Should You Buy a Buyback ETF?

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Dividends aren’t the only way companies reward their shareholders.

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Share buybacks are lately the go-to method for many firms to return cash to their investors. In fact, more than 95% of all the companies in the S&P 500 will purchase shares of their own stock in 2014. They’re spending a whopping $450 billion to do so. That’s 50% more dollars than all the new money that flowed into mutual funds throughout the year.

According to some analysts, that massive spending on share repurchases has helped the stock market reach new highs in recent years.

Given all the focus on buybacks, Wall Street is happy to capitalize on the opportunity. Exchange-traded fund (ETF) sponsor State Street Corp (STT) has announced plans to unveil an ETF that will focus on share buybacks. It joins the PowerShares Buyback Achievers ETF (PKW) and TrimTabs Float Shrink ETF (TTFS) in the space.

The question for investors is whether or not the buyback craze is really all it’s cracked-up to be.

Buybacks in Focus

The basic idea behind share buybacks is simple. Either in the open market or through a tender offer, a company will purchase its own shares in order to reduce the firm’s total share count. The lower amount of shares outstanding has a few positive effects. First, the hope is that share prices will rise as there is now less supply meeting investor demand. If there was 100 of something and now there is only 50, generally prices for those remaining assets will rise.

Secondly, the shares are worth more after the buyback as metrics like earnings-per-share, dividends-per-share, etc. are spread among fewer shares. For example, during the third quarter of 2014, stock buybacks managed to boost earnings of stocks in the S&P 500 by 2.35%. That extra dose of earnings growth makes the remaining shares more desirable.

The strategy of using buybacks to reward shareholders works. According to investment bank Barclays, since 2008, firms with the largest stock buyback programs by dollar value have outperformed the broader market by more than 20%.

Unfortunately, this doesn’t always work.

Buyback Risks

In fact, the returns of both buyback funds, PKW and TTFS, have trailed the S&P 500 this year.

The problem is that most firms will initiate their buyback programs during periods of jubilation — often when their earnings and cash flows are booming. Growing earnings and cash flows generally mean high stock prices. Thus, most firm’s buyback stock at just the wrong times and actually waste cash on high stock prices.

Compounding the problem is that most companies will buy back stock and then turn around and issue new stock to executives as options in their compensation plans. That defeats the logic of buying back stock in the first place and takes away cash available for reinvestment, dividends and debt reduction.

Finally, one of the reasons that buybacks have worked well over the last few years is that activity has been high. However, the pace at which firms buy back their own shares has slowed throughout 2014, decreasing with each quarter. That $450 billion number quoted at the top is still $25 billion less than what companies purchased in all of 2013. In order to get the real “boosting” effect, S&P Dow Jones Indices notes that firms will have to significantly increase their buyback programs from their pace in recent years.

Buying a Buyback ETF

The new State Street ETF will track the performance of the S&P 500 Buyback Index. That measure looks at the 100 stocks in the S&P 500 with the highest buyback ratio over the last 12 months. It’s equally weighted and rebalanced every quarter. Tech stocks make up the bulk of the proposed ETFs holdings, followed by consumer names. The SEC filing did not include any information on ticker symbol or expenses.

So should you bite on this ETF or any other buyback ETFs for that matter?

Given that buybacks torrid run could be coming to an end in the near term, State Streets’ new ETF may fail to catch on like wildfire. The other two ETFs in the sector may have their fires put out in the short run.

Near-term, I think it’s hit or miss for buybacks. But you could make a case for owning it or either PKW or TTFS for longer term diversification.

Working in concert with a dividend-focused ETF, the buyback ETFs could provide a potentially powerful total return element in your portfolio. Sometimes dividends will be the clear winner, other times buybacks will be the best way for companies to return cash to shareholders. Buy owning both, you guarantee yourself nice total return over the longer haul.

All in all, buybacks can be great when they work properly. When done right, companies buying back stock can be terrific performers. And adding one of the buyback ETFs to the income portion of your portfolio could provide some meaningful gains over the long haul.

Aaron Levitt is an investment journalist living in Ohio. With nearly two decades of experience, his work appears in several high-profile publications in both print and on the web. Also likes a good Reuben sandwich. Follow his picks and pans on Twitter at @AaronLevitt.


Article printed from InvestorPlace Media, https://investorplace.com/2014/12/pkw-ttfs-stt-state-street-buyback-etf/.

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