IQLT - ICOW: History May Not Repeat Itself

2023-11-13 23:24:20 ET

Summary

• Pacer Developed Markets International Cash Cows 100 ETF seeks to provide exposure to the top 100 international companies based on free cash flow yield.
• ICOW currently has $915 million in net assets and charges a net expense ratio of 0.65%.
• The Fund has outperformed cap-weighted international index products since its launch in June 2017.
• ICOW is currently very overweight in the energy sector and thus near-term relative performance will be driven by the performance of the energy sector.
• I am cautious about the energy sector right now and thus prefer expressing international exposure via international cap-weighted index products such as VEA instead of ICOW.

ETF Overview

The Pacer Developed Markets International Cash Cows 100 ETF ( ICOW ) seeks to provide investors with exposure to the Pacer Developed Markets International Cash Cows 100 Index. The index seeks capital appreciation over time by screening the FTSE Developed ex-US Index for the top 100 international companies based on free cash flow yield.

ICOW focuses on companies outside the U.S. that have high free cash flow yields on a trailing 12-month basis.

ICOW currently has $915 million in net assets and charges a net expense ratio of 0.65%. Fund characteristics include a 4.76% dividend yield, 14.01% free cash flow yield, and a trailing P/E ratio of 6x.

Index Methodology

The initial index universe is derived from the FTSE Developed ex US Index. The initial index is screened based on average projected free cash flows and earnings over the next two fiscal years. Companies with no forward projections for free cash flows or earnings remain in the index universe while companies with negative average projected free cash flows or earnings are removed from the index universe. Also, financial companies, other than REITs, and companies with a market capitalization of less than $3 billion are excluded from the index universe.

Remaining companies are ranked by average daily trading value ("ADTV") for the prior three months. Next, the 500 companies with the highest ADTV are ranked according to free cash flow yield for the trailing twelve-month period. The 100 companies with the highest free cash flow yield are included in the index.

At the time of each index rebalance, which occurs on the 3rd Friday of June and December, companies included in the index are weighted in proportion to their trailing twelve-month free cash flow. Weightings are capped at 2% for each company.

Management Fee

ICOW charges a net expense ratio of 0.65%. To put that into context, the average expense ratio for an actively managed equity mutual fund is ~0.66% and the average equity ETF expense ratio is ~0.16%.

While ICOW is more expensive than the average equity ETF, it is priced in line with the average actively managed equity mutual fund. Additionally, ICOW appears somewhat expensive compared to similar products such as the iShares MSCI Intl Quality Factor ETF ( IQLT ) which charges an expense ratio of 0.30%.

Strong Historical Performance

In a world where most actively managed products have failed to outperform their benchmarks over the long term, ICOW stands out due to its strong performance.

ICOW launched in June 2017 and has significantly outperformed the Vanguard FTSE Developed Markets ETF ( VEA ) since then. VEA seeks to track the investment performance of the FTSE Developed All Cap ex US Index.

Since inception, ICOW has delivered a total return of 40% compared to 27.1% delivered by VEA. Additionally, ICOW has delivered strong relative performance vs VEA over more recent time frames as well.

ICOW's outperformance is also impressive on a risk-adjusted basis. Since its inception, ICOW has realized an average 30-day trailing volatility of 16.15% compared to 15.82% for VEA. Thus, ICOW has delivered returns well in excess of VEA with only slightly more volatility.

While ICOW's performance is impressive it should be noted that the fund has slightly underperformed IQLT which represents another quality-based approach.

Holdings Analysis

ICOW is well diversified with no single holding marking up more than 2.43% of the fund. The top 5 holdings account for 11.55% of the fund. Comparably, the top 5 holdings in VEA account for 7.39% of VEA's total holdings. ICOW is modestly more concentrated in its top holdings than market cap-weighted index products such as VEA.

In terms of country weights, ICOW exposures are fairly similar to VEA. ICOW's largest overweight is Norway (5.1% of ICOW vs 0.8% for VEA) which is offset by an underweight exposure to Japan (16.3% of ICOW vs 21.6% for VEA).

Sector exposures represent a key difference between ICOW and VEA. ICOW has 33.8% of its assets invested in the energy sector compared to 5.9% for VEA. This massive overweight is offset by my significant underweight in financials (ICOW has 0% exposure compared to 19% for VEA) and healthcare (ICOW has 0.6% exposure compared to 11.1% for VEA.)

In terms of fund characteristics, ICOW has a trailing P/E ratio of 6x compared to 12.75 for VEA. Moreover, ICOW has a free cash flow yield of 14.01% compared to 3.68% for VEA. ICOW's dividend yield of 4.76% is also significantly higher than VEA's 2.91% yield.

Structural Financial Sector Underweight

One of the most interesting aspects of ICOW is that it does not hold financial sector companies as these are automatically eliminated as part of the index construction process. Financial companies make up a large share of global cap-weighted indexes and account for ~19% of VEA. Thus, ICOW will always be 19% underweight the financial sectors with overweights shifting between other sectors based on historical cash flow yields.

Since ICOW's inception, the financial sector has significantly underperformed the broader market which has been a major driver of positive relative performance for ICOW. As shown by the chart below, global financials ex-US have returned -8.3% since ICOW's inception while VEA has returned 27.15%. Underperformance is even greater than it seems as financials account for ~19% of VEA. Excluding the drag due to the financial sector, VEA would have been up 28.7%.

Taking this a step further we can estimate that ICOW has experienced positive relative performance vs VEA of ~7% since inception due to its financial underweight. For context, as discussed previously ICOW has outperformed VEA by 12.8% since inception.

The takeaway here is that ICOW has benefited significantly from a structural underweight in the financial sector. If the relative underperformance of the financial sector were to reverse then I believe it would become much more challenging for ICOW to outperform.

Why I Would Own VEA over ICOW Right Now

The biggest difference between VEA and ICOW right now comes down to energy sector exposure as ICOW has a weight of 33.8% compared to 5.9% for VEA.

The energy sector has performed very well of late but I am concerned that the sector will not continue to outperform going forward. Despite ongoing wars in both the Middle East and Ukraine, oil prices have failed to rally in recent weeks which suggests underlying oil market weakness.

The chart below shows the United States Oil Fund LP ( USO ) which seeks to gain exposure to oil futures. USO has fallen substantially over the past few weeks. I view this price action as highly negative for the energy sector given the headlines of late involving key oil producers such as Russia and Iran. Over the past month, the global energy equity sector has fallen by ~4% while the broader market has been roughly flat. This move has resulted in ICOW underperforming VEA over the past month by ~2.6%.

I believe this underperformance will continue as the energy sector remains poised to underperform.

Conclusion

ICOW is an ETF that stands out relative to peers due to its strong historical performance. ICOW has outperformed VEA on both a long-term and short-term basis.

A significant driver of long-term outperformance has been a structural underweight to the financials sector which has significantly underperformed the broader market since ICOW's inception.

Currently, ICOW has a very big overweight to the energy sector and I am concerned that the energy sector will underperform the broader market going forward as recent price action has been concerning despite ongoing wars in both the middle east and Ukraine.

My view is that energy exposure will continue to hurt ICOW on a relative basis over the near term and thus I prefer to own market cap-weighted products such as VEA to get international exposure. I would consider changing my view on ICOW if the fund reduces its overweight to the energy sector going forward.

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