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The Fundamental Difference: Through A Lens Of Net Buybacks

By Jeremy Schwartz At WisdomTree, we believe that screening and weighting equity markets based on fundamentals such as dividends or earnings can potentially help produce higher total and risk-adjusted returns over a complete market cycle. One of the most important elements of a fundamental index is the annual rebalance process, where the index screens the eligible universe and then weights those securities based on their fundamentals. In essence, the process takes a detailed look at the relationship between the underlying fundamentals and price performance and tilts weight to lower-priced segments of the market. One way to illustrate the benefits of this approach for our earnings-weighted family is to compare the net buyback yield of the WisdomTree Earnings Index to a market cap-weighted peer universe. Below we look at how the net buyback yield changes when you screen and weight U.S. equity markets by firms’ profitability instead of market cap. Earnings Weighting vs. Market Cap Weighting Click to enlarge The WisdomTree Earnings Index consistently had a higher net buyback ratio than did a market cap-weighted universe consisting of the 3,000 largest securities by market cap. The WisdomTree Earnings Index averaged a net buyback yield of 2.2% over the period, compared to just 1.1% for the market cap peer universe. We believe that having an annual profitability screen for inclusion in the WisdomTree Earnings Index helps avoid speculative and unprofitable smaller-capitalization firms that have a tendency to raise capital by periodically issuing new shares. The earnings-weighted approach that tilts weight to more profitable firms can also be a reason the weighted average net buyback yield is higher. The chart below looks at the net buyback yield on a universe of the lowest price-to-earnings (P/E) ratio stocks within the 3,000 largest stocks by market cap and contrasts that with the net buyback yield on the highest P/E ratio stocks. Net Buyback Yield by P/E Ratio Click to enlarge If corporate America responds well to incentives, the higher-priced basket would issue more shares (given that their stocks are high priced and issuing more of them would be an effective way to raise growth capital) and the lower-priced basket would issue fewer shares or actually buy back shares to reduce their shares outstanding and thus power their earnings-per-share growth. What we see in the data is the higher-priced universe buys back fewer share, and instead issues more shares (having more companies with negative net buyback yields). Why Earnings Weight Going back to the WisdomTree Earnings Index in the first chart-weighting by Earnings Stream is essentially tilting weight from a market cap-weighted scheme to over-weight those companies with below average P/E ratios and to under-weight those companies with high P/E ratios. The Earnings Stream can be defined as earnings per share times shares outstanding or market cap x earnings yield (which is equivalent to 1/PE ratio). Tilting weight to the higher-earnings-yield stocks by earnings weighting thus is one effective way to tilt the net buyback yield balance in one’s favor. Companies reducing shares outstanding are essentially locking in earnings-per-share growth by reducing their share count, while companies that are issuing more shares are creating a higher hurdle to overcome to achieve earnings-per-share growth. There is a philosophical debate about the motivations for all the buybacks we are seeing today as well as fears that companies are failing to reinvest for future growth (or that they just see no growth opportunities, hence all the dividends and buybacks). One thing is clear to us from the data: the lower-priced stocks issue fewer shares, and the more expensive stocks issue more shares (and have lower net buyback yields). This can be especially true in the small-cap space, as we will discuss in a future blog post. The consistently greater-than 2% net buyback yields seen on the WisdomTree Earnings Index over the last five years, combined with 2% dividend yields on this basket today, provides critical valuation support and also helps explain why we think the earnings-weighted approach can add value over time. Jeremy Schwartz, Director of Research As WisdomTree’s Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel’s head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper “What Happened to the Original Stocks in the S&P 500?” and the Wall Street Journal article “The Great American Bond Bubble.”

Many MLP CEF Investors Are Using The Wrong Benchmark – Are You?

By James Wang Click to enlarge Today there are 95 publicly-traded energy MLP-access products on the market; a figure that nearly matches the number of MLPs [1] themselves. While having options is generally a good thing, having too many options brings up the paradox of choice [2]. So how do you objectively choose the best fund? Well, as an indexing company, we’d tell you to compare it to a benchmark. You may ask, “but isn’t the Alerian MLP Index (AMZ) already the gold standard for MLP benchmarks?” and you’d be right. (Clearly, we’re biased.) However, with the abundance of MLP investment funds, comes a variety of different product structures and nuances. We’ve launched the Alerian MLP Closed End Fund Index (AMCI) to address a particular subset of those products: closed-end funds (CEFs) which elect to be taxed as C Corporations for federal tax purposes. So what are closed-end funds and what makes them special? Well, to start with, CEFs were the first type of pooled investment products to enter into the MLP space, with Tortoise Capital Advisors launching the Tortoise Energy Infrastructure Corp (NYSE: TYG ) in 2004. Today CEFs make up about 20% [3] of all MLP investment products by AUM. As partnerships, MLPs have certain tax complexities that reduce their efficiencies in pass-through investment products. While traditional mutual funds, CEFs, and ETFs may pass on all gains/losses to their investors, funds whose holdings comprise more than 25% in MLPs must elect to be taxed as a C Corporation [4] for federal income purposes. This means that there’s an extra layer of corporate taxation that shaves off approximately 35% [5] of all gains before it even reaches the investor. Yeah, it kind of stinks, but unfortunately those are the rules, and it’s the only way to construct a pure-play MLP fund. C Corp CEFs, however, have the ability to mitigate some of that tax drag through the use of leverage. Furthermore, since the funds are “closed” in construction, unlike open-end funds (ETFs, Mutual Funds), the capital they have is permanent, allowing them to hold less-liquid investments. A potential downside (or upside, if you time it right) to the structure is that these funds may trade at a significant discount or premium to their net asset value. To make things even more complicated, there are a number of CEFs with the words MLP in their title, but they merely hold 25% of their fund in MLPs (to get around the C Corp rules). Those types of funds are referred to as “RIC-Compliant funds” and may have significantly different investment characteristics. For the purpose of the AMCI, RIC-Compliant funds are excluded, as it would not allow for an apples-to-apples comparison. Click to enlarge The Alerian Closed End Fund Index’s construction is relatively straight-forward. Today, there are 21 MLP C Corp CEFs on the market, with AUMs ranging from $19 million to nearly $2 billion. All of these funds are included and equal-weighted within the AMCI. Historical data was generated by backtesting the index back to 2004, when the first MLP C Corp CEFs were launched. Click to enlarge Examining the total return performance of the AMCI in the chart above, you’ll notice that it lags significantly behind the AMZ. This is expected and really showcases the effect of the C Corp tax drag. Even though CEFs use leverage [6] to offset some of this drag, that leverage is only helpful on the way up. On the way down, leverage exacerbates losses. Although in the past three months, the AMCI has outperformed the AMZ, over periods of a year or longer, it has significantly underperformed. When looking at the yield of the AMCI, you’ll see that it’s also significantly higher than the AMZ. While some CEFs may focus their investments on higher-yielding MLPs, it’s not necessarily a universal trend, with leverage playing a larger role in boosting yields. One important note is that since this index is equal-weighted, small funds have an outsized influence on index performance while larger funds may be under-represented when compared to an AUM- weighted index. Unfortunately, the smallest funds are also the worst-performing in the index. When looking at the price return of the AMCI as of 3/31/16, the following data points stand out. 12 of 21 funds have outperformed the AMCI on a trailing one-year basis 11 of 13 funds have outperformed the AMCI on a trailing three-year basis 7 of 8 funds have outperformed the AMCI on a trailing five-year basis 4 of 4 funds have outperformed the AMCI on a trailing 10-year basis How is it possible that the majority of index constituents outperformed the index for the 3-, 5-, and 10-year history? Unfortunately, two funds [7] dragged the entire index down by hundreds of basis points [8]. Although it’s unfortunate that these funds had such a negative impact on index performance, it also showcases that there can be large disparity between the best- and worst-performing active managers. In the end, Alerian exists to equip investors to make informed decisions about their MLP investments. There are multitudes of MLP-related funds in the marketplace today and the most important thing is to know what you own. If you’ve already made the decision to go with an active manager and are comfortable with the pros and cons of C Corp CEFs, we hope that the AMCI better equips you to make an informed decision with your investments. 2016.05.19 2:30PM CST – Edited to correct phrasing in paragraph 4 and footnote 4. Footnotes [1] There are 118 energy MLPs as of the end of April. [2] As psychologist Barry Schwartz has said “Autonomy and freedom of choice are critical to our well-being, and choice is critical to freedom and autonomy. Nonetheless, though modern Americans have more choice than any group of people ever has before, and thus, presumably, more freedom and autonomy, we don’t seem to be benefiting from it psychologically.” [3] Over $9B in aggregate AUM as of February 29, 2016 [4] This is due to the American Jobs Creation Act of 2004. Previously, MLPs could not be held at all in such funds without making a corporate tax election. [5] The federal corporate tax rate is 35%, but state taxes could push the fund tax rate higher. [6] The amount of potential leverage can be found in each fund’s offering documents, but typically a fund’s maximum debt leverage is 33% while its equity leverage is 50%, as governed by the Investment Company Act of 1940. [7] The Cushing MLP Total Return Fund (NYSE: SRV ) fell over 87% from its inclusion on December 21, 2007 to March 31, 2016 while the Cushing Energy Income Fund (NYSE: SRF ) fell over 93% from its inclusion in the index from June 15, 2012 to March 31, 2016. [8] Theoretically, if we were going to cherry-pick this index and remove SRV and SRF, the annualized 10-year total return performance would have jumped 220 basis points from +1.7% to +3.9%. The 5-year annualized performance shows similar results, jumping nearly 370 bps from -7.8% to -4.1%. Disclosure: © Alerian 2016. All rights reserved. This material is reproduced with the prior consent of Alerian. It is provided as general information only and should not be taken as investment advice. Employees of Alerian are prohibited from owning individual MLPs. For more information on Alerian and to see our full disclaimer, visit http://www.alerian.com/disclaimers. James Wang is the Director of Data Analytics at Alerian, which equips investors to make informed decisions about Master Limited Partnerships (MLPs) and energy infrastructure. Mr. Wang conducts quantitative and statistical analyses in order to bring to light historical and emerging trends in the asset class. He also oversees the firm’s efforts to efficiently integrate and utilize technology in its brand management activities. Prior to Alerian, Mr. Wang was an Associate in the Equity Research Division of Raymond James & Associates Inc, where he constructed financial models for energy infrastructure MLPs and published comprehensive research reports to discuss his findings. Mr. Wang graduated with a Bachelor of Science in Biomedical Engineering and a minor in Management from the Johns Hopkins University Whiting School of Engineering.

ETF Update: Social Media Sentiment And Millennials Get Their Own Funds

Welcome back to the SA ETF Update. My goal is to keep Seeking Alpha readers up to date on the ETF universe and to gain some visibility, both for the ETF community and for me as its editor (so users know who to approach with issues, article ideas, to become a contributor, etc.). Every weekend, or every other weekend (depending on the reader response and submission volumes), we will highlight fund launches and closures for the week, as well as any news items that could impact ETF investors. There was a lot to cover from the last three weeks, so let’s dive right in. Fund launches for the week of April 18th, 2016 Guggenheim launches an ETF focused on low correlation (4/19): The Guggenheim Large Cap Optimized Diversification ETF (NYSEARCA: OPD ) is a smart beta fund designed to provide optimized diversification to the U.S. large-cap equity market. By investing in a portfolio of 100 to 120 holdings that have a lower correlation to a large-cap index the ETF hopes to deliver higher returns than a standard large-cap index. As described by William Belden, Guggenheim Managing Director and Head of ETF Business Development, in a press release, “combining differentiated return streams from lowly correlated stocks may provide the potential for attractive risk-adjusted returns.” Global X invests in Catholic values (4/19): The Global X S&P 500 Catholic Values ETF (NASDAQ: CATH ) offers investors a way to be sure their investments are considered acceptable under social responsibility standards, as designated by the United States Conference of Catholic Bishops. For further analysis on CATH, please read Religion Meets Investing In This New ETF , by Dave Dierking, and ETF Investing According To Your Religious Beliefs , by David Fabian. Sprott launches an ETF that watches social media for holdings (4/19): The Sprott BUZZ Social Media Insights ETF (NYSEARCA: BUZ ) tracks an index of U.S. stocks which rank highest in terms of bullish investor perception from insights derived from the social media collective. The “social media collective” being Twitter, Facebook, LinkedIn, YouTube, Flickr, Reddit, etc. “This ETF brings together the powerful combination of social media and big data analytics. Not only does the Index measure investor sentiment, it also identifies and ranks social media members who have historically been the most successful in their forecasting accuracy,” stated John Ciampaglia, Head of ETFs at Sprott, in a press release . For further analysis on BUZ, please read A New Social ETF With Seeking Alpha Data Used For Index Selections , by Brad Kenagy. Deutsche Asset Management expands its Comprehensive Factor ETF line up (4/19): The Deutsche X-trackers FTSE Emerging Comprehensive Factor ETF (NYSEARCA: DEMG ) targets five factors for investing in emerging market equities: value, momentum, size, volatility and quality. This is following the path laid down by the Deutsche X-trackers Russell 1000 Comprehensive Factor ETF (NYSE: DEUS ) and the Deutsche X-trackers FTSE Developed ex US Comprehensive Factor ETF (NYSE: DEEF ), which were both launched in 2014 and 2015 respectively. Amplify ETFs launches its first ETF (4/20): The newcomer is starting on a recent hot topic, online shopping. The Amplify Online Retail ETF (NASDAQ: IBUY ) targets an index of companies that generate at least 70% of their revenues from transactions in the online retail, online travel or online marketplace spaces. While the fund does cover international companies, 75% of the holdings will be weighted to domestic firms. For further analysis on IBUY, please read Amazon Is Not The Only Name In Online Retail , by Jane Edmondson. iShares launches an ETF for investing in positive global impact (4/22): The iShares Sustainable MSCI Global Impact ETF (NASDAQ: MPCT ) tracks an index of public companies whose products and services aim to address major social and environmental challenges. As stated by Jane Haines, Managing Director and Head of Equity Index Products for the Americas for MSCI, in a press release , “based on MSCI ESG Sustainable Impact Metrics , a new framework aligned with the Sustainable Development Goals (SDGS) adopted by the United Nations, the index weights securities by companies’ revenue exposure to sustainable impact themes and excludes companies that fail to meet minimum ESG standards.” Fund launches for the week of April 25th, 2016 Fund launches for the week of May 2nd, 2016 REX Shares launches 2 new VIX ETFs (5/3): The REX VolMAXX Long VIX Weekly Futures Strategy ETF (NYSEMKT: VMAX ) and the REX VolMAXX Inverse VIX Weekly Futures Strategy ETF (NYSEMKT: VMIN ) are actively managed funds that invest in near-month VIX futures. “We believe VMAX and VMIN are exactly what sophisticated investors have been asking for: exchange-traded funds that get closer to spot VIX,” said Greg King, Founder and CEO of REX Shares, in a press release . Weekly expirations for VIX futures were introduced by the CBOE in July 2015. For further analysis on VMAX and VMIN, please read Is The Holy Grail Of VIX Investing Finally Here? by Stephen Aniston. Global X targets millennial spending habits with a new fund (5/5): The Global X Millennials Thematic ETF (NASDAQ: MILN ) will track an index of stocks that have a high likelihood of benefiting from the rising spending power and unique preferences of the U.S. Millennial generation (birth years ranging from 1980-2000). Rather than focusing on a specific market category, MILN will invest across a broad range of industries that align with the spending trends of millennials. All companies included are domestic and have a market cap of at least $500 million, with an average daily turnover for the preceding six months of at least $2 million. This is the first ETF to give investors access to the spending habits of a generation, but now that the idea is out there I would be surprised if it was the last. Fund closures for the weeks of April 18th, 25th, and May 2nd 2016 Global X GF China Bond ETF ( CHNB) Horizons Korea KOSPI 200 ETF (NYSEARCA: HKOR ) Have any other questions on ETFs or ETNs? Please comment below and I will try to clear things up. As an author and editor I have found that constructive feedback is the best way to grow. What you would like to see discussed in the future? How can I improve this series to meet reader needs? Please share your thoughts on this first edition of the ETF Update series in the comments section below. Have a view on something that’s coming up or a new fund? Submit an article. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.