Chicago-based Distillate Capital has launched the Distillate US Fundamental Stability & Value ETF (DSTL US) on NYSE Arca, becoming the latest player to enter the fast-growing ETF space.
Tom Cole, co-Founder and CEO, Distillate Capital.
DSTL tracks a proprietary index which screens a starting universe of the 500 of the largest US companies for stocks where quality and value overlap.
While this may sound like a conventional fundamental strategy, the index uses Distillate’s own definitions of value and quality factors within its selection process. This involves making a number of balance sheet adjustments to enhance the comparability of factors across firms.
The index initially screens the parent Solactive US Large Cap Index to exclude those stocks with significant leverage based on the firm’s proprietary debt-to-income ratio that adjusts for off-balance sheet leases or other calls on capital that may not be picked up by traditional measures.
Each company is then scored based on a proprietary measure of the volatility of its historical and projected cash flows as an indicator of fundamental stability. Distillate utilizes a cash-based proprietary measure called distilled cash yield which it says restores comparability between older, more physical asset-based companies and newer, more research and development-oriented ones. The bottom 50% (i.e., the least stable) based on this measure are excluded.
Finally, each company is scored based on a proprietary measure of the company’s free cash flow yield (a measure comparing a company’s normalized free cash flow to its enterprise value). Distillate’s proprietary metric seeks to address the perceived ineffectiveness of traditional valuation methods which stem from the differing accounting treatment of intangible and physical assets.
For example, the firm highlights companies such as Apple or Johnson & Johnson (whose most valuable assets tend to be their intellectual property and research & development) which often appear expensive using traditional valuation metrics and may not compare favourably with more “physical-based” companies that own large factories or refineries.
The top 100 companies (the most undervalued) based on Distillate’s value metric are included in the index.
Tom Cole, co-Founder and CEO, Distillate Capital, commented, “Value investing isn’t dead. Far from it. Value investing works by exploiting behavioural biases, which are well-documented and recurring; the problem lies in how ‘value’ is defined. What we’ve observed as fundamental analysts going back to the 1980s is that many traditional valuation metrics have become increasingly ineffective as tools for comparison as the economy has evolved from physical assets to intellectual ones.”
“These metrics lie at the very heart of what we’re trying to accomplish with DSTL,” added Matt Swanson, co-Founder of Distillate Capital. “They circumvent the inconsistent balance sheet treatment of intangible and physical investments while incorporating a company’s total firm value—not just its market cap.”
“With DSTL’s focus on fundamental stability, low leverage, and redefined valuation and quality metrics, we seek to outperform in up markets and remain resilient through periods of market stress,” said Swanson. “In upward-trending or flat markets, DSTL’s process systematically pushes the ETF towards solid value opportunities.”
As of the index’s quarterly reconstitution and rebalancing, each stock is weighted based on the sum of two-thirds of its equal weighting weight (i.e., 2/3 of 1%) and one-third of its proportion of the index’s total normalized cash flow.
The fund comes with an expense ratio of 0.39%.