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The Buyback ETF

This distinctive strategy has a strong record, but its high turnover, fee, and myopic selection criterion detract from its appeal.

Alex Bryan, 01/27/2017

PowerShares Buyback Achievers ETF PKW has built a strong record by selecting stocks based on short-term repurchasing activity. But share repurchases in one year may not carry forward to the next, so this approach can lead to high turnover and is not necessarily indicative of future repurchasing activity. Nor does it provide a holistic view of a firm's distributions to shareholders. The portfolio still ends up with a bias toward highly profitable and smaller firms, which has helped performance, but there are cheaper and more direct ways to get this exposure. Therefore, the fund earns a Morningstar Analyst Rating of Neutral.

The fund targets U.S. stocks that have reduced their shares outstanding by at least 5% in the previous year through share repurchases. It then weights these holdings by market capitalization, subject to a 5% cap. Firms that make the cut, such as Boeing BAExpress Scripts ESRX, and Lowe's LOW, tend to have strong profitability and shareholder-friendly management teams. Like dividends, a disciplined share-repurchase program can constrain managers from making low-return investments. However, share repurchases are less binding than dividend payments, so they may be less effective in constraining managers. Share repurchases can also hurt returns if managers overpay for their shares.

At times the fund can make large sector bets. It currently has greater exposure to the consumer cyclical and industrials sectors than the Russell 1000 Index and less exposure to consumer defensive, healthcare, and telecom. This tilt toward cyclical sectors could hurt performance during a market downturn. However, so far the fund's downside performance and volatility have been similar to the Russell 1000 Index.

This strategy has worked well over the long term. The fund outpaced the Russell 1000 Index by 1.3 percentage points annualized from its inception in December 2006 through December 2016, ranking in the top 5% of the large-blend Morningstar Category. More-favorable stock exposure in the financial-services industry, coupled with the fund's underweighting in this sector and overweighting in the consumer cyclical sector, contributed to its outperformance.

Fundamental View
The mechanics of a share repurchase should have no impact on the value of the stock, if it is fairly valued when it is repurchased. Even though this transaction increases earnings per share, its impact on the value of the stock is offset by the reduction in cash or increase in debt the company used to finance the buyback. However, if managers buy their shares below fair value, they effectively transfer wealth from the sellers to the remaining shareholders.

Managers may have better information about what their stock is worth than the investing public. They can use this information for their long-term shareholders' benefit by repurchasing their stock when it is trading below fair value. The market may perceive the initiation or increase of a share-repurchase program as a signal that managers believe their stock is undervalued, which can push its price up.

While increasing share repurchases when a stock is undervalued is sound justification for repurchasing stock, buybacks were procyclical during much of the past decade, according to data published by Factset. Companies tend to institute buyback programs when they are flush with cash, not necessarily in the depths of a bear market when their share prices are most depressed. Consequently, a company's decision to institute a repurchase program does not necessarily mean that its stock is undervalued.

A more cynical view suggests companies use share-repurchase programs to manage earnings per share to meet analyst expectations. But it is more likely that most managers use repurchases to return excess cash to shareholders when they do not have more-attractive investment opportunities.

While dividends are still an important cash distribution channel, share repurchases are more tax-efficient. When a dividend is paid out, all taxable shareholders get hit with the dividend tax. In a share-repurchase program, only those investors who sell their shares face a tax liability. This option to defer taxes makes share repurchases more tax-efficient, even when the capital gains and dividend tax rates are the same.

However, because they are less binding, share repurchases send a weaker signal to the market about management's confidence in its business prospects than traditional dividend increases. There is a negative stigma associated with cutting a dividend payment. Consequently, managers don't usually commit to them unless they are confident they will be able to honor them throughout the business cycle. In contrast, failing to fully execute an announced share buyback program is more common and is usually not interpreted as a sign of trouble. This flexibility makes share repurchases an ideal way to distribute residual cash flows that may fluctuate over time.

While the fund's market-cap-weighting approach gives larger stocks greater influence in the portfolio, it often has a smaller-cap orientation than most of its peers. But it doesn't sacrifice profitability. Its holdings tend to generate higher average returns on invested capital than the constituents of the Russell 1000 Index.

Portfolio Construction
This strategy's focus on share buybacks indirectly leads it to profitable stocks with shareholder-friendly management teams. But it uses a short period to measure share repurchases, which may not be indicative of future repurchases, often creating high turnover. Therefore, it earns a Neutral Process Pillar rating.

The fund tracks the Nasdaq U.S. Buyback Achievers Index, which includes U.S. stocks that have reduced their shares outstanding by 5% or more during the trailing 12 months through December. The index is reconstituted annually in January and rebalanced quarterly. Repurchasing activity can be lumpy because firms often use share-repurchase programs to distribute residual cash and are not obligated to fully execute these programs. This can create high turnover, which reached 68% in the most recent fiscal year. Mirroring its index, the fund weights its holdings by market capitalization but imposes a 5% cap to improve diversification. The fund climbs much further down the market-cap ladder than most of its large-blend peers. Its average market capitalization is less than half that of the Russell 1000 Index.

Fees
It is difficult to justify the fund's 0.63% fee. This fee is not much lower than many actively managed alternatives. The fund has significantly lower operating costs than actively managed strategies because it simply tracks a benchmark and should therefore charge a much lower fee. But because this price is still fair relative to the entire large-blend category, the fund earns a Neutral Price Pillar rating. During the trailing 12 months through December 2016, the fund lagged its benchmark by 69 basis points, slightly more than the amount of its expense ratio. The additional drag likely comes from transaction costs.

Alternatives
Funds that track companies with shareholder-friendly payout policies, such as a consistent record of dividend growth, may be good alternatives. Within this category, Vanguard Dividend Appreciation ETF VIG (0.09% expense ratio) is one of the best. It carries a Gold rating and targets companies that have increased their dividends in each of the past 10 years. Cambria Shareholder Yield ETF SYLD (0.59% expense ratio) measures investor cash flows more holistically. It includes dividend payments, net share repurchases, and net debt reduction in its selection criteria. This fund invests in and equally weights the 100 top-scoring stocks, resulting in a mid-cap value tilt.

Investors looking for more direct exposure to quality stocks might consider Silver-rated iShares Edge MSCI USA Quality Factor QUAL (0.15% expense ratio). It screens for companies with high returns on equity, earnings stability, and low debt/capital ratios. This fund anchors its sector weightings to the broad market-cap-weighted MSCI USA Index to mitigate unintended sector bets. Schwab US Dividend Equity ETF SCHD (0.07% expense ratio) may be a more appropriate quality option for value-oriented investors. It targets stocks with high dividend yields, ROE, cash flow/total debt, and dividend growth.

PowerShares International BuyBack Achievers ETF IPKW (0.55% expense ratio) applies very similar portfolio construction rules to PKW in foreign markets. While this fund charges slightly less than its U.S. counterpart, its expense ratio is still a bit rich.

 

  

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

 

Alex Bryan is an ETF analyst with Morningstar.

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