Stock splits are typically seen as bullish events, even though they don’t change the value of your investment. They simply increase the number of shares outstanding and reduce the price per share on a proportional basis.

What’s important is the reason for a split. Companies usually do it when the stock price has risen so high that management thinks a price cut is necessary to keep shares looking attractive for investors, many of whom equate lower-priced shares with better values.

Investors tend to see a stock split as a sign of financial strength, since splits are often announced at the same time as dividend hikes. Plus, studies have found a strong positive correlation between stock splits and future earnings growth.

Clearly, splits have positive implications for portfolio performance, and a good real-world example of this comes from a unique exchange-traded fund called the USCF Stock Split ETF (NYSE: TOFR). The fund, which provides an easy way to gain regular exposure to stock splitters, has risen roughly 10% in value since last September, while the S&P 500 has risen around 7%. 

The fund is still only about eight months old, and only has about $5 million in net assets thus far. However, TOFR has delivered promising results so far with sensible and systematic strategy.

Its goal: track the equal-weight 2-for-1 Index^® created by NYSE Euronext, the well-known securities exchange operator. As its name implies, the index is dominated by stocks that recently split shares on a 2-for-1 basis, the most common type of stock split. Stocks with greater split ratios are sometimes included, though.

#-ad_banner-#Like its benchmark, TOFR generally holds 30 common stocks in roughly equal proportions, each of which typically carries a 3%-to-4% weighting in the portfolio. The lion’s share of holdings (84%) are U.S. companies. Foreign holdings are limited to those traded on a major U.S. exchange.

To ensure that the portfolio holds stocks with the most recent splits, the index manager aims to add a new stock and delete the longest-held one monthly. Thus, the holding period for each stock is generally capped at 30 months. New additions have typically split within the past two months and “may be from a wide range of industries and from a wide range of market capitalizations,” according to TOFR’s latest prospectus.

At present, the portfolio is comprised of 37% large-cap stocks, 27% mid-cap stocks and 34% small-cap stocks. Fund holdings currently have an average market value of about $9 billion.

To keep the stock selection process systematic and impartial, new candidates are ranked with a proprietary algorithm that incorporates a number of variables. These include the date of the stock split; price-to-earnings ratio; price-to-book ratio; beta (the stock’s volatility relative to the broader market); dividend yield; market capitalization; and daily trading volume.

In the unlikely event that the selection process yields no suitable picks, the index manager may still opt to delete the oldest holding but not make a new addition, temporarily leaving the index short a stock. Or the index may simply be left unchanged.

The latter case would be the only time that a stock might be in the index for more than 30 months. The fund will, on occasion, add an extra short position in any given month.

The following table lists the top 10 fund holdings as of May 15.

TOFR currently has positions in several well-known firms in addition to Starbucks Corp. (Nasdaq: SBUX) and Apple Inc. (Nasdaq: AAPL). These include consumer products giant Colgate-Palmolive Co. (NYSE: CL), specialty retailer Tractor Supply Co. (Nasdaq: TSCO) and railroad industry leader Union Pacific Corp. (NYSE: UNP). In each case, there was a two-for-one split within the past couple years.

Compared with its Morningstar category (mid-cap growth), TOFR currently allocates a substantially greater proportion of assets to the basic materials, consumer cyclical, financial services and utilities sectors. The fund is markedly underweight in the energy, technology and healthcare sectors. Thise weightings are subject to change, depending on which companies in the future decide to split their stock. At 2.1%, its annualized dividend yield is similar to the category average of 2.4%.

As a group, though, fund holdings have been displaying significantly faster-than-average growth in sales, earnings and cash flow. This has likely contributed to TOFR’s noticeable outperformance relative to the S&P 500 since inception.

Risks To Consider: A 29- or 30-stock portfolio like TOFR arguably does not provide adequate diversification. Also, the selection process for its benchmark may often lead to highly concentrated positions in particular sectors, industries or market capitalizations. This, too, contradicts the conventional wisdom about diversification.

Action To Take –> TOFR was never intended as a diversified core portfolio holding and shouldn’t be regarded as such. However, it’s an effective tool for capitalizing on stock splits, and results so far suggest it can outperform. Since TORF is really just getting underway, investors may want to start off with small positions and build their exposuregradually into a meaningful satellite holding as the fund establishes a longer-term track record.

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