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Is bandwagon effect taking spinoff ETF on a downward spiral?

Special to The Globe and Mail

Here's a great idea: An ETF tracking spinoffs.

Or is it?

After Tim Hortons Inc. was spun off from Wendy's International Inc., its shares became as popular as the double-double coffees and Timbit doughnuts served at the chain's ubiquitous fast-food outlets. The gain over the 16 months to December, 2007, was a mouth-watering 40 per cent.

Spinoffs, like Tim Hortons, usually make good investments, according to many academic and brokerage studies. One, released in 2006 by Lehman Brothers, for example, found that 88 spinoffs between 2000 and 2005 outpaced the S&P 500 stock index by an average of 45 per cent during their first two years of trading.

Why do they do so well? One reason is the extra incentive managers and employees have from owning shares and stock options. Another is the unfettered freedom to pursue new ventures and streamline costs.

The positive findings of the Lehman and other studies prompted Lisle, Ill.-based Claymore Securities Inc. to launch on Dec. 15, 2006, an exchange-traded fund (ETF) for spinoffs. Called the Claymore/Clear Spin-Off (CSD) ETF, it seeks to mirror the Clear Spin-Off index.

The index tracks a basket of 40 U.S. spinoffs scoring high on criteria such as low price-earnings ratios, high return on equity and ample free cash flow. When the index is rebalanced in June and December, spinoffs older that three years are replaced by younger spinoffs at least six months old, because studies show that spinoffs aged six to 36 months tend to have the best performance.

Stocks in the ETF are weighted by market capitalization and are capped at 5 per cent of the total. The top five as of the end of October are: Spectra Energy Corp., Discover Financial Services, Windstream Corp., Western Union Co., and Embarq Co. Tim Hortons occupies sixth place.

Before the launch, the sponsors ran some simulations of the index backward in time. The average annual gain from 2001 to 2005 was 11.3 per cent, compared with 0.5 per cent for the S&P 500 during the same period.

However, the actual performance of the spinoff ETF has not confirmed the studies. Since inception nearly two years ago, the spinoff ETF is down more than 45 per cent compared with a drop of over 30 per cent in the S&P 500 for the same period.

This may reflect the fact that the ETF's underlying basket of stocks is highly exposed to the hard-hit U.S. financial and consumer sectors, rather than being diversified.

This lack of diversification may also explain the strong performance earlier this decade.

"One reason for the outperformance ... could be that the spinoffs had less weight in technology stocks," says Warren MacKenzie, president of investment advisory firm Second Opinion Investors Service Inc.

Along with a rather high annual expense ratio of 0.75 per cent, it's perhaps not too surprising that net assets in the ETF are just over $12-million (U.S.). Daily average trading volume is barely more than 11,000. This ETF does not seem to have caught on very well, despite the literature attesting to the merits of spinoffs.

Perhaps the real caveat is what the Efficient Market Theorem (EMT) has to say about profiting from repeating patterns in stock prices, such as the one the spinoff ETF seeks to exploit. Such opportunities do not persist, according to the theory. As they become better known, more and more investors are drawn to them and the increasing competition makes it harder and harder to obtain above-market returns.

"Certainly the EMT would suggest that the market anomaly will not last, as more and more investors start to exploit it," Mr. MacKenzie says. "That is certainly what happened with earning revisions and that is also what happened with the strategy of tracking companies that were expected to be added to a major index. As soon as everyone started doing it, the advantage was gone."

At present, there are at least two U.S. mutual funds and a number of investment advisories focused on U.S. spinoffs.

In response to the influx of investors, the pattern may change in various ways and become less predictable. For example, the sweet spot between six and 36 months may shift forward as investors try to be the first ones in and the first ones out.

Dan Hallett, president of investment research and investment counsel firm Dan Hallett and Associates Inc., has doubts too.

"Unfortunately, the ETF industry ... has completely muddied a very simple concept - that is, beat most other investors by obtaining broad diversification via a very cheap vehicle. Once you start slicing and dicing the market too finely - a service for which ETF providers charge a premium - that concept and its associated benefits fly out the window."

This article was written for Globe Investor Magazine Online

*****

By the numbers

88

The number of spinoffs between 2000 and 2005 that outpaced the S&P 500 stock index by an average of 45 per cent during their first two years of trading.

11.3

The average annual percentage gain of the Claymore spinoff ETF from 2001 to 2005, compared with 0.5 per cent for the S&P 500 during the same period.

© 2007 The Globe and Mail. All rights reserved.

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