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How the Buyback ETF Continues to Beat SPY

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Dividend ETFs have been one of the hot spots in the ETF world, as yield-starved investors continue to favor ETFs that provide not only steady source of income but also potential for capital appreciation.

As of now, there are more than 50 dividend ETFs available to investors. These ETFs vary in focus and investors can choose the funds that suit their risk-return preferences. (Read: 4 Excellent Dividend ETFs for Income and Stability)

However, investors have largely overlooked that companies also return cash to investors by way of share buybacks. Investors should look past dividends to benefit from this trend that seems to be gaining steam of late.

US companies are buying back their shares at a record pace this year.  February was a record month for share buyback authorizations--$117.8 billion, up from $68 billion a year ago and the highest since 1985. 

Many US companies currently have record high cash balances and record low debt. And, there is a shortage of attractive targets for acquisition. As such the buyback surge may continue this year.

According to Moody’s, US non-financial companies held $1.45 trillion in cash as of year-end 2012, up 10% from $1.32 trillion as of the end of 2011.

And, according to WSJ analysis, US banks could return more than $30 billion to their shareholders over the next 12 months—most of which will be in the form of buy backs amounting to approximately $26.4 billion, based on announcements by 14 banks.

Some companies are using ultra-low interest rates to issue cheap debt and use the money to buy back shares and save on dividend costs. Among the companies that have issued debt in recent past and used/plan to use the proceeds to buy back shares are AT&T, Intel and Home Depot.

Repurchase of shares is generally a positive signal about the health of company and its confidence in the value of its shares. However, at times it could also mean that the company lacks other productive avenues to deploy its cash.

Also, at times the repurchases are accompanies by issuance of new shares to their top executives. (Read: Boost Income and Growth with MLP ETFs)

Many investors prefer dividends to buybacks as they are simpler to understand and put money in the pocket. However, buybacks have their own advantages—they reduce the outstanding share count and thus increase earnings per share. Further, they are more tax efficient.

Research by Ford Equity Research, (creator of NASDAQ buyback index methodology), shows that companies that reduced their shares by at least 5% between 1975 and 2003, outperformed S&P 500 index in 24 out of 28 years.

The research further shows that between 2006 and 2011, companies buying back shares produced excess returns with lower volatility.  (Read: Buy these ETFs for higher returns and lower risk)

Investors have a choice of a couple ETFs that focus on this niche strategy.

PowerShares Buyback Achievers Portfolio (PKW - Free Report)

PKW tracks the NASDAQ US Buyback Achievers Index, which is comprised of companies that have repurchased 5% or more of their common stock in the trailing 12 months. The index is modified market capitalization weighted and is rebalanced each quarter such that the maximum weight of any index security does not exceed 5%.

The ETF has been outperforming the broader markets over the last five years—it has returned 60.26% versus 26.54% for the S&P 500 ETF (SPY - Free Report) . The product continues to shine this year too, with 14.43% return compared with 9.69% for SPY.

Top five holdings are Amgen (5.7%), News Corp (4.8%), and ConocoPhillips (4.5%). In terms of sector exposure, Consumer Discretionary sector (36%) accounts for a major part of the holdings, with Financials (19%) and IT (15%) rounding out the top three

The fund charges an expense ratio of 71 basis points currently.

TrimTabs Float Shrink ETF (TTFS - Free Report)

TTFS is the actively managed product within the space. It is based on Trim Tabs research on stock prices being a function of supply and demand rather than value.

According to ETF’s fact sheet, the portfolio manager screens approximately 3,000 stocks on a daily basis and invests equally in 100 highest ranked stocks that have, in addition to shrinking their float, increased their free cash flow and not increased their leverage ratio.

From a sector perspective, IT takes the top spot at 28%, followed by Consumer Discretionary (19%) and Healthcare (16%).

The fund has returned 13.48% year-to-date.  However, the cost of the fund is somewhat high at 0.99% a year while volume is also quite low, meaning that investors are likely to see a wide bid ask spread.

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