The curious case of the deviant dividends

Posted on: April 9, 2012 in: Dividends with 0 comments

GUGGENHEIM SOLAR ETF Ticker: TAN / NYSE

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Pull up any ETF ticker on your favorite finance page and a wealth of information awaits you. Ever wonder about how accurate all of it is? If the answer is No, then today’s column is for you.

Most of the information is beyond dispute. The price is the price. But some values such as price-to-earnings and especially dividend yields really need to be scrutinized to avoid nasty surprises.

The other day on Bloomberg (the paid version), I came across several ETFs with incredibly rich dividends, with one – Guggenheim’s Solar ETF (TAN/NYSE) – outshining the others.

TAN holds about 30 solar energy companies. Its dividend yield is 9.2% according to Bloomberg and others. Indeed, its dividend of $2.11 (adjusted for a 1:10 reverse split) divided by its price of $23.02 works out to 9.2%. But is that likely for what should be a high growth sector?

In fact, looking deeper, only seven of the companies in the ETF, representing about 28% of the total allocation, have ever paid a dividend. Of those, two have postponed dividends for 2012 and another has cut its dividend by more than half. The weighted average yield on the seven is under 1%.

Since holdings can change every quarter I also checked holdings as of February 2011. The picture was the same: seven dividend-payers with an average yield of below 1%.

Where then did most of TAN’s dividend come from? The answer, according to the fund’s prospectus, is securities lending. Nearly 90% of TAN’s investment income for the 12 months ending last August came from lending about half its shares to short sellers.

You may recall that short sellers, expecting a stock to fall, sell shares that they have borrowed from other investors who are “long” (ie. They are invested in the shares). If the share price falls, short sellers buy it back at the lower price, return it to the lender and pocket a profit.

TAN, being an index ETF, is always long its shares. By lending, it earns interest from the short sellers and protects itself by demanding collateral, usually worth more than the value of shares loaned.

Generally, the ETFs with higher levels of lending income tend to be sector specific or they hold securities that are thinly traded or harder to borrow for other reasons.

Now you may say, a dollar is a dollar. However, a dollar from securities lending is not nearly as safe as a dollar from dividends. Few ETFs can earn so much from securities lending. It helps that TAN targets a very specific sector of the market. That likely means its holdings are harder and more expensive to borrow.

It could also be that the manager is lending to less credit-worthy short sellers or that the manager is accepting lower quality collateral. Either way, it does open the fund up to more risk than if it prohibited or restricted securities lending to a minimal amount. If a short seller is not able to return the borrowed stock, the fund manager will have only the collateral. In the normal course, that’s OK. But in a crisis, especially if the manager is holding poorer quality assets, the fund will suffer.

The other concern, especially for those seeking a steady stream of income, is that the income from lending will be much more volatile. TAN has fallen by 70% over the last two years and valuations on its holdings are beginning to look really cheap. At some point, that should see short sellers close their positions. Without that lending income, TAN’s yield will likely be closer to 1% than to 9.2%.

One last thought: There is no argument that securities lending is a completely legitimate activity within modern capital markets. But consider the optics: a fund manager enabling short sellers to pummel the very stocks held in the fund. For investors, the extra lending income helps fill the belly but taste like cardboard.

Besides dividends, there are other factors – price-to-earnings, use of derivatives and integrity to mandate being three – that must be examined carefully when selecting an ETF. It takes time and effort but as the example of dividends shows, this added scrutiny is a must for the serious investor.

 

archerETF Metrix 05 Apr 2012
Ticker/Exchange TAN / NYSE
Name GUGGENHEIM SOLAR ETF
Categories Equity / Small-cap
Total Holdings 29
52 Week High 88.7
Recent Price 22.91
52 Week Low 22.8
Avg Daily Volume 118,848 shares
Avg Daily Volume ($) $ 2.7 Million
Total ETF Assets $ 64.3 Million
Allocation to 10 Largest Holdings 67.48%
ETF Annual Fee .70%
ETF Trading Currency USD
ETF FX Exposure USD
Annual Volatility 50.12%
Correlation to S&P TSX Comp. 65.42%
Return to Risk Ratio -1.86
Beta to S&P TSX Comp. 1.61
Price-to-Earnings Ratio N/A
Use of Leverage No
Use of Futures No
6 month Return -24.21%
1 Year Return -70.70%
3 Year Return -31.53%
Dividend Yield (TTM) N/A

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archerETF offers Global Tactical Portfolio Management.

Our outlook is Global: we invest across countries, sectors, commodities and other asset classes to improve returns. Our management is Tactical: we strive to select the right opportunities at the right times in response to changing market conditions to manage and minimize portfolio risk.

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© 2012 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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