Income can be tough to find in today’s market. And for many investors, a monthly dividend payment is their primary investment goal. With domestic opportunities offering fewer diversification benefits, many investors are looking beyond the local markets for dividend income with greater diversification.
However, focusing on dividend yield alone can lead to increased volatility and the possibility of falling into “yield traps”.1 Combining investment factors in a portfolio can help solve for this (for more on factor investing, read “Q&A: What is factor investing?”). Adding a low-volatility screen to a dividend screen creates an index that can offer investors access to companies with strong dividend growth while helping avoid the traps that dividend investing can present.
To discuss the power of combining factors to create a high-dividend, low-volatility strategy, I sat down with two experts from S&P Dow Jones Indices.
Below are highlights from the conversation I had with S&P Dow Jones Indices’ Craig Lazzara, Global Head of Index Investment Strategy and Shaun Wurzbach, Global Head of Financial Advisor Channel Management.
Chris: Can you discuss how the low-volatility factor works in combination with the dividend factor in portfolio construction?
Shaun: In factor investing, dividends pair very nicely with low-volatility strategies. We often hear advisors talk about dividends in terms of the cushion they can provide in volatile times – the potential for downside protection from companies that have grown their dividend over time.
We see many advisors looking for the low-volatility and dividend factors in combination. In fact, there is a high-dividend, low-volatility composite index that many advisors find to be a very interesting combination. I think dividends are one factor that advisors would find value in combining with low-volatility, when you consider that many are looking for some level of protection. Another idea that might work well in that sense is quality.
When advisors are feeling skeptical about the equity market, many tend to trade up to quality. This is something that we’ve seen occur for decades. When we talk to older investors they often say, “When times get tough, investors goes into blue chips.” That is really a quality statement. In addition to dividends, I think quality is a factor that many advisors would combine with low volatility.
Chris: Can you talk a little about how low-volatility/high-dividend indices are constructed at S&P?
Craig: The first thing we do is screen for the highest-yielding stocks in the index we’re working with. For example, in the S&P 500, we identify the top 75 highest-yielding stocks, and of those 75 we remove the 25 with the highest volatility. From there, we weight the remaining 50 by yield.
The indices have both a yield screen and a volatility screen. The reason that combination makes sense, in our view, is that there are times in markets when a stock may have a high yield because the business is in trouble. In these cases, it’s likely, or at least highly probable, that the dividend may be cut. The market has priced it in, but the official dividend data don’t reflect it. So the stock price has dropped, maybe even in anticipation of a dividend reduction or some business difficulty.
This is a variant of what’s often referred to as a value trap – when a stock is cheap for a specific reason, and an investor buys it only to find the price continues to fall.
One way to help avoid a value trap is to apply a volatility screen. Eliminating those stocks with the highest volatility is likely to remove stocks that have a particularly high yield because of some underlying problem in the business that has not yet been reflected in official dividend data.
As we know, investors are seeking yield – globally, yield is a top priority for many investors.
Given the construction process for the low-volatility, high-dividend indices, the strategies tend to have a substantially above-average yield, and the low-volatility screen provides an added level of protection from the possibility of a value trap. For these reasons, combining these two factors has proven attractive for many advisors and their investors.
Chris: Is it fair to consider the combination as a high-dividend strategy with a quality screen?
Craig: Yes, that’s fair. I think of it that way.
Shaun: It’s a volatility screen, and I think it’s reasonable to impart quality on that. Craig has spoken in the past about the power of removing something from a benchmark – that which you think is not going to perform. In my experience, that is how many advisors perceive this strategy – throwing out what might be the poor performers among dividend-paying companies. Right from the get-go many advisors we spoke to saw real value in this type of strategy for constructing client portfolios.
For an investor looking for U.S. or global equity exposure and high dividends, this combination of factors can provide both with the added benefit of having lower volatility than other, traditional dividend strategies. In fact, based on analysis of our index data, hypothetical combinations of these indices combined with the benchmark index shows higher returns with less volatility than the benchmark alone.
Advisors who understand this can then see how to position these indices as a risk-management tool. Their goal in using these indices for risk management would be to measure maintaining equity exposure with potentially higher return and yield while lowering portfolio standard deviation compared to core-only equity exposure. And of course, since there are now ETFs tracking these indices, they are able to put that risk management technique into practice if it suits their clients’ needs. I think that it’s a combination of a simple but powerful strategy within a very well-known and accepted benchmark (the S&P 500), so it’s likely to be globally accepted by advisors. In fact, these low-volatility, high-dividend indices have been licensed in Australia and the U.K. as well.
If you have any questions about high-dividend, low-volatility strategies, please leave a comment below.