Could this unique small-cap ETF beat the S&P 500?

Small-cap stocks have performed reasonably well in anticipation of Federal Reserve interest rate cuts, but as a group remain very undervalued relative to S&P 500. And while investors can simply buy a Russell 2000 or S&P SmallCap 600 ETF if they want broad exposure to small caps, it’s important to realize that there are some ETFs that use unique approaches that might be worth a look. Here’s a small-cap ETF in particular that has a strong track record of performance and focuses on the most profitable small-cap companies in the US.

Another type of small-cap ETF

The Pacer US Small Cap Cash Cows 100 ETF (CALF -0.52%) takes a somewhat unique approach. The fund starts with the widely used S&P SmallCap 600 benchmark index of smaller U.S. companies, but narrows its holdings to the 100 that produce the highest free cash flow yield.

Just to clarify. This is not a dividend-focused ETF. It focuses on the most profitable small-cap companies, not necessarily those that pay the most to shareholders. The theory is that companies that produce excess free cash flow have plenty of cash to buy back stock, pay dividends, or invest in growth opportunities that arise. The average company in the S&P SmallCap 600 Value Index has a free cash flow yield of 3.38%, while the average company in this ETF has an FCF yield of over three times this.

The Pacer US Small Cap Cash Cows 100 ETF is an index weighted, but not by company size. It is weighted in order of free cash flow, so the most profitable businesses receive the largest allocations. However, the fund’s methodology limits any holding to a maximum of 2% of NAV.

A popular ETF with strong returns

This is a popular ETF with about $9.3 billion in net assets, quite a bit for a specialized fund like this. Its expense ratio of 0.59% may sound high to those who invest in index funds, but it’s on par with others using unique strategies like this one.

It’s not hard to see why this is such a popular ETF. Since its inception in 2017, its annualized total returns have outperformed the S&P SmallCap 600 by two percentage points (even after taxes), 9.79% to 7.79%.

Why Small Caps and Dividend Stocks Now?

The S&P 500 is near an all-time high right now, but small-cap stocks have mostly underperformed for several years. The average S&P 500 component has a price-to-book multiple of 4.7, compared to just 2.4 for the typical S&P SmallCap 600 stock.

The valuation gap between large-cap and small-cap stocks hasn’t been this wide in 25 years, and the last time it happened, small-caps outperformed for more than a decade.

Not only that, but with the Federal Reserve likely to start cutting interest rates soon, it could create some strong tailwinds for small caps. To name just one, small caps tend to use higher levels of debt than larger companies, and falling rates create lower borrowing costs.

Of course, an ETF’s past performance does not guarantee future investment results, and it is entirely possible that small caps may continue to underperform their larger counterparts. That said, with its high cash flow investing style, if the Pacer US Small Cap Cash Cows 100 ETF can continue its record of outperforming small caps, and small caps outperform large caps in the falling rate environment, this this could end up being a great ETF for patient investors.