LVHD: Another Example Of Low-Volatility ETFs Not Doing Their Jobs

Summary

• LVHD is a low volatility, high dividend ETF that seeks to provide investors with reasonably high and sustainable dividend payments while specifically controlling for downside risk.
• However, since its inception five years ago, LVHD has significantly underperformed the S&P 500 and failed in its goals of protecting investors from this risk.
• This article explores the reason why LVHD and other low-volatility ETFs often fail, and what signals investors can look for in order to avoid such traps.

Investment Thesis

The Legg Mason Low Volatility High Dividend ETF (NASDAQ:LVHD) is not a suitable product for those looking to limit downside risk in the event of a market crash. While there is evidence supporting the benefits of using downside risk instead of total risk to build efficient portfolios, LVHD has already shown three times how bad it responds to sudden market corrections. Investors are likely to underperform the market only with slightly better risk metrics and much worse risk-return metrics. This article will explore why a fund with such an appealing marketing pitch has actually delivered these unintended results to its shareholders.

ETF Profile

LVHD tracks the QS Low Volatility High Dividend Index, a custom index with a proprietary methodology. The fund's profile page does not offer many clues as to how it selects its constituents. The main disclosed points are that it screens for profitable companies from the Solactive U.S. Broad Market Index that can pay relatively high and sustainable dividends. Furthermore, it places individual security and sector caps at 2.5% and 25%, respectively, while limiting REITs to an exposure of 15%. Finally, the fund is reconstituted annually, rebalanced quarterly, and has an expense ratio of 0.27%.

Source: Legg Mason LVHD Overview

The ETF is reasonably well diversified by sector and has a large-cap lean. Defensive sectors, including Consumer Staples, Health Care, Real Estate, and Utilities, made up about 60% of the fund as of January 31, 2021. About 80% of the fund is in U.S. securities with market capitalizations over $10 billion.

Source: Legg Mason LVHD Overview

There are currently 76 equity holdings and three currency, cash, and derivatives holdings that total 0.77%. The top ten make up 25.91%, which is about the same as the S&P 500.

Source: Legg Mason LVHD Overview

In the last 12 months, LVHD has made five dividend payments totaling $1.1175, which works out to a yield of 3.35% based on March 5, 2021 closing prices. For the 12 months ending on February 6, 2020, LVHD's dividends totaled $1.1357 - slightly less. I believe that investors should expect dividend payments to be inconsistent year-over-year given that it reconstitutes annually with a potentially much different group of stocks. Portfolio turnover last year, for example, was 48%.

Source: Legg Mason LVHD Overview

Note: Due to LVHD's inconsistent number of dividend payments made per year, the system-reported dividend yield is not accurate. This issue has been brought to the attention of the Seeking Alpha Data Team.

LVHD Performance Since Inception

Since its inception in late December 2015, LVHD has returned a CAGR of 9.20% compared to 14.90% for the S&P 500 ETF (SPY). It modestly delivered on lowering total risk as measured by the standard deviation (13.24% vs. 14.63%) but ultimately failed on maximizing downside risk-adjusted returns (0.92 vs. 1.47).

Source: Portfolio Visualizer

LVHD struggled during the pandemic, producing a higher maximum drawdown than the S&P 500 and significantly lower returns since the market bottomed out in March. From January to March 2020, it fell 24.32% compared to SPY's 19.43%.

In my opinion, the fund is too constrained by its low-volatility mandate. Low volatility strategies can be useful when market returns are smooth but usually fail to capture stocks' significant upside potential during recoveries. We saw this with virtually every low-volatility ETF on the market. Below is a summary of 24 low-volatility ETFs, showing the one-year returns from April 2019 to March 2020 and the returns from April 2020 forward.

Source: Created By Author Using Data From Portfolio Visualizer

As you can see, LVHD was one of the worst-performing low-volatility ETFs in the last two years, with its total returns being only 11.71% compared to 40.40% for SPY. Not only did it have a worse pre-pandemic return compared to the SPY (-16.78% vs. -6.68%), but its post-pandemic return fell short too (34.23% vs. 40.40%). In short, it did a poor job limiting volatility when investors needed it and then a good job when they didn't need it.

The strategy also appears particularly sensitive to the speed at which markets fall. While LVHD's history is limited, it has gone through three of the ten worst drawdown periods in the last 25 years. Each time there was a drawdown of around 5% monthly, LVHD significantly underperformed SPY in the six months that followed. I would suggest that the index is too slow to react and fails to consider how investors behave during extreme events. It's not uncommon for financial advisors to recommend that their clients rebalance when asset class weightings fall outside defined tolerance bands. Retail investors are more likely to value hunt as well, seeking out beaten-down stocks in highly-volatile sectors. Given its emphasis on minimizing downside risk, I believe it's likely LVHD will continue to miss out on these opportunities.

Source: Created By Author Using Data From Portfolio Visualizer

Research on Minimizing Downside Volatility

The Sharpe and Sortino Ratios are two common ways of measuring risk-adjusted returns. They both calculate excess returns the same (actual returns less the risk-free rate of return) but differ in their risk calculations. While the Sharpe Ratio considers both upward and downward volatility to be negative, the Sortino Ratio only considers downward volatility to be negative. It's logical, as investors have no problem with their investments producing abnormally high returns. Therefore, it is theorized that the Sortino Ratio is superior.

Solactive Research appears to support this viewpoint. In a 2017 white paper, backtesting the strategy found that low downside volatility portfolios outperformed low volatility portfolios by an average of 0.45% per annum (8.27% vs. 7.82%). The Sharpe and Sortino Ratios were also superior.

Source: Solactive Research White Paper: The Downside of Low Volatility

At the same time, it is only 0.45%. It is not nearly enough to offset the underperformance noted earlier, especially given the high probability of more volatility to come as we recover from the pandemic.

Investment Recommendation And Conclusion

I find that LVHD is not a good candidate for controlling volatility during extreme market events. On the contrary, I expect it to severely underperform after markets bottom out and only after providing a modest level of downside risk protection.

While LVHD correctly places more emphasis on downside risk than total risk, it does so at great expense by ignoring investor behaviors during periods of market turmoil. Advisors rebalance client portfolios, and value investors seek out the highly volatile stocks that LVHD screens out. Remember that there is no such thing as a safe stock during a market crash, and nobody can predict black swans. To believe that a computer-generated model can identify them based on past price and earnings performance is naïve. Therefore, I recommend staying away from LVHD and sticking to an S&P 500 index fund or a similar-yielding dividend ETF that places less emphasis on volatility.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.