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YieldCos are a relatively new market entrant focused on paying dividends. Despite some popularity among income investors, they are, at best, untested. But that didn’t stop Global X from creating an ETF to track them. I have misgivings about exchange traded funds, or ETFs, in general. While a good idea on one level, Wall Street has a habit of turning good ideas into misused and abused ideas. Which is why Global X YieldCo Index ETF (NASDAQ: YLCO ) caught my attention. I’d say this ETF is a risky investment that most investors should avoid. Here’s why… What’s a YieldCo? So an ETF is a collection of stocks or bonds that trade on an exchange all day long. Sort of like a mutual fund, sort of like a closed-end fund. The ability to trade all day makes ETFs similar to closed end funds. But the market price for a closed-end fund can vary greatly from its net asset value. The structure of ETFs lead them to trade pretty close to net asset value, like a mutual fund. ETFs are also very cheap to own. There is, in fact, a lot to like about ETFs, so long as you stick to large, well diversified funds. But Wall Street, seeing a hot new product, has ramped up its marketing machine. How many S&P 500 ETFs do we need? Not many. Which is why ETFs have gotten more and more obscure, often targeting niche areas and risky investment approaches. Is there a place for these vehicles? Probably. Should average investors be putting their money in them? Probably not. Which is why a YieldCo ETF caught my eye. YieldCos are a relatively new business construct, dating back to around 2012. At this point, they are very similar to a limited partnership structure in which there is a sponsor company that sells its assets to the YieldCo. The YieldCo then spits out income to shareholders. The big difference is that the YieldCo is generally a regular company, so there’s fewer tax headaches than you would face with an LP which is structured as a partnership. On the surface this sounds great. The YieldCos in existence have generally owned electric generating assets with long-term contracts in place, so there’s even some ability to predict a reliable income stream. Investments in the renewable power space (solar and wind, for example) are most often highlighted, though YieldCos own other types of electric generation, too. Growth comes from buying more and more assets. Like LPs and REITs, however, YieldCos spit out so much income that they have to issue more shares to pay for additional assets. There’s nothing inherently wrong with this, since there are obvious precedents for the business model. However, that still doesn’t mean this relatively new business model will work out as planned. Moreover, the focus on renewable power projects means that YieldCos are tapping into a current investor interest. That’s great right now, but what if investors lose interest? So, by and large, I’d say that YieldCos have an interesting story behind them. But, and this is a big but, the long-term legs of the story remain untested. So investors should tread lightly in the YieldCo space, tempering a desire for income and income growth with a bit reality about the very short life most of these entities have lived. If you want proof of these risks, take a moment to look at the recent events around NRG Energy (NYSE: NRG ) and its YieldCo NRG Yield (NYSE: NYLD ). Diversify to reduce risk Of course, one way to offset the risk of owning just one or two YieldCos would be to buy a portfolio of them, right? And that’s where Global X’s YieldCo product comes in. It owns 20 of the largest YieldCos and provides a one-stop shop for getting diversified exposure to this potentially up and coming space. Wait… There’s some problems here. YLCO does own 20 stocks, but its prospectus explains a minor detail you’ll want to watch: “The components of the underlying index are YieldCos selected from the universe of global publicly listed equities, which have a minimum market capitalization of $500m and an Average Daily Value Traded (“ADVT”) over the last three months greater than $1 million. If less than 20 securities satisfy this criteria, the market capitalization and ADVT requirements are lowered. If there are still fewer than 20 securities, the parent companies of proposed YieldCos with the nearest anticipated listing dates will be included in the index until there are 20 index constituents.” In plain English that says, “We want to own 20 YieldCos but there aren’t that many of them right now. So we buy all that we can, even really tiny ones. Since that still may not lead to 20 holdings, we’ll buy companies that aren’t YieldCos but that have said they want to spin one off.” So YLCO has built a niche ETF in a sector that doesn’t have enough stocks in it to support a portfolio of 20 sufficiently sized companies. Think about that for one second. You are buying everything in the sector without any regard to whether or not it’s a good or bad company. With only little regard to size. All a company needs to be is a YieldCo, or a company that says it wants to spin a YieldCo off, to pass muster with Global X. Sure, you’ve got broad exposure to this relatively new niche, but is that really the way you want to get it? If the YieldCo sector continues to grow and manages not to implode, YLCO could become a useful way for investors to get diversified exposure to the space. So, on that level, it’s not a bad idea. However, the YieldCo space just isn’t mature enough at this point to support what YLCO wants to offer. And, in the end, conservative investors should avoid it. In fact, I’d go so far as to say that most investors should avoid it until the YieldCo space has grown some more and YLCO has been stress-tested by the market. Scalper1 News
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