Since their inception in 1993, ETFs have been wildly popular, catering to a wide array of investor needs. ETFs track a variety of underlying assets or indices, ranging from stocks and bonds to volatility indices. Many of these funds are basically a result of market demand, and the strategies employed are not always based on sound investment theory. This is where Guggenheim Spin-Off ETF (NYSEARCA:CSD) is different, as I shall lay out in this article.
A lot of academic research on stock prices is carried out, and most of it is aimed at solidifying the Efficient Market Hypothesis (EMH). Sometimes, however, blue sky research is performed, which brings us to Guggenheim Spin-Off ETF. The Guggenheim Spin-Off ETF aims to replicate investment results corresponding to the Beacon Spin-Off Index.
Most of us are comfortable with the term spin-offs, which are divestitures of corporate activities and possibly related assets, but why would investors be interested in spin-offs or the Beacon Index? Focus-increasing divestitures seem to affect both the parent and subsidiary in a very positive manner. For subsidiaries, this effect is so profound that they consistently outperform the market as measured by operating cash flow and stock returns (Desai & Jain, 1999). Still this doesn't directly imply that CSD should beat the market, as is often the case with ETFs that track specific underlying assets or indices. So in plain, simple and popular investment terms: Does CSD beat the market?
To replicate the above graph: goo.gl/ewnBZ
The graph above shows one-year performance for the S&P 500, Russell 2000, the Beacon Spin-Off Index (AMEX: CLRSO) and Guggenheim Spin-Off ETF. The results are clear on first sight, the Beacon Index (CLRSO) and CSD outperform the market. Note that I did not select this timeframe because it would show the best results. Adjusting the timeframe to YTD (or longer) will yield similar results (although in a longer timeframe the Russell 2000 outperforms the S&P 500, it is no match for either CSD or CLRSO).
Guggenheim aims for an acceptable correlation with CLRSO of 0.95 over time. This is shown in the graph as a minor mismatch between returns for CLRSO and CSD. The results are astounding as, simply by observing the graph, CSD realizes greater returns than its benchmark with seemingly low volatility. I will show this is not just a coincidence but is actually based on sound fundamentals. Oh, and it's backed by academic research.
A large part of this article is based on: "Firm performance and focus: long-run stock market performance following spinoffs" by Hemang Desai, Prem C. Jain. Published in Journal of Financial Economics 54 (1999) 75-101 (Source: www.sciencedirect.com/science/article/pii/S0304405X9900032X). This link is usually accessible through university or institutional libraries. Unfortunately, I'm not allowed to provide a link to the full pdf or tables, but doing a Google search will work wonders.
Why Would A Firm Perform a Spin-Off?
Focusing on core business sometimes seems as cyclical as our economy. Investors and academics alike have acknowledged that conglomeration is a tedious activity which often fails to produce the intended results. Consequently, core business optimization through restructuring has gained attention by many firms over the years. Businesses try to increase this core focus by selling unrelated assets to others, or they spin off unrelated divisions to shareholders.
The reason why spin-offs in specific are interesting is because of intent of initiation. If a firm decides to sell off unrelated assets, this may be related to liquidity issues, such as a desire to pay off debt, instead of improving core focus. A spin-off does not involve a cash exchange, but is basically a partial detachment of a set of business activities from a main firm to its shareholders. A spin-off should therefore be the result of a careful option analysis, and maximize shareholder value.
Corporate and Stock Performance Analysis
Next up, I will discuss the corporate and stock performance of the subsidiaries of focus- and non-focus-increasing parents. Note that the intention of a spin-off in a focus-increasing parent signals management's uncertainty in their ability of managing the subsidiary optimally, and, more importantly, their desire to focus on the firm's core operations.
The above table, taken from (Desai & Jain, 1999) shows operating cash flow analysis for the focus- and non-focus-increasing sample. Operating cash flow return is defined as the ratio of the year-end operating cash flow to the year-end total assets. The subsidiaries have operating cash flow returns not significantly different from the industry standard (see -3, -2, -1 in panels A and B). We observe a small retraction in operating cash flow returns in panel A and a somewhat larger one in panel B. Furthermore, we observe in panel A that the focus-increasing sample significantly outperforms peers on an operating cash flow basis on an annual basis from year +1 to +3 (on a 5% significance level for the mean and 1% significance level for the median). For panel B there is no significant trend, although the results show some sluggishness.
The above table, taken from (Desai & Jain, 1999), effectively summarizes the stock performance of spin-offs. EX is the month of the ex-date; RAWF implies the raw buy-and-hold return of the sample firms and RAWP the return of the benchmark portfolio. AHAR is thus the abnormal, or excess, return. We observe that panel B significantly outperforms (at a 1% significance level) the market for any given timeframe. The cumulative abnormal returns are nothing short of astounding. Unfortunately, this is not the case for panel C. We observe only small cumulative abnormal returns for EX+1 to EX+12 and EX+1 to EX+24. For EX+1 to EX+36, we observe negative cumulative abnormal returns, although not significantly so (at a 10% significance level). In panel A, we observe that the combined results are still impressive. Cumulative abnormal returns for all subsidiaries are positive and significant for each timeframe (at a 1% significance level).
So what can we conclude from the aforementioned facts? The introductory graph showed that CLRSO and CSD have outperformed the market. Increasing the timeframe will show that this outperformance is consistent over a longer period of time. Because market outperformance is not necessarily unique, I further set out to assess the fundamentals of CSD.
As can be judged from the research I presented, the spin-offs perform, on average, above industry standard. Operating cash flow is stronger than industry benchmarks which allows for healthy future operations. Focus-increasing divestitures create significant positive abnormal stock returns for both parent and subsidiary. This effect is less profound for non-focus-increasing divestitures, but the pooled effect is still positive. This shows that spin-offs are fundamentally sound investment vehicles.
The Guggenheim Beacon Spin-Off ETF effectively (with correlation of 0.95) tracks the Beacon Index (CLRSO), which has shown to replicate the cumulative abnormal returns as suggested possible by (Desai & Jain, 1999).
To sum all this up, basically everything about CSD as an investment vehicle is sound. The fundamentals are solid and it has shown to adhere to its promises by beating the market. It is therefore the first ETF I have come across that I feel justifies taking a detour from standard market indexing.