When Citigroup (C) agreed months ago to accept federal bailout money, the move came with more than a few strings attached. And now one of those strings is pulling on traditional market capitalization-weighted equity indexes, as well as the ETFs that track them, to make some interesting moves. Despite a relatively stable share price, Citi’s market capitalization surged this week as the company converted a slug of the preferred stock issued to the government in return for bailout funds to common equity. Such actions, which once upon a time went largely unnoticed, have become significantly more important as a result of the tremendous rise in popularity of index funds and ETFs. Now, such an action spurs rebalancing sprees, forcing several large funds to adjust their holdings to conform with an updated benchmark.
Citi recently announced that it is moving forward with a plan to convert a huge portion of its preferred shares into common equity, giving the U.S. government a roughly one-third ownership interest in the financial behemoth. Under the plan, about $58 billion of preferred stock and trust preferred securities (“TruUps”) held by the government and private investors will be converted to Citi common stock.
So how does all of this affect the ETF world? Although Citi’s enterprise value (debt + preferred stock + common stock) will remain exactly the same (all else being equal) following the transaction, its equity market capitalization will increase significantly. Consequently, at the close of the markets on Wednesday, the S&P 500 and the S&P Financials Select Sector Index completed a rebalancing to account for Citi’s increased weighting following resulting from the conversion of preferred stock (which does not contribute towards market capitalization) to common stock (which does). Earlier in the week, MSCI and Russell completed similar “upweights” of their indexes. And due to the magnitude of the preferred stock conversion, the impact on the constitution of these indexes was material. Citi was expected to go from about 0.20% weighting in the S&P 500 to 0.41%. Its weighting in the Financials Index increased from approximately 1.44% to 2.92%.
A second set of adjustments should come sometime after September 9th, the date Citi is currently targeting to convert private holders and government interim securities into common stock. Following the conversion, major index providers will likely complete another rebalancing within two weeks, increasing Citi’s allocation within certain benchmarks once again.
Revenue-Weighted Funds Play It Right
So market capitalization-weighted ETFs, such as iShares’ S&P 500 Fund (IVV) and State Street’s Financial Select Sector SPDR Fund (XLF), are doubling their holding in Citi following a somewhat arbitrary corporate action (arbitrary in the sense that it in no way impacts the size of the company, but significantly increases the amount of common equity outstanding). Market capitalization-weighted funds, which reduced holdings in Citi as its price plunged to around $1 earlier this year, are doubling their stake now that Citi’s balance sheet is strong enough to convert its preferred stock to common. After selling low, they’re now being forced to buy high.
The RevenueShares Large Cap Fund (RWL) and RevenueShares Financials Sector Fund (RWW) take a different approach to determining the weighting for Citi (and for all of their component stocks for that matter). RWL and RWW hold the same companies as the S&P 500 and the financials sub-index, respectively, but apply a little twist when determining the weightings of each company in the funds. Instead of weighting each component according to its market capitalization, the allocation to each is based on top line revenue. Since Citi’s revenue remained relatively stable as it endured the recent market turmoil, RWL and RWW didn’t dump their holdings in the stock and aren’t now forced to up their stake. Citi’s weightings in RWL and RWW are approximately 0.5% and 3.7%, respectively, well above the allocation in similar market capitalization-weighted funds. Relative to market capitalization-weighted ETFs, RevenueShares funds will generally overweight companies that have low price-to-sales ratios and underweight those with high price-to-sales ratios. If these ratios return to their long-run average, revenue-weighted ETFs tend to outperform market capitalization-weighted funds.
The Case For Revenue-Weighting
The argument for determining weightings in a fund according to revenue is fairly simple. Over time, top line revenue has been much less volatile than market capitalization, which can be and often is influenced by investor emotions (there is perhaps no better example than the last 12 months in the U.S. equity markets). By utilizing a revenue-weighted methodology, RevenueShares ETFs seek to increase exposure to companies with low price-to-sales ratios and decrease exposure to companies with high price-to-sales ratios.Â As irrational worries depressed Citi’s stock price earlier this year, revenue-weighted indexes held steady, positioning them to benefit if the company eventually returned to its long-run price-to-sales level (which of course it now has, to some degree). And of course Citi isn’t alone. “A lot of companies that were trading well below their fundamental value last year have seen tremendous rebounds,” says Paul Weisbruch of RevenueShares. Funds that follow a revenue-weighted methodology were well positioned to benefit from such a trend.
RevenueShares ETFs have turned in remarkable performances in 2009 utilizing this strategy. By holding the same stocks, but weighting them using a different methodology, RevenueShares ETFs have outperformed funds applying more traditional weighting methodologies:
|ETF||Underlying Index||YTD Return|
|RevenueShares Large Cap ETF (RWL)||S&P 500||14.2%|
|SPDR S&P 500 ETF (SPY)||S&P 500||10.7%|
|RevenueShares Financials Sector Fund (RWW)||Financial Select Sector Index||19.6%|
|Financial Select Sector SPDR Fund (XLF)||Financial Select Sector Index||11.7%|
Disclosure: No positions at time of writing.