Outperforming the index - split shares

I recently came across a compelling paper that suggests that the good S&P 500 returns of the past are unlikely to be replicated into the future. I suggested that, for younger investors particularly, outperforming the index would be a matter of prime importance. I'd also suggest that the paper has similar implications for Canadian investors too.

I had also indicated I'd write on some relatively simple methods to outperform the index.

One that I'd like to re-visit is the idea of leveraged share structures, or leveraged funds. (Leverage: see the dangers 1, 2)

For an investor with a relatively long time line, say more than 10 years, many of these types of structures are ideal to enhance returns. They leverage underlying shares or indices and can provide a greater than average return, provided that you have sufficient time to ride out the shorter-term volatility associated with this type of leverage.

For instance, two split-shares available on the Canadian market (TSX), LSC and ALB, provide access to, respectively, the four largest Canadian life-insurers and the six largest Canadian banks. Generally, the banks and insurers have proven to be prodigious wealth-producers over time. These returns are enhanced by the leverage structure of 1.69x and 1.99x on the "capital shares", respectively, so these shares should move up or down at the underlying share rate, multiplied by that factor.

What you don't want to do is buy them when the underlying shares are over-valued. While absolute measures are somewhat subjective as to value in today's market, both corporate sectors appear to be relatively good value.

To arrive at that conclusion, I surveyed three fundamental ETFs, the IShares XCV product, a measure of Canadian value stocks. I also surveyed the Claymore Investments fundamental ETFs, CDZ (dividend-based value), and CRQ (tracks value based on four fundamental factors). In all of these three ETFs, at least four of the six banks hold a weighting in the top eight securities, while the insurers weren't too far behind, with three of the four insurers taking weightings within the top 18 spots in all those ETFs. This suggests that they are relatively cheap in the Canadian market.

Another split share, SNH.U (capital shares), tracks the Health Care portion of the S&P500; its' underlying composition is similar to the SPDRs health-care ETF, XLV. It's largest holdings are in Pfizer and Johnson & Johnson, two stocks that have recently attracted a lot of buying from the guru value set, suggesting that they too, are reasonably priced. Another recent report stated that on a historical-basis, this group is trading in the 3rd percentile of its' historical cash-flow range, indicating that valuations in the health care sector are fairly attractive at this time. But you have to be able to handle the leverage factor, in this case at 2.86x.

Therefore, using a split share structure that leverages the long-term growth and relative cheapness of these various sectors is probably a good thing for long-term performance. Which is one reason why I hold all of the above in my personal portfolio.


JW

The Confused Capitalist