Inside the ETF That Uses Supply and Demand to Pick Stocks

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Many investors take a fundamental approach to stock selection. They seek to find securities that have the best metrics in terms of PE ratios, dividends, or favorable trends on a variety of other statistics.

While this is a time tested strategy, many probably haven’t considered taking into account the forces of supply and demand and how this relates to stocks as well.

Investment research firm TrimTabs does just that by looking at what is called ‘float shrink’ in order to determine which securities are reducing the supply of their shares. TrimTabs believes that this shrinking float is vital to stock selection as the firm views stock prices as a function of supply and demand rather than value.

Intuitively, this makes sense; the same level of investor interest or capital going after a reduced number of shares should, in theory, lead to a higher average price. While it is an idea that is straight out of an economics class—and one that we are all very familiar with-- many investors fail to consider this aspect when constructing their portfolios (read 5 Best Performing Active ETFs).

Not to worry though, as TrimTabs has an exchange-traded fund around this strategy, which though overlooked by many investors, has actually been beating out the market over the long term. For those interested in this unique approach, we have highlighted more about this strategy below and how investors can utilize this approach in their own portfolios with the AdvisorShares TrimTabs Float Shrink ETF (TTFS):

What is Float Shrink?

‘Float Shrink’ is an idea that looks at corporate actions and how they influence the ‘float’ which is another way of saying the number of shares that are free to trade of all the shares outstanding. TrimTabs dives deep into a variety of actions in order to determine if the float is increasing, shrinking, or staying the same, zeroing in on secondary offerings, M&A activity, share buybacks, and certain types of insider activity in order to find the answer.

However, this isn’t the end of the process, as there is also a quality aspect as well. Managers look to find companies that are shrinking the float by increasing free cash flows, and not by taking on more debt.

Additionally, since this an actively managed strategy, TTFS managers can get in as soon as fresh corporate actions that shrink the float are revealed, while it can exit right when unfavorable plans are announced that either suggest float shrink activity is fading or even if the float is increasing (See Forget Dividends Focus on Buyback ETFs Instead).

“Investors have been experiencing more than a decade of stock supply shrink.  The number of companies available for the public to invest in has plunged from 7,562 in July 1998 to 3,663 in March 2014 (measured by the members in the Wilshire 5000 Index), as public companies were bought out, went private, or delisted,” said Minyi Chen, EVP and Portfolio Manager of TTFS.  

“According to our research in float shrink strategy, picking the companies that implement float shrink policies in a right way could result in long-term outperformance and lower volatility.  Both characteristics are highly valued for equity strategies,” continued Chen.

TTFS Portfolio

This results in a portfolio of about 100 stocks that is pretty well spread out from a market cap perspective. Currently, the holdings have a skew towards consumer discretionary, technology, industrials and health care, while it is light on energy, telecoms, and materials.

Investors should also note that the fund uses an equal weight methodology. While this technique is relatively foreign to most, it may have some benefits over traditional cap weighted approaches.

“Equal weight is relatively new compared to market cap weight.  In the past decade, numerous research results showed that equal weight portfolios could outperform their market cap weight counterparts in the long run on a risk-adjusted basis,” said Minyi Chen.

“Equal weight helps to reduce large cap bias in the portfolio and randomizes factor exposure at the same time.  In contrast, cap weighting tends to overweight overbought companies and underweight oversold companies,” continued TTFS’ portfolio manager (read Buyback ETFs Continue to Outperform).

Downsides

Investors should note that this strategy doesn’t come cheap, as the current net expense ratio comes in at 0.99% a year. This puts TTFS far higher than passively managed broad market funds, and several other niche products.

The fund also hasn’t really caught on with investors for the most part—despite its solid methodology—as assets under management are currently at just over $125 million. This produces a fund that doesn’t have the most robust daily average volume, so that is a factor to consider as well (though current bid ask spreads seem relatively tight).

ETF competition

Still, TTFS has been a strong performer over the long haul and it has proven to be a far less volatile strategy as well. In fact, the fund’s worst quarter since inception saw a loss of roughly 1.7% compared to a loss of 3.15% for the Russell 3000’s worst quarter. Meanwhile, for 2013, the fund beat out the S&P 500 (SPY) by a solid margin, despite having a similar beta, and it is looking good from a trailing twelve month return perspective too:



One competitor to be aware of though is the PowerShares Buyback Achievers ETF (PKW). This fund focuses on one key aspect of the TrimTabs methodology—stock buybacks—zeroing in on companies that have reduced their net shares by at least 5% in the past 12 months.

The fund has proven to be quite popular as it has over $2 billion in AUM, while it too has been a strong performer. PKW has slightly underperformed TTFS over the past two years (57.04% gain to 55.59%), but it does charge 71 basis points a year in fees (read 5 ETF Predictions for 2014).

Investors should also note that PKW focuses on companies that have reduced shares outstanding, compared to the TTFS focus on float reduction. Lastly, TTFS is active while PKW has a passive strategy, so there are definitely some big differences to consider between these two products.

Bottom Line

There are many ways to decide how to invest in stocks, but an often overlooked one is to consider supply and demand. TrimTabs does just that with its Float Shrink ETF which zeroes in on companies that have reduced the float of shares trading, have strong free cash flow, and are not deeply in debt either.

The technique has proven itself over the past few years, as TTFS has easily outperformed the S&P 500—without taking on more risk—while it has also edged out its top competitor, PKW. And though many investors haven’t embraced the product yet, the solid fundamentals behind supply demand investing suggest that you might want to take a closer look at this product for your own portfolio, and particularly if you are seeking a broad play that has the ability to outperform without adding more risk.

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