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ETF Issues: What You Don’t Know Might Hurt You

ETFs can be great options for investors. But you have to know what you are buying. iShares, for example, isn’t making that easy, though it’s doing the best it can. Exchange traded funds, or ETFs, are an incredible work of human ingenuity. They are pooled investment vehicles that trade close to net asset value while being traded all day long. And while there are good reasons to like these hot products, there are also reasons to dislike them. And a single data point provided by iShares shows one of those reasons. I don’t hate ETFs To start, I don’t hate ETFs. I just don’t like them as much as most investors seem to. And certainly not as much as Wall Street does, based on how many ETFs have been brought to market in recent years. Yes, they are cheap to own and provide quick and easy diversification. But it’s so easy to buy an ETF that people aren’t looking closely enough at what they are buying. That may not matter much if you pick up the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), a clone of the S&P 500 Index. But with more and more esoteric ETF product being created by rabid Wall Street salesmen, taking the time to get to know what you own is starting to matter more and more. For example, I recently wrote about the fine print in the prospectus of the Global X Yieldco Index ETF (NASDAQ: YLCO ). Essentially, this ETF is focused on buying 20 stocks in a new and niche sector that doesn’t really have 20 stocks to buy. YLCO is all about the story, not so much about the substance, in my eyes. Maybe YLCO will be a great ETF at some point, but right now it’s a risky proposition that all but the most aggressive investors should avoid. So, yes ETFs can be good. But Wall Street has been perverting this goodness in an attempt to make a buck. iShares isn’t evil But don’t think it’s only exotic fare about which you need to be concerned. Even more “normal” stuff can lead you astray. For example, the iShares NASDAQ Biotechnology ETF (NASDAQ: IBB ) has some problems of its own. Now iShares is the ETF arm of giant asset manager BlackRock (NYSE: BLK ). And, for the most part, BlackRock is a stand up company. But that doesn’t mean every product it sells is a good investment option. For example, a quick look at IBB’s overview page shows a P/E ratio of 25. That might not be too surprising given that biotech companies are high growth. You wouldn’t expect a P/E of 10 for this group. In fact, you might even say it’s on the low side for the sector, which is known for housing money losing companies looking for a big score via the creation of new drugs. Which is why you should click the little information icon next to that P/E stat. That’s where you’ll learn that the P/E ratio doesn’t include companies that don’t have earnings. So, essentially, the P/E really tells you less about the ETF’s portfolio than you might at first believe. Interestingly, the same issue pops up throughout iShare’s data on P/E. For example, the iShares U.S. Oil & Gas Exploration & Production ETF (NYSEARCA: IEO ) has a P/E that’s listed at a little over 8. With 70% of its assets in the oil and gas exploration sector, where companies are bleeding red ink, you have to step back and wonder what’s going on. A low P/E makes sense for an out of favor sector, but does that average really tell you the whole story? The thing is the warning about P/E is a standard disclosure on the iShares site and holds true for everything from a niche biotech fund to the company’s S&P 500 Index clone. And iShares really isn’t doing anything malicious. It’s a database issue. You can’t calculate a meaningful P/E if a company doesn’t have any E to work with. So in order to get the job done, in this case calculating an average P/E, you toss the garbage numbers. And, thus, you create a P/E by using only those companies with earnings. Which, unfortunately, biases the number you have just created so that it may offer a misleading picture of the portfolio. So I’m not hating on iShares, there’s not much else it could do to provide site-wide data. And at least it goes the extra step of disclosing this little problem. But it should make you step back and take pause. If you own that biotech fund or the oil and gas fund, the stats you are using to validate your purchase may, in fact, not be reliable. This issue can be found at open-end mutual funds, too, so don’t think ETFs are the only problem child. The best example comes from Morningstar. This research and data house is very open about the way it calculates most of its data, you just have to look. And when it comes to average P/E, they have a workbook available that explains, “If a stock has a negative value for the financial variable (EPS, CPS), the stock will be excluded from the calculation.” EPS is earnings per share and CPS is cash flow per share. So any site that uses Morningstar data will be impacted by this issue… like Fidelity (read the fine print at the bottom of the data page). The question is to what degree is there a problem. In some cases it’s a minor issue. In the case of IBB, roughly half of the ETF’s holding don’t make any money and are excluded from the P/E calculation, according to The Wall Street Journal . That makes the P/E figure provided by iShares pretty much useless in my eyes. And it points out yet another problem that ETF investors may not realize when they buy what is currently a hot Wall Street product. Know what you own For many investors ETFs are seen as a short cut. A punt option that doesn’t require much thinking. In many cases that’s true, but in many others it isn’t. Which is why knowing what you own is so important. Can you accept the average P/E for an S&P 500 Index fund at face value? Yeah, probably. But what about an ETF honed in on an industry that’s filled with money-losing companies, like biotech? I don’t think that passes the sniff test. You’d be better off doing a little more digging into the portfolio to get a good understanding of what’s in there. Again, I don’t hate ETFs. But they are so popular and have been pushed so hard by Wall Street that I fear investors don’t have any clue what they own. Too many people have been lulled into complacency by slick marketing and an avalanche of new products. I don’t think that’s a story that ends well. If you own an ETF, I recommend taking a deeper dive just to make sure you really own what you think you own.

Beware: SRF Is Likely To Cut Its 23.5% Distribution

Summary SRF has been punished by falling oil prices. The market price hasn’t fallen as much as the underlying asset value driving the CEF to trade at a 23.12% premium to NAV. SRF has an indicated distribution yield of 23.53%. This distribution is unsustainable if oil prices remain stay at current levels. Overview: Oil has fallen dramatically, pressuring the stocks of energy producers. Highly levered companies have been hit especially hard due to their risk of defaulting if energy prices don’t rebound. The Cushing Royalty & Income Fund (NYSE: SRF ) is a closed end fund that has been hit particularly hard by falling oil prices. SRF invests in energy related royalty trusts, exploration and production master limited partnerships (MLPs), and Canadian royalty trusts. Many of these investments have been hit hard by the falling oil price driving the fund’s net asset value down by 49.97% so far this year. SRF’s market price has held in a little better falling 37.21% likely supported by the fund’s large 23.53% distribution. The divergence in performance between the market price and the NAV has driven the fund to trade at a 23.12% premium. However, the large distribution and the 23% premium to NAV are likely unsustainable. Investors in the fund are likely to see a significant drop in value unless oil prices rebound dramatically. Key Investment Highlights: Premium to NAV: SRF is currently trading at a 23.12% premium to NAV. This is significantly higher than its 1 year average premium of 3.21%. Evidence of the wider than normal premium the Z-Statistic of 2.36 showing the current premium is more than 2 standard deviations wider than normal. Leveraged Exposure to Energy Prices: SRF invests in energy related royalty trusts and exploration and production MLPs. These investments are highly correlated with energy prices. Additionally, many of the holdings have taken on significant leverage to acquire drilling acreage. If energy prices remain depressed for long these investments will likely be forced to cut distributions and could face covenant violations or default. SRF itself has a leverage ratio of 20.76%. If the fund’s holdings have issues due to their high leverage ratios, SRF could also face issues with its regulatory leverage limits forcing the fund to sell assets. Unsustainable Distribution: SRF currently pays a 23.53% distribution. This distribution is unlikely to be sustained. Underlying holdings will likely have to cut their dividends due to lower energy prices which hurt their cash flow. SRF will likely need to follow suit so it wouldn’t be surprising to see a significant distribution cut from the fund. Key Investment Risks: Energy Prices: As mentioned above, SRF’s investment portfolio is highly correlated to energy prices. If energy prices rebound significantly, the underlying holdings should appreciate and the dividends may be sustainable. Company Acquisitions: It is in the downturn of market cycles that the strong players make their investments for long term growth. In this case, there is the risk that some of the oil majors my purchase smaller companies that have attractive assets. If holdings in SRF’s portfolio are purchased at premiums than it would support the share price and negate the downside case. Key Portfolio Metrics: Premium/Discount: 23.12% Z-Statistic 2.36 Market Distribution Rate: 23.53% Current Quarterly Distribution: $0.50 UNII Per Share: $0.1389 Effective Leverage: 20.76% Performance: Using ETFs with a similar investment objective can give a good comparison to evaluate management’s performance. I was unable to find ETFs that have a similar focus as SRF so I chose to look for ETFs that would give similar exposure to energy. I chose to use the iShares U.S. Oil & Gas Exploration & Productions ETF (NYSEARCA: IEO ), based on its similar focus on upstream energy production. The Energy Select Sector SPDR ETF (NYSEARCA: XLE ) is also included in the analysis to give a picture of the broader energy sector performance. SRF has significantly underperformed both ETFs during its relatively short life. The recent dramatic underperformance highlights the risk of SRF. Data as of 12/23/2014 Source: Morningstar Premium/Discount: (click to enlarge) Source: CEFConnect The fund closed 12/22/2014 at a 23.12% premium to the NAV, or underlying value of the portfolio. This is above the 52 week average premium of 3.34%. The dramatic fall in NAV over the past month may have contributed to the increase in premium as the market has not had a chance to respond to the lower value. Additionally the reported 23.53% distribution may have enticed some investors though the distribution doesn’t appear sustainable if oil prices remain low. The market price will likely adjust lower over time. A distribution cut could be a catalyst for the premium to erode. Expense Ratio: SRF pays 1.50% of weekly average managed assets to Cushing Asset Management for investment management. The annual expense ratio for AWF as of 11/30/2014 was 2.15%. This is a relatively high fee for investment management. The specialization and uniqueness of the portfolio are likely part of the high cost. However, investors have received a lot of risk without significant reward recently. Distribution: SRF pays a quarterly distribution of $0.50/share. Based on current market prices this equates to a 23.53% distribution. Nearly all of the distribution has been categorized as return of capital. Not entirely surprising due to the MLP structure of many of the fund’s investments. The distribution appears unsustainable and may need to be cut if energy prices don’t rebound significantly. Even with higher oil prices, SRF’s income received only covered 70% of its distribution after accounting for the advisory fee and operating expenses. The slide in oil prices will put additional pressure on this ratio. Leverage: SRF employs leverage gained through a margin account at Bank of America Merrill Lynch. The interest rate charged on margin borrowings is LIBOR plus 0.65%. The use of a margin account is a concern as margin could be pulled or the rate increased due to the fall in the margin collateral. Also, if interest rates were to increase, the cost of borrowing would increase putting upward pressure on an already high expense ratio. Liquidity: SRF is a small CEF with $116 million in net assets. Trading volume is thin with 73,000 shares traded on the average day. This represents $625 thousand in daily volume at current prices. This is thin liquidity for a CEF and large orders could cause wide swings in the market price. It is always wise to use limit orders to purchase or sell shares of closed-end funds, as the bid/ask spread can be wide. Management: SRF is managed by Cushing asset management, a subsidiary of Swank Capital. The management team is seasoned with managers averaging over 24 years of industry and investment experience. The management team is located in Dallas Texas close to the major players in the energy sector. Portfolio: Portfolio Allocation (click to enlarge) Source: Cushing Asset Management as of 9/30/2014 The fund is invested in upstream energy MLPs and trusts. The majority of the fund is invested in the United States with some exposure to Canadian royalty trusts. The focus on these high assets that have high distributions has increased they distribution the fund is able to pay but also comes with a significant amount of risk. The underlying value of the fund will be significantly influenced by energy prices. Top 10 Holdings Source: Cushing Asset Management as of 8/31/2014 SRF has a focused portfolio with 40 positions. The top ten holdings represent 76.2% of the total portfolio. The turnover rate has been relatively high, with 94.34% turnover in FY 2013. This concentration can be attractive when times are good, however, it increases the portfolio risk. A closer look at some of the top holdings reinforces the concern about the portfolio distribution. For example, Linn Energy, LLC (NASDAQ: LINE ) represents 9.4% of the total portfolio. LINE has an implied yield of 24.43%. However, LINE has $11 billion in long term debt vs. $4.9 billion in shareholder’s equity. If energy prices don’t rebound LINE will likely have to cut the dividend and use the cash to pay interest and repay debt. This would reduce the amount of cash available for SRF’s distribution. This is one of the starker examples in the portfolio, but many other holdings face similar issues. Strategy: SRF’s primary investment objective is to seek high total return with an emphasis on current income. Under normal conditions the fund will invest at least 80% of net assets in securities of energy related U.S. royalty trusts, Canadian royalty trusts, and exploration and production MLPs. Conclusion: The drop in energy prices has pressured SRF’s net asset value and share price. The net asset value has fallen faster than the share price driving SRF to trade at a large premium to the portfolio value. Additionally, SRF shows a 23.53% implied distribution. This distribution is likely to be cut if oil prices don’t rebound significantly. A lower distribution and a reduction in the premium price has the potential to drive the share price over 20% lower. Further, if energy prices don’t stabilize there is significant risk of additional downside. Investors should make sure they understand the risks before allocating capital to this fund.