Should You Buy Into This Buyback ETF?

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

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,

Investors looking for more direct exposure to quality stocks might consider Silver-rated

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