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A New ETF that Screens for Value and Quality

This article was originally published on ETFTrends.com.

With the most recent sell-offs in U.S. equities, value investing could be poised for a comeback as growth and momentum might be making their way to the exits. Distillate Capital, a Chicago-based asset manager focused on fundamental equity analysis, announced the launch of its first ETF on Wednesday--the Distillate U.S. Fundamental Stability & Value ETF (NYSEArca: DSTL), which seeks to distill a starting universe of the roughly 500 largest U.S. companies by market cap into only the stocks where quality and value overlap.

To implement this strategy, Distillate Capital begins by redefining and updating industry definitions of value and quality for the 21st century, drawing on the team’s extensive experience as fundamental value investors. DSTL then utilizes these rationally-defined measures of value, quality, and risk to weight its constituents with the goal of providing investors with superior compounded long-term returns.

“Value investing isn’t dead,” said Tom Cole, Cofounder and CEO. “Far from it. Value investing works by exploiting behavioral 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.”

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This is due in part to the differing accounting treatment of intangible assets such as research & development (which typically are treated as expenses) and physical assets such as factories (which are usually treated as assets).

“Setting accounting standards is difficult,” Cole continued, “and there are some good reasons these rules are in place. But our view is that the economy has shifted to a sufficient degree, from physical to intellectual assets, that traditional comparability is significantly impaired.”

For example, companies such as Apple or Johnson & Johnson, whose most valuable assets tend to be their intellectual property and research & development, often appear expensive using traditional valuation metrics, and may not compare favorably with more “physically-based” companies that own large factories or refineries.

It was with these deficiencies in mind that Distillate Capital devised new, updated methodologies for measuring value and quality. For value, DSTL utilizes a cash-based proprietary measure called distilled cash yield that is intended to offer a truer, more consistent gauge of valuation across the market. This measure restores comparability between older, more physical-asset based companies and newer, more research and development-oriented ones.

In terms of screening for quality, DSTL emphasizes long-term fundamental stability over short-term price-based metrics and also incorporates a financial indebtedness measure that adjusts for off-balance sheet leases or other calls on capital that may not be picked up by traditional measures.

“These metrics lie at the very heart of what we’re trying to accomplish with DSTL,” said Matt Swanson, Cofounder. “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.”

DSTL has the potential to perform well in a variety of market environments.

“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.”

DSTL seeks to track the Distillate Fundamental Stability & Value Index, and its expense ratio is 0.39%.

“We’re thrilled to draw on our long-term experience as fundamental value investors to share our approach to equity investing with ETF investors,” said Jay Beidler, Cofounder. “We take pride in the simplicity of our approach. In order to overcome our own behavioral biases, we’ve systematized an active investing philosophy and packaged it in a passively-managed vehicle. By paying attention to the fundamentals—value, quality, and risk—and how they’re measured, we’re confident that DSTL can play a key role as an equity allocation in investors’ portfolios, whether as a core or satellite holding.”

For more new ETF launch stories, visit our New ETFs category.

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