirely.

But that's the price you pay for strategy ETFs. These are 100% rules-based quant funds.

There's no discretion. The numbers are what the numbers are, and the ETF follows the rules meticulously.

That's the downside, but that's also the promise.

Seven years of blindly following a fantastic theoretical strategy turned out wonderfully for investors.

Math matches reality, as it always must.

No model is perfect, but discard it if it doesn't match reality relatively accurately over time.

Let's not forget COWZ's biggest weakness: It uses pure 12-month trailing FCF and doesn't account for growth.

COWZ Growth Consensus Forecast

30% EPS declines in 2023 and 2024, followed by modest recovery, shows weak fundamental growth.

But this is where Victory Funds says it can take COWZ's FCF yield-based approach and improve it in three key ways.

5 Reasons I'm Buying VictoryShares Free Cash Flow ETF For My ZEUS Family Fund

First, VFLO uses an average of trailing FCF and 12-month forward FCF based on the analyst consensus.

This is superior (in theory) to COWZ's pure trailing approach.

• Oil companies can have sky-high free cash flow yields, but when oil prices crash, so do the free cash flows.
• Analysts adjust for this in estimates, but COWZ is blind to it.

COWZ uses a 12-month trailing FCF because it's more conservative. Analysts can be wrong about the coming year, but the last 12 months are set in stone.

The historical backtest shows that adding a forward FCF component would have boosted returns by about 0.8%.

But that's just one reason I like VFLO's strategy more.

Reason Two: Don't Forget About Growth

Which is a better long-term investment?

• Company A trades at 10X earnings has a historical PE of 11 and is growing at 1%.
• Company B, which trades at 20X earnings but historically trades at 25X and is growing at 15%?

While company A has a lower valuation, company B is likely the far better investment. It's historically 20% undervalued compared to just 10% for company A and is expected to generate far more cash flow, the ultimate source of intrinsic value.

The point is that value investors ignore growth at their peril.

According to Ben Graham's final fair value formula, a company growing at 0% is worth 8.5X earnings.

That's a rule of thumb based on the idea that if a company with stable earnings and no growth pays out 100% of earnings as dividends, you'll earn about 12% returns on such a company.

If a company is shrinking? Then, you want an even lower valuation to compensate for falling dividends over time.

In other words, a company growing at -6% over time is worth 5.5X earnings because the dividend yield is so high that you're well compensated for owning a dying business that will one day be worth zero.

• You'll cash out so much in dividends that the final stock price of zero is immaterial.

The point is that growth always matters, just like valuation always matters in the long term.

By eliminating the 33% slowest companies from the index, VFLO's backtest results improve by 1% per year, to an even more impressive 17.6% annual return since 1991.

• 151X return in 32 years vs 22X S&P
• 7X better returns than the S&P by combining value, growth, and quality.

Reason 3: A Rules-Based System For Blue-Chip Bargain Selection

Start with 1000 of America's largest companies and trim that to 400.

Then select the 75 highest FCF yields (ex REITs and financials), and you can see how this results in a much higher FCF yield (2X higher) but much slower growth.

Then, they eliminate the 33% slowest growers (based on the average of past and future).

• The growth rate is the long-term sales growth trend defined as an average of five years historical and two-year forward sales growth.

Weight by FCF yield (core target metric) and then cap at 4% and 45% by sector, and you now have almost 3X the FCF yield you started with and the same growth rate.

It has the same growth as the S&P 400 (effectively) but a 3X better valuation. Can you see why this strategy has historically backtested 17.6% annual returns?

And compared to the Russell 1000 value index?

• Half the size.
• Growing 2.5X faster in the last three years.
• Growing more than 2X faster in the last five years.
• Slightly better debt/capital.
• Much better PE ratio.
• Much better profitability (Wall Street's favorite quality metric).

Concentration has its benefits, such as far stronger fundamentals, including the ones that drive returns, such as yield, growth, and value.

Reason Four: A More Concentrated Portfolio

(Source: Pacer, Victory Funds)

VFLO's top 22 holdings are all weighted larger than COWZ's largest holdings, showing the power of concentrated diversification.

Fifty stocks is plenty diversified if the strategy is sound.

As little as 15 stocks are diversified enough if you have enough sectors.

And while VFLO is highly concentrated by sector, remember this is not meant to be the only ETF you own.

And look at what VFLO doesn't own: 3M (MMM) and VF Corp (VFC).

COWZ is buying those because they are cheap, but VFLO is avoiding them due to weak growth forecasts from the analyst consensus.

That's a superior strategy, in my opinion.

VFLO Earnings Growth Consensus Forecast

FactSet's consensus of all analysts covering these companies estimates 1% to 2% better growth in the coming years.

• VFLO: 5.1% EPS growth from 2023 to 2026 (including the earnings recession for cyclical companies)
• COWZ: 2.9% EPS growth from 2023 to 2026

Remember how VFLO's backtest was 1.8% better than COWZ's? Because of its use of forward growth metrics and eliminating slower growers?

Here's evidence that it's not just historical backtest data, but analysts expect it to continue.

Reason 5: Historical Returns Now Starting To Prove VFLO's Strategy Is Correct

When VFLO started in mid-2023, there was no track record. All we had was brilliant backtest data.

We have the first evidence that VFLO's highly logical, rules-based strategy for combining quality (profitability), value (FCF yield, most accurate value metric since 1991), and growth, is working.

Not only is VFLO beating COWZ, but COWZ and VFLO are beating the Nasdaq, the S&P, and Vanguard value.

Value still works... you have to own the right value funds using the right strategy.

Historical Returns Since July 2023

Similar historical volatility to the S&P 500, but far higher returns and a much higher negative volatility-adjusted return (Sortino ratio).

A Treynor ratio of 30 means that for every unit of volatility, VFLO generates 30% excess total returns above treasuries, twice that of the S&P and VTV.

12% alpha relative to just buying the S&P 500.

COWZ is doing great, but VFLO is delivering block-buster returns so far.

And in a market where the Mag 7 is supposedly the only thing going up.

The Limitations Of VFLO

VFLO is a concentrated strategy fund with just 50 stocks. I've only seen one other ETF that concentrated (XLG, the S&P 50 ETF).

The top three sectors comprising 70% of the portfolio are healthcare, energy, and consumer discretionary.

Tech is just 8%, so if you think VFLO will track the S&P all the time, you're incorrect.

There will be times, many times, that VFLO isn't beating the market.

If those top sectors are out of favor, VFLO could experience poor or even negative returns for years.

COWZ experienced a period of negative returns for three years.

Only at five years has its worst return (10.6% per year) beaten the S&P's worst five-year return (9.1%).

The point is that owning a strategy ETF like VFLO COWZ, SPGP, OMFL, or any others you might like will require patience.

How I Plan To Add VFLO To My Family Fund Over Time

VFLO's strategy, on paper, is superior to COWZ in three ways.

1. Incorporates forward FCF estimates, not just trailing.
2. Incorporates growth forecasts (and historical growth rates) to screen out the worst-growing companies.
3. Concentrates the portfolio into a still safe (4% risk caps) but more potent portfolio with 3X better valuation than large caps but the same average growth rate.

In theory, VFLO should beat COWZ and nearly every other ETF you can imagine.

• Nasdaq's 38 year return is 13.5% per year
• VFLO's 32 year return (backtest) is 17.6% per year

But math must always match reality. As the saying goes on Wall Street, "I've never seen a backtest I didn't like."

So how do I weigh the fact that VFLO is now significantly outperforming COWZ as it is designed to, as well as the S&P and Nasdaq (also how its designed)?

Given the fact that less than one year of data = 4% statistical confidence that VFLO's success isn't just luck?

Seed Positions: Make Your Assets Prove Themselves Worthy Of Your Money

You should understand why you own every asset in your portfolio, whether stocks, bonds, managed futures, or other alternatives.

What is the role of that asset? That ETF, that stock? That bond? That CD?

For VFLO, the goal is simple: Combine the best valuation metric of the last 32 years with a sensible approach to boosting growth and total returns even more.

Theoretically, it's the best deep-value ETF I've ever seen. Heck, at 17.6% historical back test for 32 years, it's the best historical returns I've ever seen from any ETF.

• 151X return since 1991 vs. 22X S&P = 65X adjusted for inflation.
• $1 invested in VFLO's strategy in 1991 is now worth $65 adjusted for inflation, S&P just $9.50.

But math must always match reality. And it will be another six years before VFLO can reach statistical significance.

• After seven years, 54% of returns are from fundamentals

In other words, for the first seven years, you can't know if a new ETF or fund is doing well out of luck or strategy or active management skills.

But so this is where the seed position idea comes in.

I'm buying $1,000 worth of VFLO, and then whatever money COWZ is going to get, VFLO will get it instead, up to the target allocation of 3.05%.

Current Target Allocation For My ZEUS Family Fund

(Source: DK ZEUS Portfolio Tracking Tool, FactSet Research, Morningstar)

Suppose VFLO proves itself over time by maintaining its outperformance over COWZ once it achieves enough track record and we can see how it compares to its peers and COWZ itself. In that case, I will consider replacing COWZ with VFLO entirely.

• This would boost the long-term return potential on the fund by 0.1% to 16.2%.

If VFLO can deliver those historical back test results (17.6% since 1991), I might even consider replacing SPGP and giving it the total 12.2% deep value ETF allocation in my family fund.

• 34.4% ETFs split 12.2% growth, 10% yield, and 12.2% deep value

Why those three strategies?

But that's a discussion for another day.

For now, I want to congratulate the VictoryShares team on a great first year and a great fund design.

Now, keep up the great work, and earn my assets.

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