On January 10, a groundbreaking development occurred in the investment landscape of China, as the initial batch of Exchange Traded Funds (ETFs) focused on free cash flow received official approval.

The financial market is always evolving, and ETFs have gained immense popularity in recent years due to their flexibility, cost efficiency, and ease of tradingThe approval of the first-ever free cash flow ETFs marks a significant milestone for investors seeking to diversify their investment strategiesBoth the Huaxia Fund and the Guotai fund have successfully launched their respective free cash flow ETFs, with the funds slated to be officially unveiled on December 16, 2024. These ETFs follow the National Securities Free Cash Flow Index and the FTSE China A-shares Free Cash Flow Focus Index, respectively.

From an insider's perspective, the approval of these ETFs signifies a broadening of index investment tools available to investors

While the free cash flow selection strategy might seem novel in China, it has long been established in overseas markets, where products and corresponding indices have already reached a considerable level of maturityFor instance, the Pacer US Cash Flows 100 ETF, known by its ticker COWZ, was launched in 2016 and has since amassed an impressive asset size of $26.8 billionThis ETF tracks the Pacer US Cash Flows 100 Index, which emphasizes the percentage of free cash flow as its core selection criterion.

Huaxia Fund articulated that free cash flow serves as the lifeblood for a company's survival and growthIt also plays an essential role in sustaining stable dividend distributions for public companiesFurthermore, cash flow is less susceptible to manipulation compared to net profit, thus providing a more accurate reflection of a company's operational quality

Over the last decade, companies listed on the A-share market demonstrating a solid free cash flow return have continuously seen their stock prices reach new heightsIn contrast, those with lower free cash flow returns and higher capital expenditures have experienced declining fortunes, particularly during the past three years marked by macroeconomic volatility, where portfolios focused on high free cash flow delivered significant outperformanceThese ETFs fulfill both the demand for asset allocation and the need for trading.

Industry experts poised optimistic views as the financial markets mature, emphasizing that investors now demand more professionalism, diversity, and effectiveness from their investment toolsThe introduction of the first free cash flow ETFs is an important step in expanding the range of index-based investment options for investors.

Unique Characteristics of Index Composition

Specifically, the National Securities Free Cash Flow Index, debuted in late 2012, underwent modifications slated for the second half of 2024. This reformation aims to expand the scope of stock selection while also excluding the financial and real estate sectors due to their cash flow characteristics deviating significantly from other industries

The criteria for index sample selection are rigorousSecurities are excluded if they rank in the lowest 20% based on average daily trading volume over the last six months, or if they belong to the financial or real estate classifications according to National Securities guidelinesStocks are further refined based on factors like return on equity (ROE) and free cash flow metrics before narrowing down to the top 100 candidates.

As of late November, the index's main sectors include Industry, Consumer Discretionary, Energy, and Materials, reflecting a balanced distribution of free cash flow across diverse economic segments.

On the other hand, the FTSE China A-shares Free Cash Flow Focus Index aims to signify stocks that possess ample free cash flow while simultaneously being undervalued in the marketThis index utilizes negative filtering based on liquidity, company quality, growth potential, and volatility to mitigate the risks associated with value traps

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Stocks are ranked based on a composite score derived from their free cash flow rates, dividend yields, and return on equity metrics, highlighting the top 50 stocks as its constituents.

Interestingly, unlike the National Securities Index, the Guotai Fund's focus does not omit financial and real estate stocks, resulting in an industry distribution that remains comparatively equitable, featuring sectors such as automotive, petrochemicals, coal, and non-ferrous metalsPast performance of this index indicates notable long-term gains with a substantial defensive characteristic, attracting the attention of discerning investors.

Growing Interest in "Free Cash Flow" Concepts

It is essential to note that the concept of "free cash flow" is currently capturing considerable attention in market discussions, leading to a surge in the development of related indices

The China Securities Index Company has announced plans to officially launch three indices by November 12, 2024, focusing on free cash flow metrics from the CSI 300, CSI 500, and CSI 1000 indices.

These newly issued free cash flow indices will incorporate stocks renowned for their elevated free cash flow ratios derived from the broader indicesWith a focus on empowering investors by showcasing firms with robust cash creation capacities, these indices intend to enhance investor awareness of financial health.

Industry commentators recognize the utility of free cash flow indices as evaluative tools that assist investors in identifying high-quality investment opportunitiesOn one hand, free cash flow denotes the cash available for distributions, debt payment, and reinvestment post capital expenditures; on the other hand, firms showcasing robust free cash flow tend to exhibit superior resilience against economic downturns, offering stable cash inflows essential for investors to gauge intrinsic value and mitigate risks more effectively.