4 Reasons ROE Is Not A Useful Metric For Investors

4 Reasons ROE Is Not A Useful Metric For Investors…more attention to return on invested capital (ROIC)

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Recently, we ran through the various flaws in the price to earnings ratio and explained why investors need to be paying more attention to return on invested capital (ROIC). This week, we’re tackling another of the market’s favorite metrics, return on equity (ROE).

Return on equity has a very simple formula:

It’s tempting to think of ROE as just an easier-to-calculate version of ROIC. All you need to do is just find the Net Income line on the Income Statement and divide it by the Shareholder’s Equity line on the Balance Sheet. Unfortunately for investors, a metric that’s so easy to calculate is rarely going to be useful in terms of explaining valuation, as Figure 1 proves.

Figure 1: ROE Has Almost No Impact On Valuation

Sources: New Constructs, LLC and company filings.

Figure 1 shows the relationship (or lack thereof), between ROE and enterprise value/invested capital, which is a cleaner version of price to book. Less than 1% of the difference in valuation between S&P 500 companies can be explained through ROE. A similarly nonexistent relationship shows up when we plot ROE against the P/E ratio.

Figure 2: ROE Doesn’t Impact P/E Either

This evidence is clear. No meaningful relationship exists between ROE and P/E or enterprise value/invested capital[1]. It has an appealing simplicity, but ROE has several fatal flaws that keep it from being a useful metric.

Flaw #1: It’s Based On Accounting Earnings

I’m not going to belabor this point because it’s one we’ve made time and time again. Reported net income is not a useful metric for equity investors. GAAP rules were designed for debt investors, and GAAP net income has a number of issues that make it especially poor at measuring profitability.

  • It contains many accounting loopholes that can distort reported earnings.
  • There’s almost no enforcement in place to keep executives from manipulating earnings.
  • Changing accounting rules and differing interpretations mean net income is not necessarily comparable over time or between different companies.
  • Financing costs such as interest can impact reported earnings, obscuring the actual operating performance.

ROIC fixes these issues by using net operating profit after tax (NOPAT) as the numerator. Unlike GAAP net income, NOPAT excludes financing costs, uses consistent rules across all companies and timeframes, and adjusts out the impact of unusual items and changing management assumptions.

Flaw #2: It Ignores Off-Balance Sheet Items

Companies have all sorts of tools they can use in order to hide assets off the balance sheet. One of those tricks, using operating leases as off-balance sheet debt, is going to get taken away in 2018. Still, there are other hidden off-balance sheet items, such as reservesdeferred compensation, andasset write-downs.

These all represent committed uses of capital for which the company is not being held accountable. This is an area where we really see how accounting rules are geared towards the needs of debt investors rather than equity investors. Writing-down assets helps debt investors by giving a clearer picture of the liquidation value of a company, but it hurts equity investors by obscuring the true amount of capital invested in the business.

We use invested capital for the denominator in our ROIC calculation because it factors in these hidden items so that the company is being held accountable for all of its uses of capital.

Flaw #3: ROE Can Be Influenced Through Leverage

A true measure of profitability should be focused on the operating side of the equation, without allowing financing decisions to have a big impact. By only using shareholder’s equity as the denominator, ROE becomes extremely susceptible to financing decisions, as a company can significantly boost ROE by taking on more leverage and increasing its risk.

The opposite also holds true. A company holding a great deal of excess cash will be penalized with a lower ROE, even though it may be making the responsible decision to hold that cash until a more opportune time arises to invest it at a higher return or to return that cash to shareholders more efficiently.

As an example, let’s look at Nordstrom (JWN) and Apple (AAPL). According to ROE, Nordstrom is the more profitable company, with an ROE of 47.9% compared to Apple’s 44.7%. This misleading comparison stems from the fact that Nordstrom’s total debt is equal to 41% of its market cap, whereas Apple has over $130 billion in net cash (20% of market cap).

When we remove the impact of leverage and just look at the operating profitability of these two companies, we can see that Apple has an ROIC that is more than 10 times higher than Nordstrom.

Flaw #4: Executives Have An Interest In Manipulating ROE

ROE is another one of the “advanced” or “non-GAAP” metrics that companies often use to set performance targets that executives need to hit to earn their annual and long-term bonuses. Consequently, executives will be more likely to manipulate accounting earnings, structure transactions to keep them off the balance sheet, and take on more leverage in order to boost ROE.

Because ROE is so easy to manipulate, and because executives potentially have such a strong interest in artificially boosting it, investors can’t know whether that ROE number is reliable or just a result of financial wizardry. One company might have a significantly higher ROE than a competitor simply because it’s more aggressive exploiting accounting loopholes rather than being superior in terms of profitability.

The ease with which ROE can be manipulated, as well as its various structural flaws, explain why it has almost no value in terms of explaining differences in valuation. As we see so often in the market, simplicity is not always a virtue. ROIC might not be as simple to calculate, but it’s a much better indicator of profitability and valuation.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

[1] We explore the often misunderstood relationship between ROE and price-to-book in this report.




The One-Man, $1.2 Billion ETF Shop, full outsourcing in finance as well.


The One-Man, $1.2 Billion ETF Shop, Andrew Chanin’s HACK is a rocket in an industry full of zombies.

There’s little that can’t be outsourced in ETF-land.

Starting an exchange-traded mutual fund is a little like launching a rocket. There are lots of different contractors and regulations. There are plenty of crashes.
Andrew Chanin, the 30-year-old founder of New York–based PureFunds, watched two of his first three ETFs fail before reaching Earth orbit. They liquidated because they couldn’t gather enough assets to cover expenses. A third fund barely made it aloft; it still has just $3.6 million in assets.
Chanin kept at it. In November, he launched the PureFunds ISE Cyber Security ETF (Symbol: HACK). By July, HACK had attracted $1.4 billion—one of the fastest ascents in ETF history. (On Aug. 25, after two days of turmoil in the market, it had $1.2 billion.)
It got lift from a well-timed computer breach. Just 12 days after HACK started trading, news broke that malefactors had looted the computer network at Sony Pictures Entertainment, taking terabytes of data, including Social Security numbers, salary figures, and e-mails that exposed the film studio’s leaders as the petty backbiters everyone imagines Hollywood big shots to be. Relentless coverage made computer security look like a crucial and immediate concern. And its ticker symbol advertised HACK as the way to play it.
PureFunds had, and still has, just one employee: Chanin, who looks like Ferris Bueller in a suit. He was competing against the biggest ETF companies around: BlackRock, Vanguard, and State Street. But Chanin was first to market with a computer-security ETF, and he had a perfect, memorable ticker symbol in an industry that is full of them: CURE (a health-care fund), FAN (wind energy), CROP (agribusiness), IPO (recent non-U.S. IPOs), and TAN (solar).

There are 6,500 ETFs in the world, with $3 trillion of assets under management. A new one rolls out, on average, every business day. The industry is surging, for a variety of reasons. Investors are dumping mutual funds for ETFs, which have a reputation for lower fees (though mutual funds are catching up, and some Vanguard funds are cheaper). Even better, ETFs can be bought and sold like equities during the trading day, and they have tax advantages, because ETF shares are created and redeemed in kind and thus almost never produce capital gains for shareholders.
Like the cheapest mutual funds, almost all ETFs are driven by indexes. With such scant fees, it’s hard to pay human managers, and, thanks to index evangelists like John C. Bogle, the founder of Vanguard, many people think managers aren’t worth the money.
But Bogle has never rolled out indexes like these. Take GURU—the Global X Guru Index ETF. It tracks the Solactive Guru Index built by Solactive AG, in Frankfurt. The gurus in this case are hedge fund managers, the alpha dogs who move billions in and out of stocks based on their wits and, sometimes, their whims.
A group at Solactive called the Index Committee compiles a list of hedge funds from various sources (including this magazine, according to Solactive documents) and then eliminates those managing less than $500 million, making that the guru cutoff. Also, the largest holding must be at least 4.8 percent of the fund, and the manager can’t change more than 50 percent of the portfolio in a quarter. Then Solactive takes the top holding from each of those funds and puts them in an index.
But is it really an index, or is it an ever-changing list of stocks held by hedge fund managers, most of whom are active managers, Bogle’s sworn enemy? Solactive CEO Steffen Scheuble says it is an index, because the methodology is strict.
In the worst cases, the index alchemists are preying on Bogle-headed investors who think indexes are always safe and cheap, says Chris Abbruzzese, chief investment officer at Rain Capital Management, which oversees $250 million in Portland, Oregon. “Just because something tracks an index doesn’t mean that the index doesn’t have its own tortured logic,” Abbruzzese says.
Gary Gordon, president of Pacific Park Financial in Ladera Ranch, California, is more charitable. He says the biggest problem with ETFs is liquidity. Some of the small ones trade so infrequently that they are hard to sell if you own them.
That’s the dirty secret of the ETF industry. All of the innovation has led to a lot of failure. Many ETFs are zombies. They stagger on with few assets and little trading. Take ProShares UltraShort Telecommunications, ticker symbol TLL. The fund, which lets investors make a bet that telecom shares are going to crater, has $154,000 of assets, and some days no shares trade. The fund started in April 2008, so ProShares, which has 146 funds with total assets of $25 billion, has had plenty of time to market it, a tough job in a bull market. ProShares declined to comment on TLL, which was set to close in September.
There are so many zombie funds that Ron Rowland, a portfolio manager at Flexible Plan Investments in Smyrna, Georgia, chronicles them on his website, Invest With an Edge, in a section titled ETF Deathwatch. “You and I could create an index in the next five minutes,” Rowland says. And because it’s an index, we can show how it performed during, say, the last five years, and then, voilà, we have a track record.
Many ETFs fail because no one ever hears about them, Rowland says, despite catchy tickers and trendy themes. It’s hard to stand out in a crowded field. “The bottom 50 percent of these things are untradable,” he says. Just eight ETFs accounted for half the trading, in dollar volume, for all U.S. ETFs in June, Rowland calculated. More striking: 81 percent of all the listings totaled 2.4 percent of dollar volume.
The bottom line: Most ETFs live in oblivion. All the clunkers show just how remarkable HACK is. And Chanin knows luck played a big part. But Chanin, a hyper-driven millennial, was well prepared when good fortune arrived.
Chanin at ISE’s New York offices. ISE collects a piece of the $9 million in fees HACK generates annually.
Chanin at ISE’s New York offices. ISE collects a piece of the $9 million in fees HACK generates annually.
He grew up in Mendham, New Jersey, and went to college at Tulane University, where he joined a club called the Jobs Group that aimed to put members in finance positions after graduation. During his senior year, a professor from the business school arranged for a group of students to go to New York for interviews. Chanin signed up for one at Kellogg Group, a brokerage. On the way to the airport, he got an e-mail list of the students scheduled for interviews. His name wasn’t on it. He called, and the professor said she had decided to take just graduate students.
Irked, Chanin flew to New York anyway and showed up at Kellogg with 10 other Tulane students. They went in one at a time until Chanin was the only one left in the lobby. The hiring manager took pity on him and asked him in. He got the job. “It never hurts to try,” he says.
At Kellogg, he became a market maker in ETFs, buying from sellers and selling to buyers and maintaining liquidity in various funds. He loved it. After two years, he went to Cohen Capital Group, another small New York brokerage.
He talked often with ETF issuers and suggested ideas for funds that Cohen would trade. One day, an issuer asked why he was giving away his best ideas. Why not build his own ETFs?
He and a friend from Cohen, Paul Zimnisky, considered it. “We thought you had to be a big banker to launch your own,” Chanin says. Not so. He soon discovered the cottage industry that existed for building ETFs. All he needed was an idea, seed capital, and some money for expenses.
Chanin and Zimnisky left Cohen and started PureFunds in 2010. Zimnisky became CEO, Chanin COO. They had in mind three ETFs: one holding diamond miners, another tracking small silver producers, and a third made up of companies that service miners. Metals were soaring, so the new themes seemed like money magnets.
Chanin chose a New York company called International Securities Exchange to devise his indexes. ISE has cooked up indexes that track things like Wal-Mart’s suppliers; Israeli tech stocks; and companies that make things that are bad for you: gambling, cigarettes, and booze. The symbol for a now-defunct ETF that tracked that last index (or SINdex, as ISE sold it) was PUF.

There’s little that can’t be outsourced in ETF-land.

Chanin needed a prospectus, approval from the U.S. Securities and Exchange Commission, an exchange listing, and a hairball of other things that go along with launching a regulated investment company, which is what an ETF is.
He chose ETF Managers Group, in Summit, New Jersey, to make all that happen. Founder Sam Masucci is trying to be a one-stop shop for ETF entrepreneurs. He also helps with marketing and sales, which is the toughest part for small ETFs. “ETFs are sold, not bought,” Masucci says. “You’re fighting for shelf space.” Chanin rolled out his three funds in November 2012. The diamond one sported the ticker symbol GEMS. Even so, it struggled to attract investors. Chanin tried to spread the word, appearing in videos on HardAssetsInvestor.com and other sites. GEMS and the mining ETF (MSXX) liquidated in January 2014.
Zimnisky left that same month (he didn’t return phone calls asking for comment), and Chanin was on his own with one ETF, the tiny PureFunds ISE Junior Silver Small Cap Miners/Explorers ETF (SILJ). He hadn’t been drawing a salary since starting PureFunds; he says he lived on a single slice of pizza for lunch, day after day.

A small-cap silver fund wasn’t going to pay the rent, not after metals plunged. But his friends at ISE were about to huck him a lifeline.
Like so many other crafts, building securities indexes has become something of a commodity. For years, ETF sponsors were required by the SEC to use indexes invented by other firms and to keep those firms at arm’s length. Otherwise, a sponsor could develop plans to change an index by adding another stock, say, and at the same time instruct employees to buy the stock. When the change in the index was executed, demand would drive the shares higher.

Keeping the fund sponsor and the index provider separate would mitigate the risk of such front-running.
Then, in 2006, the SEC allowed WisdomTree Investments to “self-index,” provided the methodologies behind its ETFs were rules-based and transparent.
Self-indexing is now widespread, and companies such as ISE have more competition. They have also lost some of the pricing power that brings them a chunk of an ETF’s fee action. ISE, for one, became an ETF venture capitalist, investing money to get ETFs up and running, in exchange for more of the fees.
Kris Monaco heads the ETF venture group at index builder ISE. HACK tracks an index created by ISE.
Kris Monaco heads the ETF venture group at index builder ISE. HACK tracks an index created by ISE.
The idea for computer security struck ISE’s ETF venture team, led by Kris Monaco, in 2012. Hacking was in the news, it was scary, and it was untapped. “There was no classification for computer security,” Monaco says.
He reached out to some fund sponsors, but no one was interested. So he shelved the idea. Then more hackers attacked, and ISE dusted it off. Index manager Mark Abssy started digging into the industry, learning about attacks and sifting companies that defended against them.
When you make indexes, you make enemies, Abssy says. ETF wonks can have strong opinions about what mix of companies should represent an industry. “I get guys calling me up with plenty of vitriol saying, ‘Why is this name in here?’” Abssy says.
For computer security, some companies are obvious, like Fortinet, which makes mostly hardware- and software-based firewalls. At other companies, like Cisco Systems, security is dwarfed by other businesses. But Cisco also controls 12 to 15 percent of the anti-hacker market, Abssy says. Monaco and Abssy decided that both focused upstarts and eclectic giants had to be included in their index.
Computer-security companies, in their analysis, fell into two broad categories: those that made infrastructure, like firewalls, and those that provided consulting and other services.
The formula for picking companies in those categories and setting their weights in the fund can be seen in the methodology guide for the ISE Cyber Security Index, a 23-page Levitical document written so strictly that the index probably could be resurrected even after an asteroid hit the Earth.
In the midst of the research, ISE reached out to Chanin at PureFunds. He loved the idea. So ISE pressed on and published the methodology on Sept. 2, 2014.
The HACK ETF launched on Nov. 12. The first headlines about the Sony hack hit Nov. 24. HACK jumped as cybersecurity stocks rallied. Then, in February, health insurer Anthem said computer intruders had stolen data on tens of millions of customers. HACK has been in orbit ever since, returning 21.7 percent from its inception through July 31, compared with 4.7 percent for the Standard & Poor’s 500 Index.
With fees of 75 basis points and an asset base of $1.2 billion, HACK stands to toss off fees of $9 million a year, shared by ISE, PureFunds, ETF Managers, and some of their service providers. In July, Chanin launched two new funds, one tied to mobile payments (IPAY) and another tracking companies that work with so-called big data (BDAT). He plans to hire staff.
Being the only game in town almost certainly helped HACK corral assets. On July 7, it got a competitor: the First Trust Nasdaq CEA Cybersecurity ETF. Symbol: CIBR. It had $60 million of assets after a month in business.
Chanin is still blown away by how HACK took off. “It was timing,” he says, “and a whole bunch of other things that I don’t know about and that I wish I could bottle.”


‘Smart Beta’: Bridging Active Vs. Passive and managing risk via volatility

Institutional investors have used alternative weighting and factor-driven strategies since the 1970s, though no one called them “smart beta” back then. Now that the term has become mainstream, nonmarket-cap-weighted ETFs have gained steam.

“Smart beta” approaches are currently the fastest-growing segment of the ETF marketplace, pulling in assets at twice the rate of the entire ETF market.

“The default setting for an ETF, a non-strategic beta ETF, is to be tied to an index whose components are weighted by market capitalization … A strategic (or “smart”) beta ETF, on the other hand, has its components weighted by some other criteria.”

Advantages & Disadvantages Of Smart Beta

To use smart beta effectively, you need to:

  1. Be able to identify which factor(s) can produce alpha
  2. Be able to identify when that factor will come in and/or out of favour via a market environment change

You may also need to overcome some disadvantages of smart beta; namely, the following:

  1. Ask yourself, does the expected alpha overcome higher expense ratios?
  2. More concentrated portfolios can increase return but they can also increase stock-specific risk.
  3. Wider spreads on trading these less liquid products require one to ask whether the expected alpha outweighs the risks.

Managing risk to the upside and downside via low-volatility and higher-volatility ETFs seems to be the most valid use of smart beta


Evolution of Indexing. Are you smarter about ‘smart beta’ ETFs?


Smart beta ETFs. Alternatively-weighted ETFs. Indexing 2.0. Whatever you want to call this trend in exchange-traded funds, it’s attracting more investor dollars.

Overall, Morningstar slaps its “strategic beta” label on more than 340 ETFs that together have attracted more than $310 billion in assets. The entire U.S. ETF industry consists of about 1,600 products with $1.7 trillion in assets, so strategic beta has 18% of the asset pie.

If the SPY makes you feel like you’re getting a ride from a teen who’s had one too many energy drinks, then you might like SPLV. It aims to deliver a less choppy ride for risk-averse investors, as it tracks an index comprised of the 100 least-volatile S&P 500 stocks.