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

A different kind of small-cap ETF

The Pacer U.S. Small Cap Cash Cows 100 ETF (CALF 1.17%) takes a somewhat unique approach. The fund starts with the widely used S&P SmallCap 600 benchmark index of smaller U.S. companies, but it narrows its holdings down to the 100 that produce the highest free cash flow yield.

Just to clarify. This isn’t 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 lots of money 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 3.38% free cash flow yield, while the average company in this ETF has FCF yield of more than three times this.

The Pacer U.S. Small Cap Cash Cows 100 ETF is a weighted index, but not by company size. It is weighted in order of free cash flow, so the most profitable businesses get the biggest allocations. However, the fund’s methodology caps any holding at 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% might sound high for those who invest in index funds, but it is on-par with others that use unique strategies like this.

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

Why small caps and dividend stocks right now?

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

The valuation gap between large and small cap stocks hasn’t been this wide in 25 years, and last time it happened, small caps went on to outperform 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. Just to name 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 doesn’t guarantee future investment results, and it’s entirely possible that small caps will continue to underperform their larger counterparts. Having said that, with its cash-flow-heavy investment style, if the Pacer U.S. 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 could end up being a great ETF for patient investors.