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A pragmatic approach to income investing – UBS analysis on ETF selection

UBS report highlights analysis showing that how shareholder yield is financed can make a difference to ETF selection


Many investment strategies target high yielding stocks for income and capital enhancement, even though this might come at a risk. Ideally, companies should strike the right balance between cash distributions and reinvestments to ensure future business growth. That’s the call from UBS Asset Management, as they suggest that advisers should pay greater attention to how shareholder yield is financed by the underlying companies in which a fund invests and highlight how ETFs can be used effectively in this area.

It’s time to look beyond the headline yield figures and examine a company’s capital structure to get the real picture as to how sustainable dividend income is likely to be in future.

The MSCI Total Shareholder Yield Index is derived by taking into account both equity and debt considerations, thus building on a more holistic view of each respective company’s capital structure. When seeking long-term shareholder value, the key is to focus on companies that finance dividends and/or buybacks from free cash flow, rather than from capital structure arbitrage.

Dividends or share purchase?

Companies may return excess cash to their shareholders either through dividend payments or by the repurchase of outstanding shares (buybacks). Both methods generate value for shareholders. While a dividend provides a fixed return at payment date (income subject to taxation), share buybacks lead to an increase in per-share measures of profitability (earnings, sales, etc.), due to a reduction in the number of shares outstanding. Buybacks are frequently interpreted as a signal that a company’s management perceive their stock price to be undervalued relative to its intrinsic value.

Let’s get technical

The study of Brav et al. (2005) reports that perceived undervaluation is one of the key factors that drives a stock repurchase decision (tax advantages and protection against potential hostile takeovers being other important drivers). Buybacks usually drive a share price higher, resulting in significant capital gain, which is taxable if a shareholder decides to realise the profit. Many investors pursue these yielding stocks for income and capital enhancement, even though this might come at a risk. Ideally, companies should strike the right balance between cash distributions and reinvestments (capex) needed for future business growth. Index benchmarks are available which capture the performance of stocks with above-average dividend and/or buyback yields. These allow investors to access the risk premium indexed investments and to evaluate their performance.

The value of dividends and/or buybacks can be initially assessed by looking at the basic indices that reflect the performance of shareholder yielding stocks. For example, the S&P 500 Buyback Index measures the performance of 100 stocks with the highest buyback yield in the broad S&P 500 universe, whilst the S&P 500 High Dividend Index reflects the performance of 80 stocks with the highest dividend yield amongst the S&P 500 underlying stocks. Both the S&P 500 Buyback Index as well as the S&P 500 High Dividend Index have simplistic methodological frameworks, where the S&P 500 underlying stocks are ranked in descending order, based on their respective yield, and the top 80 to 100 stocks are selected and equally weighted to formulate the index. The equal weighting scheme underpins the maximum diversification approach, with no explicit tilt towards higher yielding stocks, regardless of company size or the source of financing repayments.

Inherent sector bias between dividend yield vs. share buybacks

The graph shows the dividend yield and buyback yields per sector for the S&P 500 universe. Importantly, if an investor buys a dividend index, then they overweight sectors according to the orange values (i.e. only high dividend yielding companies), while they ignore the buyback yield. These two ways of returning capital to investors should be equivalent assuming efficient capital markets. Hence, as UBS have highlighted, what really should matter to investors is the total shareholder yield, which is the sum of dividend and buyback yields.

Additionally, the graph makes clear that looking just at dividends for example would underweight a number of key sectors: IT, Consumer Discretionary, Healthcare, Financials etc., as in these sectors, companies have historically preferred share buybacks over high dividends. While the highest dividend yielding sector may be Telecoms followed by Real Estate, if one looks at the full picture of dividends combined with share buybacks, Consumer Staples actually comes out on top.

Key consideration: debt-financed shareholder value

A number of studies have discussed the value of cash repayments, and argue that in recent years, amid low interest rates and cheap debt financing, debt issuance has been excessively used for stock buybacks and dividends. As Andrew Walsh, Head of Passive & ETF Specialist Sales at UBS AM suggests, “this essentially rewards equity holders at the cost of bondholders (debt/ equity arbitrage), and implies that companies maximise short-term shareholder value rather than investing for the long-term”. The current incentive structure, implied by low interest rates and tax inducements, works against long-term investments and supports levered buybacks.

In the view of UBS, when seeking long-term shareholder value, it’s worth focusing on companies that repay shareholders from free cash flow and which have healthy balance sheets, rather than from those employing capital structure arbitrage.

Factor indexation of shareholder yield: more sophistication

The MSCI Total Shareholder Yield Index, for US and Eurozone equities uses a methodology derived from the aforementioned equity-debt considerations, thus building on a more holistic view of the each respective company’s capital structure. This index targets companies that have returned above-average capital to shareholders (through dividends and/or buybacks), whilst aiming to minimize exposure to the companies that have concurrently raised their debt levels, assuming that debt issuance has been used to fund share buybacks. Within this framework, the focus is on the companies that favour long-term shareholder value. The index construction used here is a rules-based process (with semi-annual rebalancing) where for each variable (dividend yield, buyback yield and debt repayment yield) a ‘Z-score’ is computed and then averaged, resulting in the composite Z-score used to rank stocks in view of their shareholder value. The Z-score concept uses standard deviation analysis so as to more easily compare like for like. In contrast to a basic index structure, the MSCI approach favours top shareholder-valued stocks by overweighing them in the index composition.

Exchange Traded Funds provide effective access

UBS AM offer two Exchange Traded Funds (ETFs) that provide access to the MSCI Total Shareholder Yield indices, for the USA and the Eurozone (EMU) equity markets. For European market access, the UBS ETF (LU) Factor MSCI EMU Total Shareholder Yield UCITS ETF (EUR) fund invests in those European large and mid- cap stocks which have the strongest yield and share buyback profiles as defined by the MSCI EMU Total Shareholder Yield index.

As Andrew Walsh explains, “typically, the number of stocks which ‘make the grade’ would represent about 25% of the constituents of the MSCI EMU parent index. Similarly, the UBS ETF (IE) Factor MSCI USA Total Shareholder Yield UCITS ETF (USD) invests in those US large and mid-cap stocks which have the best profiles in this respect and also represents c. 25% of the MSCI USA parent index”. Finally, it should be noted that within the distributing share class, the dividends are distributed (income), whilst buybacks result in a capital gain, if the underlying price has moved up. This capital gain is reinvested in line with the index methodology.

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