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Do Buybacks Lead to Better Returns?

NEW YORK (TheStreet) -- In the last couple of years, the term smart beta has made its way into the lexicon of exchange-traded funds.

The term refers to screening a broad-based index such as the S&P 500 for some sort of valuation or qualitative metric that seeks to offer a better return in either nominal or risk-adjusted terms.

ETF provider PowerShares has embraced the term, branding more than 40 of its funds as being smart beta. Some of its funds are considered to be smart beta for offering low or high volatility or for dividend screening. Then there is PowerShares Buyback Achievers Portfolio (PKW).

The basic argument for owning stocks in companies that buy back their shares is that the companies must generally be in good enough financial condition to execute a buyback. Buybacks are viewed as a return of capital to shareholders because a reduced share count increases the earnings per share of the remaining shares and potentially leaves more capital available for dividends.

The word achievers in the name of the fund refers to companies that have reduced their share counts by at least 5% over the trailing 12 months. The companies that meet the achievers threshold are weighted in PKW with a modified market-capitalization methodology where the largest weighting for any company will be 5% of the fund's assets.

The fund is now heaviest in the consumer-discretionary sector at 34%, followed by technology at 16% and financials and health care at 11% each.

The fund reconstitutes every January, and so from year to year, its makeup can change. The current sector allocation would likely leave the fund vulnerable to an economic slowdown as people tend to cut back on discretionary items during times of financial hardship.

Many of the companies in PKW will be familiar, such as Pfizer (PFE), Oracle (ORCL) and Home Depot (HD), the three largest holdings in the fund with 4-5% weightings each.

The fund also has a few unfamiliar stocks, such as Telenav (TNAV), a provider of mobile services, and Pike Corp. (PIKE), a company that repairs power delivery systems used by utilities companies.

The idea of buying this fund is that it should outperform the broad market, and while there can be no assurances in the future PKW's track record, it has mostly outperformed since its inception in 2006.

The PowerShares literature compares PKW to indexes tracked by the SPDR S&P 500 (SPY) and the iShares Russell 3000 Value ETF (IWW). When PKW first began trading, it went down mostly in lockstep with SPY and IWW during the last bear market. However coming off the March 2009 bottom, PKW is up 225%, compared with 149% for SPY and 148% for IWW.

While the performance was excellent, with only one bear market/bull market cycle, it isn't clear whether the result is attributable to the buybacks or to the fund favoring cyclically sensitive sectors that tend to outperform the broad market on the way up.

As mentioned, consumer discretionary is the largest sector in PKW, and while PKW is up 225% since that low almost five years ago, the Consumer Discretionary Select Sector SPDR (XLY) has rallied 272% in the same time period.

That doesn't mean PKW is a bad fund, but understanding potential performance drivers for any fund you invest in should reduce the extent to which you are surprised by any future results.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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