Investors love to be "paid" through dividends from companies they own, but they can reap benefits from another tactic: share buybacks, which help push up a stock's price.
When a company buys its own stock on the open market, it effectively reduces the number of shares outstanding. Buybacks have boomed in recent years as companies flush with cash have repurchased their stock for assorted reasons, effectively boosting earnings per share. Low interest rates have also made it easier for firms to borrow money to do so.
A handful of exchange-traded funds have made investing in these companies easier. These ETFs had previously been listed only in the United States, but now First Asset, a unit of CI Financial Corp., has launched similar funds in Canada.
While some buyback ETFs have outperformed market indices and also offer shareholder distributions – firms can return cash to shareholders through both dividends and stock buybacks – investors should check under the hood before they buy.
The PowerShares BuyBack Achievers ETF, which launched in December of 2006, targets the U.S. market and is the oldest North American buyback ETF. Since inception to Sept. 30, 2016, the $1.3-billion fund has outpaced the S&P 500 Total Return Index by more than 1 per cent annually.
Given the strong record of some of these ETFs, "we think there is a lot of credence to a buyback strategy," says Daniel Straus, an ETF analyst with National Bank Financial in Toronto.
Keep in mind, however, that market conditions over the past 10 years, except for the 2008 financial crisis, have been "pretty bullish," he says. Against a backdrop of low interest rates that has helped propel the stock market, some companies may be "taking on debt, which is very, very cheap, and putting the proceeds of a debt issue to share buybacks," he added.
If they have done so, he says, "then we would expect them to have a higher risk than the overall market."
Mr. Straus likes PowerShares Buyback Achievers for its exposure to the U.S. market, but he notes that most of its strong performance came before mid-2015. Its has achieved a good record despite charging a 0.63-per-cent fee, which "in our view is pretty expensive to hold over the long term," he said. Some U.S market index ETFs charge 0.05 per cent or lower.
Investors might consider a buyback ETF to supplement core holdings that track the overall market or as a tactical move during a bull market, he suggested.
"If an investor is optimistic about the market, thinks the recovery is strong and that we are entering a kind of secular growth cycle, a buyback strategy would let you ride that further," Mr. Straus says. "I would recommend [buyback ETFs] for a more risk-tolerant investor."
Buyback strategies can also be compelling for tax reasons in non-registered accounts, said Christopher Davis, director of research at Morningstar Canada. "You have to pay taxes every single year on dividends, whereas buybacks are designed to increase the value of a company's share price, and you don't have to pay taxes until you sell the stock.
"You will also be paying capital gains taxes [from the selling of stock] instead of income taxes," Mr. Davis points out.
Stocks tracked by buyback ETFs are also often held in core ETF holdings within a portfolio, so investors should consider what else they own, Mr. Davis said. "It may well be that they already have exposure to these companies."
In Canada, the First Asset Canadian Buyback Index ETF and First Asset U.S. Buyback Index ETF began trading recently after backtests of their strategy yielded strong results. The ETFs outperformed broad market indexes over 15 years to Sept. 30; the Canadian ETF returned 11 per cent annually compared with 8 per cent for the S&P/TSX Composite Total Return.
The Canadian fund, whose 40 names include Encana Corp., Manulife Financial Corp., Saputo Inc. and Dollarama Inc., tracks higher-quality stocks than the S&P/TSX Composite, says Mr. Davis, referring to metrics such as return on equity and return on assets.
"The ETF has TSX-like exposure to financials but less exposure to energy," he notes. "It may have some diversification advantages … as its index appears to target a broader swath of the Canadian market."
Despite rosy backtest returns, investors should be cautious about jumping into new buyback ETFs because companies could always dial back share purchases in the future, he said. "Buybacks are completely discretionary. But when it comes to dividends, company managers are loathe to cut them. Those are sacrosanct because investors count on them."
The problem with looking backward is that current stock prices likely reflect a company's strategy to use extra cash to buy back stock, he added. While many firms may repurchase their shares when they think they are undervalued, others can inadvertently end up buying their shares when they trade above fair value and are expensive, Mr. Davis warned.
Todd Rosenbluth, director of ETF and mutual fund research at New York-based CFRA Research, agreed that some companies may end up buying back shares at the wrong time, but investors can "offset some the risks" through ETFs that offer multiple companies and sector diversification.
While dividends appeal to investors seeking a stable income stream, buyback ETFs may be attractive to those seeking large-cap growth strategies, as "companies that are growing are the ones that typically buy back their stock," Mr. Rosenbluth said.
He favours the PowerShares BuyBack Achievers ETF partly because it is the largest in assets, and holds "undervalued companies" like McDonald's Corp., Qualcomm Inc., Boeing Co. and Mondelez International Inc. among its 226 names. "It's a good way to get exposure to companies that have strong fundamentals and happen to be buying back their stock," he said.
He also likes the stocks in the younger $93-million PowerShares International BuyBack Achiever ETF, which tracks 50 foreign names, and the $7-million SPDR S&P 500 Buyback ETF, which owns 104 U.S. stocks. However, both trade infrequently, so they can be costly to purchase with wide bid-ask spreads, he warned. "Investors need to be mindful that when they are buying an illiquid ETF, it comes with a risk."
In addition to ETFs that track indexes, investors can consider buyback ETFs whose stocks are chosen by portfolio managers. The $137-million AdvisorShares Wilshire Buyback ETF, formerly known as AdvisorShares TrimTabs Float Shrink, has been a strong performer since its inception in 2011, but it saw a manager change last summer so its track record is now meaningless, Mr. Rosenbluth said.
Investors also need to be mindful that the strategies behind buyback ETFs can vary, Mr. Straus said. Some require a steady and persistent pattern of decreasing outstanding shares over two years. Others require a 5-per-cent or more net reduction in shares in the trailing 12 months. Some ETFS will equally weight stocks in their index, giving smaller names more influence.
Investors should note that profits that fill company coffers cannot go on forever, but rising interest rates could also curtail buybacks in the future, Mr. Straus said. The monthly outflows of assets in the Powershares BuyBack Achievers ETF since February may indicate investor concern about a slowdown in the buyback bonanza.
But a buyback ETF focused on the Canadian market is probably less risky, since interest rates, which were cut in 2015 after the oil price selloff, are likely to "remain stable for some time," he suggested.