How to target optimal cash returns

In a world where interest rates seem destined to remain lower for longer than anyone anticipated, and economic growth feels muted, two of the most important considerations for advisers and clients are finding secure income streams and paying low fees to access them.

The former is a vital part of any client’s financial plan and the quest for secure, yet sufficient, dividends and coupons is a relentless one.

Meanwhile, the McKinsey Global Institute’s report which suggests the next 20-30 years’ equity returns may be lower than the previous 30, coupled with record low bond yields and interest rates, means low costs are one good way of helping portfolio returns at a time of considerable uncertainty.

In certain cases, Exchange-Traded Funds (ETFs) can address both of these needs simultaneously.

So-called ‘smart beta’ ETFs create their own custom-made index, rather than a well-known benchmark, and then track this basket of securities, with the aim of providing the underlying assets’ returns, minus the running costs of the product.

Targeting a basket of cash-rich stocks that are capable of returning surplus cash to their investors seems like one potentially interesting strategy and stock market action in the UK this month so far backs this up. Shares in megabank HSBC jumped after the FTSE 100 stalwart announced a $2.5 billion share buyback, while life insurer Aviva’s shares also rose sharply when the company announced a 10% increase in its interim dividend.

In each instance the firm returned cash, although they used different mechanisms to do so, one using a buyback, the other a dividend.

Advisers and clients are unlikely to have the time or inclination to analyse the merits of specific firms, their balance sheets, cash flows and strategies, but ETFs mean they do not have to.

Invesco's PowerShares Global Buyback Achievers UCITS ETF is listed on the London Stock Exchange, with the EPIC code of BUYB, as is the SPDR Global Dividend Aristocrats ETF, which has the EPIC code GBDV.

Advisers and clients can then choose which cash return mechanism they prefer, if income is indeed a key part of their investment plan, and it is therefore worth assessing the relative merits of the instruments and the strategies which they choose to follow.

Cash returns

The Invesco PowerShares Global Buyback Achievers ETF tracks a basket of securities which comprises the constituents of both the NASDAQ US Buyback Achievers and the NASDAQ International Buyback Achievers indices.

The NASDAQ US Buyback Achievers Index is comprised of corporations that have effected a net reduction in shares outstanding of 5% or more in the trailing twelve months. The NASDAQ International Buyback Achievers Index is comprised of corporations that have effected a net reduction in shares outstanding of 5% or more in their latest fiscal year.

Yet buybacks are not to everyone's taste and the debate over which is ‘best’, dividends or buybacks, rages on. A client's tax situation and long-term investment goals will have a large say here, but the arguments in favour of dividends (and their reinvestment) remain compelling.

Professor Jeremy Siegel's book Future for Investors demonstrates, in a US equity market context, how the highest yielding US stocks had consistently outperformed market over a 50-year view, and done so while offering lower-than-average volatility, as benchmarked by beta.

Stocks with the highest dividend yield have consistently outperformed in the USA

Source: Professor Jeremy Siegel, Future for Investors. Shows average annual total returns from 1957 to 2013, dividing S&P 500 index into five quintiles, weighted by market capitalisation

Pros and cons

Despite the positive case that can be made in favour of dividends, there is the risk that the payout could be cut in the event of a recession or sudden profit shock at a company.

A good active manager should look to pick the consistent payers and dodge the cutters. To help mitigate this danger the SPDR Global Dividend Aristocrats ETF selects stocks that have not only a decent yield but also a 10-year record of stable or increased dividends.

There are also risks associated with share buybacks.

History shows companies have a habit of buying stock back during bull markets (when their stocks tends to be more expensive) and not doing so during bear ones (when their stock tends to be much cheaper).

For example, buybacks in the US peaked in 2007 and collapsed in 2008 and 2009 only to accelerate again in 2011 and 2012.

This exposes clients to the risk management teams are buying high rather than low could therefore question whether executives are sufficiently objective when they sanction a buyback to show the market they feel their stock is undervalued.

There is also the risk that firms buyback stock using debt, potentially weakening their balance sheets and competitive position in the long term (although the same danger lurks with dividends).

When it comes to buybacks, it may therefore be worth heeding the words of master investor Warren Buffett from his 2012 letter to shareholders: “Charlie [Munger] and I favour repurchases when two conditions are met: first, a company has ample funds to take care of the operational liquidity and needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated.”

Acid test

It will be interesting to see how both ETFs do over time and whether one cash return approach proves more valid than the other.

At the moment, dividends have the edge. Since the October 2014 launch of Invesco PowerShares Global Buyback Achievers, the instrument has risen by 7.5%, while SPDR Global Dividend Aristocrats has gained 18.3%. Over the same period, the FTSE All-Share is up 5.2%.

Source: Thomson Reuters Datastream

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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