ETF Month #5: KBWY Weighed Down By Uniti – Invesco KBW Premium Yield Equity REIT Portfolio ETF (NASDAQ:KBWY)

This article was first released to CEF/ETF Income Laboratory subscribers 1 month ago, so data may be out of date. Please check latest data before making investment decisions.

During “ETF Month“, I will focus on profiling different exchange-traded funds. Some of these will be income-focused, whereas others may not be. Additionally, I may profile some higher-risk, sector-specific or leveraged ETFs that I can find particularly interesting. Hence, none of the ETFs profiled this month should be automatically considered to be “Buy” recommendations!

(Note: Due to the delay to the start of the series, “ETF Month” will be designated as lasting throughout May.)

I will also be taking ETF suggestions, so do let me know if you have any ETFs on your horizon.

What are the advantages and disadvantages of ETFs compared to CEFs?

• Most ETFs are passively managed. The advantage of this is lower fees compared to CEFs, which are actively managed. The disadvantage is that a passive fund will simply own everything in the index indiscriminately.
• ETFs will nearly always trade close to their net asset value (NAV). The advantage of this is that one does not have to worry about premiums or discounts. The disadvantage is that one does not have the opportunity to buy funds at a discount, nor to exploit the concept of premium/discount mean reversion.
• ETFs usually do not employ a managed distribution policy; in other words, they pay out as dividends what they receive as income from their underlying investments. The advantage is that one doesn’t have to worry about an ETF overpaying from its earnings, leading to destructive ROC. The disadvantage is that ETFs are generally lower-yielding than CEFs.

There are exceptions to the above, of course. Some ETFs are actively managed and will have higher fees. Illiquid ETFs may trade at significant premiums or discounts to their NAV, which demands caution when buying or selling those funds. A few ETFs use a managed distribution policy, such as the Global X SuperDividend ETF (SDIV), which is profiled in the first ETF Month feature.

ETF Month #5: Invesco KBW Premium Yield Equity REIT Portfolio ETF

The Invesco KBW Premium Yield Equity REIT Portfolio ETF (KBWY), formerly known as the PowerShares KBW Premium Yield Equity REIT Portfolio ETF, is a $349 million REIT ETF that invests in small- and mid-cap domestic REITs using a dividend yield-weighted methodology rather than market capitalization weighting. It was incepted in December 2012 and charges an expense ratio of 0.35%. Its trailing 12-month yield is 6.73%, and it is paid monthly.

According to the fund’s website:

The Invesco KBW Premium Yield Equity REIT ETF is based on the KBW Nasdaq Premium Yield Equity REIT Index. The Fund generally will invest at least 90% of its total assets in the securities of small- and mid-cap equity REITs in the United States that comprise the Underlying Index. Keefe, Bruyette & Woods, Inc. and Nasdaq, Inc. compile, maintain and calculate the Underlying Index, which is a modified-dividend yield-weighted index that seeks to reflect the performance of such companies. The Fund generally invests in all of the securities comprising the Underlying Index in proportion to their weightings in the Underlying Index. The Fund and the Index are rebalanced and reconstituted on the third Friday of March, June, September and December.

KBWY was once part of our Tactical Income-100 portfolio. However, we sold it in favor of the closed-end fund, the Nuveen Real Estate Income Fund (JRS), in August of last year as the latter’s discount widened out. It turns out that that swap was well-timed, as KBWY soon began underperforming, and we are now effectively up +14% on our REIT position since the trade compared to if we hadn’t made the swap.

What was the cause of this underperformance? As we analyzed in our last update, “KBWY Update: Recent Underperformance And Distribution Reduction” (public link), KBWY may have been hindered by its high-yield/small-size methodology that aims to invest in the highest-yielding small/mid-cap REITs on the U.S. market. When riskier issues were melting down during last December’s correction, KBWY became disproportionately affected compared to the benchmark REIT fund, the Vanguard Real Estate ETF (VNQ).

Weighed down by UNIT?

More recently, KBWY appears to have been weighed down by its investment in Uniti Group (UNIT), which is currently by far its largest holding at 9.35% of assets.

(Source: Invesco)

UNIT was added to KBWY’s index during last December’s rebalance:

(Press release)

UNIT has become quite the battleground stock on Seeking Alpha. The stock price lost -37% in a single day when Windstream (OTCPK:WINMQ), which is linked to UNIT via its master lease, lost a widely publicized trial against Aurelius Capital Management. Windstream has since filed for Chapter 11 bankruptcy. At its lowest point, UNIT was down -66% from its 52-week high of $23.42, and currently still sits -54% below that peak.

While I don’t have anything particularly insightful to add to the saga, it is interesting to note that the ETF has undergo another rebalancing after the Windstream debacle.

The timing of the rebalance couldn’t have been more unlucky for KBWY. Just a few days after the rebalance was effected (March 15), UNIT announced a -92% distribution cut, cratering the yield.

Before the cut, it had a yield of around 24%, and so it would have sat as the top holding in KBWY’s index due to its outsized yield. Needless to say, if UNIT had announced the distribution cut before the rebalancing date, then it would have been dropped from the index altogether.

The silver lining from this is that UNIT has actually done pretty well since the rebalance, up around 15%. Still, counting from last December, when the stock was first added to KBWY, UNIT has been a drag on the ETF’s performance, especially due to its overweight position in the index. I estimate that the share price damage to UNIT contributed around -2% to -3% of underperformance overall to KBWY as a whole.

Distributions continue to fall

Because of the unlucky timing of UNIT’s distribution cut announcement mentioned above, KBWY is in the unfortunate position of having to hold sub-2% yielding REIT as by far its largest position (9.35% weight) until the next rebalancing date, which is slated to be June 21 (the third Friday of June). This means that the decline of distributions we discussed about in our last update has continued to accelerate.

Not counting an aberrantly low distribution in September, the monthly distribution from KBWY is now lowest since the end of 2015. The 1-year dividend growth rate (DGR) is now -18.1%, although the 3-year and 5-year DGRs are still positive at +5.3% and +8.2% respectively.

The TTM yield of KBWY is now down to 6.74%, which is significantly below its levels seen last year.

On the positive side, we should see an uptick in yield in KBWY when UNIT, the largest holding in the index, gets replaced next month. All other things being equal, of course.

Here are the top 10 holdings again with their yields as well as their yields. We can see that in terms of yield, one of these REITs is not like the others! (Hint: It’s UNIT.)

(Source: Invesco)

The following shows the yields of KBWY’s top 10 holdings in bar chart form.

As expected due to its value focus, many of these REITs are facing headwinds, which could explain their high yields. For example, the second- and third-largest holdings, PEI and WPG, are retail REITs that are under pressure from the ongoing “death of retail” phenomenon.

We’re not in the business of analyzing individual REITs, so I called upon our resident REIT expert, Jussi Askola of “High Yield Landlord”, who collaborates with our newsletter, to provide his expert opinion on the top 10 holdings of KBWY.

It is very speculative stuff. From this list, the only solid companies are KRG and GLPI – the rest is junk. I am bullish on UNIT but it is very risky.

It is really a bet on deep value REITs – companies that have greatly underperformed in the past years. Most often due to asset quality which is an issue that is difficult to solve over time.

Summary

KBWY has probably been a disappointment to investors on both the capital appreciation and income fronts, (no) thanks to UNIT. However, does that mean that it is an automatically bad ETF? Not necessarily. Both small size and high yield are generally viewed as factors that deliver positive alpha versus a market capitalization-weighted benchmark over long periods of time. Moreover, with regard to REITs, especially, Jussi has presented data in a recent article showing that small-cap REITs trade at 12x FFO versus large-cap REITs at 20x FFO, meaning that KBWY’s small-/mid-cap focus actually delivers a “value” factor as well (this is in contrast with the broader stock market, where faster-growing small-cap stocks tend to trade at higher valuation multiples compared to large-cap stocks). Finally, as we’ve noted before, KBWY has shown periods of outperformance versus the benchmark VNQ, particularly during risk-on environments. In fact, the KBWY/VNQ ratio is currently at the lower end of its historical range, suggesting that KBWY is now currently cheap versus the benchmark.

In a nutshell, the recent year has a been a difficult period for KBWY due to the confluence of multiple negative factors: the December sell-off, the ongoing “death of retail” phenomenon and the UNIT saga. However, I am still positive on the methodology overall and believe that KBWY will once again have its day in the sun.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.