These Reverse Splits Are Not What They Seem

Reverse stock splits are often viewed solely as bad news for stocks. And unbeknownst to many, even exchange-traded funds (ETFs) execute reverse splits. With both groups, reverse splits can be cause for a little more investigation, but they're not always purely bad news, especially for ETFs.

Consider this news: The folks at Direxion, which offers a bunch of highly leveraged bullish and bearish ETFs, have just announced plans to execute reverse splits for six of their funds. Five, including the Direxion Daily Financial Bull 3x Shares ETF  (NYS: FAS) , will be splitting 1-for-5. Another, the Direxion Daily Russia Bull 3X Shares ETF, will split 1-for-3. What does it all mean?

Putting it in context
A traditional stock split, such as the 2-for-1 split that Freeport McMoRan Copper & Gold (NYS: FCX) executed early this year, often gets investors excited, but it's really not too meaningful. If you had 100 shares of Freeport when it closed at $114 per share on Feb. 1, you had $11,400 worth of stock. The next day, after the split, the stock opened at about $57 per share, which is half of $114. You may have been suffused with glee to now see 200 shares in your portfolio, but 200 times $57 is ... $11,400. The overall value of your shares didn't really change.

Companies do stocks split for various reasons, sometimes in order for their shares to be more affordable. Google shares, for example, were recently trading above $500 per share, making some people feel unable to invest in it (even though you can buy just one share of a stock). Warren Buffett's Berkshire Hathaway (NYS: BRK.B) class B shares were trading around $3,500 per share until the company split them 50-to-1 in early 2010, thereby reducing them to around $70. (The catalyst was the purchase of the Burlington Northern railroad, which required small payments of stock to shareholders.)

The red flag
Reverse splits, though, are another beast. While you shouldn't get too excited about a regular split, you should take a close look at a reverse split, as it's often executed by a company in trouble, in order to prop up its stock price and make it look more respectable -- or to enable it to meet stock exchange listing requirements.

Many well-known companies, including E*TRADE (NAS: ETFC) and Citigroup, have executed reverse splits when they weren't at death's door -- albeit with mixed success. Not so long ago, Sirius XM Radio (NAS: SIRI) looked like it might do well to execute one. It's now in better shape, although its conservative projections are worrying some investors.

Meanwhile, having gobbled up Global Crossing, Level 3 Communications (NAS: LVLT) is executing a 1-for-15 reverse split, which will boost the stock's recent price of $1.70 per share to roughly $25, a much more dignified level. As the company expands its content delivery networking business, it has attracted more believers.

Beleaguered transportation company YRC Worldwide executed a 1-for-25 one last year and with its stock all the way down near $0.06 per share, it's considering another one -- a whopper, too. Its shareholders are being asked to approve a split of up to 1-for-300. The stock seems to be in big trouble, although it's actually generating more cash than is immediately apparent.

When ETFs split
Armed with all that perspective on splits and reverse splits among common stocks, let's visit our about-to-reverse-split ETFs. Since these aren't companies, but are instead bundled investments in various companies, we shouldn't view a reverse split as automatic cause for concern. Remember that the F in ETF stands for fund. Fund managers often set an initial price, which can then move up or down a lot.

As Chuck Jaffe pointed out at MarketWatch.com last year, "[S]ome technical issues in how ETFs work could result in low-priced volatile funds sometimes trading at a net asset value that is different from its actual share price; that's an invitation for traders trying to game the system. Low share prices also allow the smallest fast-money traders to get in and out with very little skin in the game."

Direxion's real red flag
With Direxion's issues, they're extra likely to move sharply, as they're often very leveraged. The "3X" ETFs, for example, are designed to deliver three times the market's daily return -- or loss. As my colleague Travis Hoium has explained, that tends to push their returns down over time. In fact, he called them "the riskiest investments on earth." With prices so volatile, it's not surprising to see occasional splits to pull up per-share prices.

It's also clear that in cases such as these, with highly leveraged ETFs, it's not the reverse split that's the red flag, but the leverage itself. My colleague Dan Caplinger has looked at various Direxion funds and noted that both its bull and bear funds can plunge in value over the same period -- and have.

The next time you read about a reverse split, know that it's not necessarily a portent of doom, but it might be time to do a little digging into what's going on with the investment. Both great stocks and disaster stocks have executed reverse splits.

There are plenty of terrific ETFs out there that can serve you well without any or many reverse splits or implosions. Check out our free report: "3 ETFs Set to Soar During the Recovery."

At the time this article was published Longtime Fool contributor Selena Maranjian owns shares of Google, but she holds no other position in any company mentioned. Click here to see her holdings and a short bio. The Motley Fool owns shares of Google, Citigroup, Berkshire Hathaway, and Freeport-McMoRan Copper & Gold. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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