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High Income ETFs Worth Their High Costs

With negative interest rates dominating international headlines and the benchmark 10-year U.S. Treasury yields slipping to below 2%, there is huge demand for income ETFs. Yield-hungry investors have rushed to high-dividend securities and ETFs in search of steady current income. Global growth continues to flounder, and the Fed is in no mood to hike rates frequently this year, suggesting continued outperformance by dividend ETFs. That being said, we would like to note that current income turns futile if you end up paying high expenses for a high-dividend or high income ETF. After all, everybody wants value for money. Also, cheaper funds have the potential to outperform the pricey choices. Keeping capital gains or losses constant and considering an expense ratio of 1%, a fund of $10,000 invested at 8% annual dividend will grow to $19,672 in 10 years, while the same fund invested at an expense ratio of 0.1% will grow to a higher amount of $21,390. But there are a few high income ETFs that can be intriguing picks despite the high costs associated with them. These ETFs have given decent performances so far this year (as of April 15, 2016), overruling the heightened volatility in the market. Also, since these have offered solid yields, their high costs do not hurt investors. Below, we highlight a few of such high dividend ETFs that are worth their high expense ratios. YieldShares High Income ETF (NYSEARCA: YYY ) The fund seeks to provide the performance of the ISE High Income Index. This $81.5 million fund definitely has a high expense ratio of 1.82%, but yields a stupendous 10.71% annually. The fund holds 30 closed-end funds ranked the highest overall by the ISE on the basis of three criteria, namely fund yield, discount to net asset value and liquidity. Around 66% of the fund is targeted at debt securities, while the rest are in equities. The fund is up 2.5% so far this year (as of April 15, 2016). Though the capital gains here are not solid, a 10.71% yield makes up for feeble market performance. AdvisorShares Athena High Dividend ETF (NYSEARCA: DIVI ) This $7.4 million actively managed ETF offers dividend yield of about 4.05% and has an expense ratio of 1.30%. The fund is heavy on North America (55%), followed by emerging Asia (16%) and developing Asia (6%). None of the stocks accounts for more than 4.36% of the portfolio. The fund is up 10.7% so far this year (as of April 15, 2016) – a sturdy performance which makes its dividend-adjusted return sturdier. Guggenheim S&P Global Dividend Opportunities Index ETF (NYSEARCA: LVL ) This ETF follows the S&P Global Dividend Opportunities Index, which focuses on high-yielding securities worldwide. As many as 109 securities are chosen from around the world for inclusion, with heavy exposure going toward finance (26.36%), utilities (22.21%), telecom (16.3%) and energy (12.88%) securities. Australian, American and British stocks account for about 20.6%, 17.1% and 15%, respectively, of total assets. This $52 million fund charges 65 bps in fees. It yields 6.06% annually (as of April 15, 2016) and is up 8.3% so far this year (as of April 15, 2016). First Trust Dow Jones Global Select Dividend Index ETF (NYSEARCA: FGD ) This $352 million fund provides exposure to the 100 high-yielding stocks. None of the securities accounts for more than 1.73% of the assets. From a sector look, financials takes the top spot at 34.33%, while energy, telecom, industrials, consumer discretionary and utilities round off the next five spots with double-digit exposure each. About half of the portfolio is tilted toward large- cap stocks, while mid caps and small caps take the remainder. In terms of country profile, Australia, U.S., Canada and United Kingdom occupy the top four positions. The fund yields 5.16% annually, while its expense ratio comes in at 0.58%. Agreed, an expense ratio of 0.58% is not too steep, but it is way higher than many high dividend ETFs like Vanguard High Dividend Yield ETF (NYSEARCA: VYM ), which charge just 10 bps in fees. The fund is up 5.3% so far this year (as of April 15, 2016). SPDR Income Allocation ETF (NYSEARCA: INKM ) INKM is an actively managed fund of funds that seeks to provide total return by focusing on investment in income and yield-generating assets. The ETF primarily invests in SPDR ETFs, but also includes other exchange-traded products. Investment-grade bonds (31.5%) and equity (27.6%) occupy the top two spots in the portfolio. The expense ratio is 70 basis points, while it yields about 4.13% annually. The fund is up 3.3% so far this year (as of April 15, 2016). Original Post

The Power Of Quantifying Market Expectations For McDonald’s And Williams Companies

” It’s difficult to make predictions, especially about the future. ” This quote has been repeated so many times that no one quite knows who said it first. Perhaps it was baseball player Yogi Berra. Or humorist Mark Twain. Or Danish physicist Niels Bohr. The point is, this quote has become a part of our cultural fabric, and it has done so because it expresses a simple and fundamental truth. Accurately forecasting what’s going to happen in the future is incredibly difficult, almost impossible. Few areas illustrate this difficulty more profoundly than financial markets, where analyst projections of earnings are regularly off by 10+% . Sometimes, even the most well recognized experts make shockingly bad predictions . No one truly knows (legally) what the market is going to do next, and the risk involved in that uncertainty is what creates the potential for significant returns. The Alternative To Making Predictions Of course, those returns are only available to those that participate in the stock market, and participating in the market implies some sort of prediction about the future. Even if you just buy a broad-based index fund, you’re predicting the broader market will go up. Otherwise, why make that (or any) investment? However, there’s a better way to invest. Instead of making your own prediction about the future, you can analyze the market’s prediction by quantifying the cash flow expectations baked into the market’s valuation of a stock. Then, you can make a more objective judgment about whether or not those expectations are realistic. This method, termed ” Expectations Investing ” by Alfred Rappaport and Michael Mauboussin in their book of the same name, can be incredibly effective. It’s effective because it removes the need to make precise predictions about the future. By quantifying market expectations across thousands of stock as we do, it’s easy to find pockets of irrationality and identify companies that are over or undervalued. How To Quantify Market Expectations There are a couple of methods we use to quantify market expectations. One of the simplest is to calculate a company’s economic book value , or the no-growth value of the business based on the perpetuity value of its current cash flows. This value can be calculated by dividing a company’s LTM after-tax profit ( NOPAT ) by its weighted average cost of capital ( WACC ), and then adjusting for non-operating assets and liabilities. Figure 1: Why We Recommended McDonald’s Click to enlarge Sources: New Constructs, LLC and company filings. The ratio of a company’s stock price to its economic book value per share (PEBV) sends a clear message about market expectations for the stock and can be a very powerful tool for investors. Figure 1 shows how PEBV influenced our decision to recommend McDonald’s (NYSE: MCD ) shares to investors in late 2012. Shares at that time were trading at a PEBV of 0.82, an unprecedented discount for a company with MCD’s track record of growth and profitability. The market’s valuation suggested that MCD’s NOPAT would permanently decline 18% and never recover. Those expectations seemed overly pessimistic to us. As it turned out, MCD did end up struggling significantly after our call. Increased competition from fast casual restaurants like Chipotle (NYSE: CMG ) and Panera (NASDAQ: PNRA ) that appealed to health-conscious diners compressed MCD’s margins and sent its sales slumping. Despite its struggles, however, things never got quite as bad for MCD as the market predicted. Between 2012 and 2015, NOPAT fell by only 16%, not the 18% projected by the stock price, and recent signs of a recovery have sent shares soaring to all-time highs. Figure 2 shows how MCD has delivered significant returns to investors since we made our prediction despite lackluster financial results. Figure 2: Disappointing Profits No Obstacle To Shareholder Returns Click to enlarge Sources: New Constructs, LLC and company filings. Though MCD’s poor results caused it to miss out on the bull run of 2013-2014, its surge over the past twelve months has it at a 51% gain since our initial call, outperforming the S&P 500 (NYSEARCA: SPY ) on a capital gains basis while also yielding a higher dividend. We didn’t know exactly how McDonald’s was going to perform when we made the prediction in 2012. We simply knew that the expectations baked into the market’s valuation were so pessimistic that even if the company’s profits significantly declined, as they did, investors could still earn healthy returns. Delayed Gratification As Figure 2 shows, basing investment decisions off a quantification of market expectations doesn’t always deliver immediate results. In the case of MCD, it took nearly three years for our call to come to fruition. Short-term sector trends and market forces can allow a company to stay valued at irrational levels for quite some time especially when we know that very few people practice Expectations Investing these days. Roughly three years ago, we warned investors to stay away from Williams Companies (NYSE: WMB ), calling it an example of the “sector trap.” Analysts excited about the company’s exposure to the rapidly growing natural gas sector were pumping up the stock, ignoring its low and declining return on invested capital ( ROIC ), significant write-downs indicating poor capital allocation, and the high expectations implied by its stock price. Specifically, our discounted cash flow model showed that the company would need to grow NOPAT by 13% compounded annually for 15 years to justify its price at the time of ~$37/share. Those expectations seemed to be clearly unrealistic given the company’s 7% compounded annual NOPAT growth over the previous decade and a half. For a time, WMB continued to gain in value despite the disconnect between its current cash flows and the cash flows implied by the stock’s valuation. As recently as mid-2015, the stock was up nearly 60% from our original call. However, as Figure 3 shows, WMB crashed hard when the market turned more volatile. It now has fallen nearly 60% from our original call, and it has significantly underperformed the S&P 500, the S&P Energy ETF (XEP), and peers Spectra Energy (NYSE: SEP ) and Enterprise Products Partners (NYSE: EPD ). Figure 3: Short-Term Gains, Long-Term Declines Click to enlarge Source: Google Finance Stocks with overly high expectations embedded in their prices can still perform well in the short-term, but they tend to face a reckoning eventually. Stocks Due For A Correction Roughly a year ago, we put engine manufacturer Briggs & Stratton (NYSE: BGG ) in the Danger Zone . Back then we argued that BGG’s history of value-destroying acquisitions, significant write-downs, and declining profits made it unlikely that the company would hit the high expectations set by the market. Specifically, our model showed that the company needed to grow NOPAT by 10% compounded annually for 17 years to justify its price at the time of ~$20/share. BGG actually did manage to meet this goal in year 1, growing NOPAT by 14% in 2015. However, we think this growth rate is unsustainable, as the company’s ROIC remains mired below 5%. Moreover, the company keeps spending money it doesn’t have on acquisitions, dividends, and buybacks, so it now sits with almost no excess cash and $660 million (68% of market cap) in combined debt and underfunded pension liabilities. Despite the balance sheet concerns, the market only seemed to pay attention to the GAAP earnings growth, and BGG is up 13.8% since our call. At its new price of ~$23/share, the market expects 10% compounded annual NOPAT growth for the next 11 years . Despite one good year in 2015, there’s no reason to suspect that level of growth is sustainable for BGG. High market expectations mean this stock should drop hard the moment growth slows down. On the other side of the coin, we still believe last year’s long pick Fluor Corporation (NYSE: FLR ) has significant upside. Despite slumping commodities prices affecting its oil, gas, and mining businesses, FLR still managed a 21% ROIC in 2015 and finished the year with a larger backlog than it had at the end of 2014. Investors only saw the downside though, and they sent FLR down 11% Due to this decline, the market continues to assign FLR a low PEBV of 0.9, just as it did last March when we made our original call. Given the recent rebound in commodities, we don’t think a permanent 10% decline in NOPAT from these already low levels seems likely. Strong profitability and low market expectations lead us to believe an investment in FLR will pay off sooner or later. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. 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.

Lack Of Earnings Quality And Debt Downgrades Limit S&P 500’s Upside

Four in a row. That’s how many consecutive 3-point baskets Andre Iguodala scored against the Houston Rockets in last night’s playoff game. There has also been a “4 for 4″ in the financial markets. One after another, major banks have lowered their year-end targets for the S&P 500. Most recently, the global equity team at HSBC shaved its year-end target to 2,050 from 2,100. On the surface, HSBC’s cut is less severe than other bank revisions to S&P 500 estimates. That said, J.P Morgan pulled its projection all the way down from 2200 to 2000. Credit Suisse? Down to 2,050 from 2,200. And Morgan Stanley slashed its year-end projection from 2175 to 2050. So what’s going on? We had four influential banks expressing confidence in the popular benchmark a few months earlier. Their analysts originally projected total returns with reinvested dividends between 5%-10% in the present 12-month period. Now, however, with the S&P 500 only expected to finish between 2000-2050, these banks see the index offering a paltry 0%-2%. Another way some have phrased it? Excluding dividends, there is “zero upside.” Here is yet another “4 for 4” that makes a number of analysts uncomfortable. Year-over-year quarterly earnings have fallen four consecutive times. That has not happened since the Great Recession. And revenue? Corporations have put forward year-over-year declines in sales growth for five consecutive quarters. That hasn’t happened since the Great Recession either. The bullish investor case is that the trend is going to start reversing itself in the 2nd half of 2016. However, forward estimates of earnings growth and revenue growth are routinely lowered so that two-thirds or more companies can surpass “expectations.” And it is not unusual for estimates to be lowered by 10%. Take Q1. Shortly before the start of the year, Q1 estimates had been forecast to come in at a mild gain. Today? We’re looking at -9% or worse for Q1. Over the previous five years, Forward P/Es averaged 14.5. They now average 16.5 on earning estimates that will never be realized. In essence, S&P 500 stock prices are sitting a softball’s throw away from an all-time record (2130), while the forward P/E valuations sit at bull market extremes that do not justify additional appreciation in price. And what about earnings quality? Wall Street typically presents two kinds: Generally Accepted Accounting Principles (GAAP) earnings and non-GAAP earnings that excludes special items, non-recurring expenses and a wide variety on “one-time charges.” The foolishness of non-GAAP presentations notwithstanding, one might disregard the manipulation when non-GAAP and GAAP are within the usual 10% range. This was more or less the case between 2009 and 2013. By 2014, however, the gap between the two different earnings per share reports began to widen. By 2015, “manipulated” pro forma ex-items earnings exceeded actual earnings per share by roughly $250 billion, or 32%. Can you spell c-h-i-c-a-n-e-r-y? Of particular interest, there was a similar disconnect between GAAP and non-GAAP in 2007. Non-GAAP in the year when the last bear market began (10/07) was 24% higher than GAAP earnings per share. It follows that the discrepancy today in earnings quality is even wider than it was prior to the stock market collapse. “But Gary,” you protest. “As long as the Federal Reserve and central banks are exceptionally accommodating, stocks should excel.” In truth, however, the long-term relationship between the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and the Vanguard Total Bond Market ETF (NYSEARCA: BND ) demonstrate that the bond component of one’s portfolio has been more productive over the last 12 months than the stock component. Bulls can point to the market’s eventual ability to shake off the euro-zone crisis of 2011. That was the last time that the SPY:BND price ratio struggled for an extended length of time. Back then, however, the Federal Reserve offered two aggressive easing policies – “Operation Twist” and “QE 3.” Today? Stocks are not only extremely overvalued on most historical measures, but the Fed has only lowered its tightening guidance from four hikes down to two hikes. Is that really enough ammunition to power stocks to remarkable new heights? “Okay,” you acknowledge. “But rates are so low, they are even lower than they were in 2013. And that means, going forward, there is no alternative to stocks.” Not only does history dispel the myth that there are no alternatives to stocks , but many corporations that have been buying back their stocks at attractive borrowing costs are now at risk of debt downgrades, higher interest expenses and even default. For example, the moving 12-month sum of Moody’s debt downgrades hopped from 32 a year ago to 61 in March of 2016. Meanwhile, the longer-term trend for the widening of credit spreads between investment grade treasuries in the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) and high yield bonds in the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) suggest that the corporate debt binge may soon come to an ignominious end. Foreign stocks, emerging market stocks as well as high yield bonds all hit their cyclical tops in mid-2014, when the credit spreads were remarkably narrow. The IEF:HYG price ratio spikes and breakdowns notwithstanding, the general trend for 18-plus months has been less favorable to lower-rated corporate borrowers. The implication? With corporate credit conditions worsening at the fastest pace since the financial crisis , companies may be forced to slow or abandon stock share buybacks. What group of buyers will pick up the slack when valuation extremes meet fewer stock buybacks? Click here for Gary’s latest podcast. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.