Friday, September 25, 2015

New-to-Market SPYB

New-to-Market - This blog series highlights ETFs that have recently gone public and reflect those strategies currently most in demand by investors.  While ETFs are not eligible for ETFG Risk Ratings until traded for 3 months and ETFG Reward Ratings for 12 months, our goal is to highlight the most cutting-edge investment strategies that have recently embraced the ETF structure – we hope you enjoy this special series of posts.

For this edition of our “New-to-Market” series, we investigate the latest fund to offer exposure to share buybacks and the newest addition to State Street’s line-up of smart beta funds focused on shareholder yield, SPDR S&P 500 Buyback ETF (SPYB).  So join us while we learn more about the fund, it’s chief competitor and while from the outside the fund might just appear to be a “better mousetrap,” once you get under the hood, you discover it’s all together a different animal.

What makes SPYB’s quiet introduction so interesting is that the buyback sphere is dominated by the first fund to enter the space with the Powershares Buyback Achievers ETF (PKW) controlling the bulk of the assets.  It’s always hard to compete with an established fund.  Since its inception, SPYB and its larger rival have both underperformed the S&P 500, with SPYB down 8.4%, PKW down 6.66% to the market’s 5.8% loss. For most investment committees, that performance and a quick glance at a holdings report would seem to be all the information they’d need for a decision, but getting past the one sheet reveals two very different products.

Both funds are passively managed, so we begin by comparing their respective benchmarks which draw from very different universes. SPYB is built to track the performance of the S&P 500 Buyback Index, rebalanced (and reconstituted) quarterly, that tracks the 100 components of the S&P 500 with the highest buyback ratio for the trailing twelve months, measuring the amount of money spent on share repurchases in the prior four quarters divided by the total market capitalization at the start of the period.  There’s no specific target ratio or other portfolio constraint to consider, keeping it simple and focusing on the most liquid stocks helps keep the funds expense ratio to an attractive 35 bps.  PKW could be said to have the more elaborate strategy as the fund’s NASDAQ based-benchmark provides a much broader universe of stocks to choose from but unlike SPYB, which buys the 100 stocks with the highest buyback ratio, PKW uses a buyback threshold of 5% that potential investments must meet to be included in the portfolio while also holding a much larger number of positions, currently 208, which gives you two very different portfolios.

What truly sets these funds apart is their weighting systems where SPYB allocates to its 100 stocks using an equally weighted system that leads to the inclusion of smaller names (the smallest market cap included in the fund currently is just over $2.8 billion) and gives the fund more a mid-cap feel with an average market cap of $19 billion.  PKW uses the more familiar market cap weighting system that puts over 35% of the allocation into the top 10 holdings and brings the average market cap of the fund to more than $27 billion.  And yes, the two funds do share certain names but those different weighting systems lead to different portfolios.  A good example of how their different portfolio construction processes work is the current buyback king, Apple, which despite having one of the largest share buyback programs in the world was only included in PKW’s portfolio for the first time at the end of January after their record spending in 2014 helped push the stock above the 5% cutoff.  Under the rules governing SPYB’s portfolio, Apple would’ve been included after it first began its share repurchase program, but the fund’s equally weighted system would have given a much smaller 1% allocation to Apple compared to PKW’s 4.75%.  Considering Apple’s loss since the introduction of SPYB is 120 bps less than that of the broader market and that larger market cap weighting starts sounding more attractive.

While using an equally weighted system might sound like a minor evolution of PKW’s already successful strategy, the potential returns going forward between the two methodologies could be very different.  There’s been a pronounced trend of those S&P 500 components who didn’t buy back shares (Amazon, Netflix, Google) consistently outperforming those who did since March of 2014.  Turning again to the performance of PKW does offer some clues.  After strongly outperforming the S&P 500 from 2011 to the end of 2013 82% to the S&P 500 TR index’s 56.8%, the fund began to slightly lag the broader market in the first quarter of 2014 and since has delivered a more market like return from April 1st 2014 to yesterdays close of 6.1% to the S&P 500 TR’s 8.45%.  To confirm suspicions, a back test of different strategies bundling companies who repurchased shares into different quartiles depending on their buyback yield, discovered that the weighting system used was one of the key differences between whether the strategy delivered positive and consistent alpha.  When share repurchasers were weighted equally rather than by market cap, they tended to outperform both the broader market and those companies that have yet to repurchase shares on a consistent basis over an extended period of time compared to a traditional market cap weighted portfolio.

Now if you’ve stuck with us for this long, you’ve clearly recognized the merit of a buyback strategy and are wondering where SPYB might fit within your broader portfolio strategy and while the idea of replacing your core SPY position with a relatively new fund might cause you to go pale, the fund does have a number of attributes that could make it a valuable supporting player in any portfolio.  Consider that the funds benchmark was built using a large and diversified equity index like the S&P 500 while retaining a relatively larger number of stocks in its portfolio and the equal weighting system that keeps individual positions from becoming too concentrated although the fund doesn’t have a system in place to keep sector weights in-line with the S&P.  As we mentioned before, what it does have is a quarterly rebalancing system that helps the fund stay on-top of changes in buyback plans while preventing individual positions from drifting too far from where they started, an all for 35 bps compared to the 64 bps charged by PKW. Considering the dearth of new investment opportunities for some of America’s largest corporations, 35 bps might prove be a small price to pay for a diversified portfolio of disciplined companies devoted to returning capital to their shareholders.

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