3 ETFs That Make the Most of Buybacks

If used correctly, stock buybacks are a tax-efficient way to return cash to shareholders: a virtual dividend without the double taxation aspects that go along with a cash dividend. And in this era of 3.8% Obamacare “surtaxes” on investment income, a tax-free virtual dividend is all the more attractive.

smart moneyAlas, share buybacks are rarely used correctly. Companies are not always the best market timers, having a tendency to buy their shares when prices are high and, in the worst cases, sell them when prices are low by issuing new stock.

For example, share repurchase in the United States hit a record in 2007 but then fell by more than 80% by 2009 — when stocks were trading at generational lows, and when management should have been buying with both fists.

Worse, large share buyback programs are often little more than cover for shareholder-diluting executive stock options and employee stock purchase plans. In the worst cases, it is outright thievery. The company will buy back its shares at market value and then effectively resell them to employees at a discount.

How bad is it? As I wrote last year, the 500 largest U.S. companies repurchased about a quarter of their equity’s dollar value from 1998 to 2012, but the number of shares outstanding actually grew more than 7% over that same period.

Still, share buybacks can be an excellent source of shareholder value if bought at reasonable prices and if they truly reduce share count. Today, we’re going to take a look at competing “buyback” ETFs that focus on shareholder friendliness. While none can completely escape the issue of market timing, they can certainly address the most critical aspect: ensuring that share buybacks do indeed return capital to shareholders by reducing share count.

Buybacks: PowerShares Buyback Achievers ETF (PKW)

qqq etfI’ll start with the oldest buyback-focused ETF, the PowerShares Buyback Achievers ETF (PKW).

PKW tracks the NASDAQ U.S. Buyback Achievers Index, and its methodology is strict. In order to make the cut, a company must have effected a net reduction in shares of 5% or more in the trailing 12 months. The ETF and its index are reconstituted annually in January and rebalanced quarterly in January, April, July and October. Also, to be considered, a stock must trade on the NYSE or NASDAQ and have average daily cash trading volume of $500,000.

That 5% is a pretty impressive hurdle. But there is one aspect I don’t particularly like: PKW focuses only on the preceding year and makes no consideration for companies that consistently buy back their shares over time.

I’m also somewhat ambivalent about its weighting methodology. The ETF is market-cap weighted (like the S&P 500), though the maximum weight of any single holding is capped at 5%. While not a “bad” weighting strategy, per se, I might have preferred to see the companies weighted by the size of their buyback rather than by market cap. After all, the entire purpose of the ETF is to get exposure to companies aggressively buying back their own shares.

Still, all things considered, PKW is a solid investment option that has soundly beaten the S&P 500 since its creation in 2006. Its underlying index trounced the S&P 500 with annualized returns of 9.8% vs. 6.1%. Even after allowing for taxes, the ETF returned 7.2% annualized. Not bad at all. Expenses for PKW run 0.71%, or $71 for every $10,000 invested.

Buybacks: AdvisorShares TrimTabs Float Shrink ETF (TTFS)

AdvisorShares185Next up is the AdvisorShares TrimTabs Float Shrink ETF (TTFS), a relatively new entrant that began trading in late 2011.

The TrimTabs ETF is based on the same principle as the PKW — that reducing share count is ultimately good for shareholders — but the ETFs’ methodologies are very different.

TrimTabs uses the Russell 3000 index as its starting point, and equally weights a portfolio of 100 stocks that meet its criteria:

  1. Outstanding shares must have decreased over the past 120 days.
  2. Buybacks should be financed via strong free cash flows, not debt issuance.

The second point is a key differentiator for quality and prevents the index from being bogged down with companies that are simply swapping equity for debt.

Also, unlike the PKW, which is rebalanced and reconstituted mechanically, the TrimTabs ETF is actively managed, rebalancing as new information becomes available rather than by a set calendar schedule. Whether this is good or bad depends on your faith in active managers.

One aspect in which TTFS and PKW are similar is that they place, in my view, undue significance on buybacks in the immediate past rather than considering a long track record of shareholder friendliness. Expenses for TTFS run 0.99%, making it more expensive than other ETFs focused on buybacks.

Buybacks: Cambria Shareholder Yield ETF (SYLD)

Cambria Funds 185Finally, we come to the most recent addition, the Cambria Shareholder Yield ETF (SYLD).

SYLD invests in 100 stocks with market caps greater than $200 million that rank among the highest in shareholder yield, which is calculated as a combination of cash dividends, share repurchases, and paying down debt.

The Cambria option is an interesting hybrid ETF. Share buybacks are one of only three criteria it considers when ranking stocks for shareholder friendliness. It has the most open mandate of the lot, as it has the ability to invest in foreign securities as well as American. SYLD, like TTFS, also blurs the lines between active and passive management.

In both cases, stock selection is mostly formulaic, though the manager maintains a good deal of discretion. In the case of SYLD, the manager chooses what he considers to be the top 100 stocks based on shareholder yield, as well as the portfolio weights. In order to avoid “value traps,” or cheap stocks that continue to get cheaper, the manager will generally wait until a potential stock is in an uptrend before buying.

Expenses for SYLD run 0.59%, making it the cheapest of the ETFs on our list.

Buybacks: Conclusion

Buyback ETFs
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So, which ETF is the “best” option for shareholder friendliness? Truth be told, are all solid options. Both PKW and TTFS have handedly beaten the S&P 500 over their respective lives (see chart), and SYLD has beaten the S&P 500 as well, though its trading history only goes back to May of last year. Though past performance is, of course, no guarantee of future returns, I consider it reasonable that all will continue to outperform over time.

Interestingly, SYLD has the lowest expense ratio of the three — 0.59% vs. 0.99% for TTFS and 0.71% for PKW, respectively — despite the fact that SYLD is the most actively managed of the lot. SYLD doesn’t have a long enough trading history for portfolio turnover, but management estimates that portfolio turnover will be “about 50%” per year. This is about in line with TTFS and considerably lower than PKW. Lower fees and portfolio turnover are certainly points in SYLD’s favor.

TTFS has a smaller average cap weighting than SYLD or PKW; Morningstar classifies TTFS as a “mid-cap” ETF rather than large-cap. This is a selling point if you’re specifically looking to avoid a large-cap bias. But given the relatively high turnover of all three ETFs, that may not always be true. (All else equal, PKW should have the largest average market cap due to its market-cap weighting.)

My personal preference would be to utilize SYLD for its broader shareholder methodology rather than TTFS and PKW’s more limited focus on share repurchases. But investors could also choose to invest in separate dividend-focused ETFs, such as the Vanguard Dividend Appreciation ETF (VIG), to complement their investments in TTFS and PKW.

Finally, I’m going to offer one piece of advice that managers would probably prefer I leave out. If you prefer to buy individual stocks rather than ETFs or funds, you can piggyback on the research of all three funds by going to their websites and viewing their complete portfolio holdings.

Something I have done in the past is compare the holdings of my favorite ETFs for overlap. If a stock is held by two or more of these ETFs — and perhaps by VIG as well — that might be a stock you single out for further research.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long SYLD and VIG. Check out his new premium service, Macro Trend Investor, which includes a free copy of his e-book, The New Megatrend Investor: The Ultimate Buy-and-Hold Strategy That Will Make You Rich.

Article printed from InvestorPlace Media, https://investorplace.com/2014/03/stock-buybacks-buyback-etfs/.

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