By Robert Goldsborough
In an environment of ultra-low interest rates, high market volatility, and consistent flows out of equities, investors have shown a steady interest in high-dividend-paying equities and low-volatility stocks.
Some might make the case that low-volatility stock exchange-traded funds represent the first truly successful kind of factor investing within the ETF wrapper, particularly if one excludes investing in dividend-paying stocks from that nebulous term. Indeed, Russell Investments, PowerShares, and iShares last year rolled out a host of equity ETFs geared toward high-beta, low-beta, high-volatility, and low-volatility stocks. And the ones that have drawn the most investor interest? Indisputably, they are PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV), iShares MSCI All Country World Minimum Volatility (NYSEARCA:ACWV), iShares MSCI Emerging Markets Minimum Volatility (NYSEARCA:EEMV), iShares MSCI USA Minimum Volatility (NYSEARCA:USMV), and iShares MSCI EAFE Minimum Volatility (NYSEARCA:EFAV).
Low-Volatility Stocks: When Boring Is Beautiful
With low Treasury yields, it's easy to understand why investors would be drawn to high-dividend-paying ETFs. But what explains investors' embracing of low-volatility stocks? Clearly, investors want reduced volatility, and there is a perception that a more conservative asset allocation has not adequately filled that role.
Solid historical performance doesn't hurt, either. Some note that over the past 50 years, the market's least-volatile stocks have performed about as well as the market, but with considerably less risk. The likeliest explanation for this market inefficiency -- which has persisted both in developed and emerging markets -- is leverage aversion; investors seeking above-market returns typically buy volatile stocks to do so (instead of utilizing leverage). This has the effect of whacking those risk-seeking investors with lower risk-adjusted returns. A word of caution (which the current wave of low-volatility investors hopefully is taking into account): During extended bull markets, investors in the least-volatile stocks should be prepared for extended periods of potential underperformance.
A Plethora of Dividend ETF Options
Are low-volatility stocks and high-dividend-paying ones simply two sides of the same coin? Not necessarily. They are distinct factors that are somewhat related to value. And unlike the still-narrow range of low-volatility ETFs, there is a wide variety of dividend ETF choices for investors. There are 43 dividend-themed ETFs in the U.S., and they have attracted some $7.5 billion in fund flows this year. Far and away the biggest dividend ETFs out there are Vanguard Dividend Appreciation ETF (NYSEARCA:VIG), iShares Dow Jones Select Dividend Index (NYSEARCA:DVY), and SPDR S&P Dividend (NYSEARCA:SDY).
At Morningstar's ETF Invest conference in Chicago, which takes place from Oct. 4 through Oct. 6, Morningstar associate director of fund analysis Shannon Zimmerman will moderate a breakout panel discussion on low-volatility ETFs versus high-dividend ETFs. Speakers will be Jeremy Schwartz of WisdomTree, Juliana Bambaci of MSCI, and Craig Lazzara of S&P Indices.
Pioneers in Fundamental Indexing
As the director of research at WisdomTree, Jeremy Schwartz was an early proponent of fundamentally based indexes. WisdomTree offers a suite of dividend-themed ETFs, such as WisdomTree Emerging Markets Equity Income (NYSEARCA:DEM), which has earned 5 stars from Morningstar and has outperformed the MSCI Emerging Markets Index by nearly 6% with lower volatility over the past five years by tilting toward dividend-paying stocks. WisdomTree LargeCap Dividend (NYSEARCA:DLN) has earned 4 stars and it returned 0.96% over the past five years, slightly underperforming the S&P 500 Index, albeit with lower volatility. The fund weights stocks by the total dollar amount of dividends paid, which results in a value tilt but also a less risky approach than weighting by yield since the highest-yielding stocks tend to be the riskiest.
Craig Lazzara helped develop the S&P Low Volatility Index that SPLV follows. That index selects the 100 least volatile stocks from the already high-quality S&P 500. SPLV was the most successful new launch of 2011, collecting more than $600 million that year. Since inception, the fund has returned 12.8%, compared with 9.5% for the S&P 500. Despite its low-volatility mandate, SPLV also sports a respectable dividend yield of 2.97%.
Juliana Bambaci is a senior associate for index-applied research at MSCI, which is the index provider for the suite of minimum-volatility ETFs that iShares issues. The indexes seek to reflect absolute return and volatility with the "lowest absolute risk," according to MSCI's website.
ETF Analyst Michael Rawson contributed to this article.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.