Legg Mason: Low Vol, High Div ETF Hits 3 Years

Mike LaBella
Global Head of Equity
Strategy and Portfolio Manager
QS Investors, LLC

QS Investors, subadvisor and fully owned affiliate of Legg Mason, introduced one of the first ETFs in the Legg Mason lineup in December 2015. The Legg Mason Low Volatility High Dividend ETF (LVHD) captures two complementary factors in one strategy and showcases the manager’s expertise. Here, Global Head of Equity Strategy and Portfolio Manager, Mike LaBella, discusses the fund’s anniversary and what makes LVHD stand out.

Tell me about your firm’s recent milestone and what it means for Legg Mason.
We’re coming up on the three-year anniversary of one of our first ETFs [the Legg Mason Low Volatility High Dividend ETF (LVHD)], our low-volatility high-dividend ETF that we launched back in December 2015.

We’re excited about the milestone, as it comes at a junction that actually highlights how relevant LVHD is, considering the big rotation markets have experienced over the last couple of months, particularly with market volatility spiking, drawdowns coming back and tech stocks coming under big pressure.

Do you see this as a trend? How are you positioning the ETF?
We appear to be moving into a late-cycle environment with mounting inflation, rising interest rates and increasing volatility. The post-global financial crisis economic recovery is still supported by strong fundamentals, but some segments of the market have become remarkably stretched.

Growth has led the way during the nine-year historic bull run, but value has started to make a recovery of late. Now may be the time to take profits out of the crowded technology/growth/momentum trades that have been dominating markets and add exposure to “unloved” value and defensive sectors, such as utilities and consumer staples, where some investors may be underallocated. Investors shouldn’t panic, but they should consider rebalancing.

Where did the concept of blending dividends and low volatility in your ETF, LVHD, come from?
There’s an acknowledgment that there are a lot of dividend ETFs out in the market, and there are also a good number of low-volatility products out there. But when we initially started to bring these together, we weren’t thinking about just trying to get factor exposure; we were trying to solve for a specific outcome: delivering income-oriented equity market returns with better downside results.

What we found was that, historically, companies that pay a sustainable dividend yield and that exhibit lower volatility have been more supportive of that objective than either metric in isolation.

When you look at dividend-paying ETFs, for example, investors may assume that comes with higher quality and less risk; they feel good when they see dividends. But that’s not always the case, right?

If you think back a couple years ago and look at the energy sector, for example, there were some great dividend-paying names, but many of those names also came with really high volatility, and also significant drawdown. This is a good example of why targeting dividends alone isn’t enough to really identify quality.

If you look at just pure-low-volatility strategies, or minimum-volatility strategies, those are entirely statistical; they’re all backward-looking. So what does that tell you in a year like 2017, when volatility was low just about everywhere and there’s little differentiation?

What you saw was that many of those pure-low-volatility strategies started buying a lot of technology companies because they exhibited low volatility in 2017. And that certainly wouldn’t have helped this year, as technology has significantly reversed.

So, applying these screens together is really investment common sense; that is, essentially ensuring companies have strong fundamentals first—and by that we mean not just high dividends, but high earnings to support those dividends—and additionally having relatively low price and earnings volatility to help guard against potential market drawdowns.

The idea of growth and sustainable dividends, do you look at both? Do you blend them?
We think that sustainability is critical when looking at dividends. If you look at a company that just has a high dividend yield, that could be a sign of distress. Or a company could be having that high dividend yield regardless of what’s going on with its earnings or market profile.

We want to make sure that the company can continue to pay dividends over time. So the first step is evaluating for sustainability of dividends. Companies need to have enough earnings to support the dividends they’re paying out.

Now, why are dividends important for growth? If you think about equity total returns, there are really two main components. You have capital appreciation, how much a stock goes up; and you also have income, the dividend contribution to total return.

If you look at the market over long periods of time, looking back over 80 years, you see that the split between income and capital appreciation is pretty close to 50/50. Almost half of the return comes from income; the other half comes from capital appreciation.¹

Investors using traditional market cap weighted index products to gain equity exposure may be more heavily tilted to capital appreciation with less exposure to equity income. So, when we thought about this strategy in particular, part of it was about being able to deliver an option for investors to create more balance within their portfolios and enhance diversification.

How should a financial advisor approach the whole concept of volatility?
An advisor should look at volatility in two ways—as an opportunity, but also as a risk. And the risk is twofold. Not just for what’s going to happen to markets, but what it may cause an investor to do. It may cause them to make a bad decision.

We’ve seen the scars from the financial crisis. Legg Mason put out a global investor survey not too long ago, and one of the startling results of that survey was that 56% of the millennials surveyed reported that they felt pain from the financial crisis, and 60% of them reported making an emotional decision they later regretted in their 401(k). That type of scar doesn’t go away easily.

If you look at millennials’ equity allocations right now, on average, the survey shows that they only have about 40% allocated to equities in their retirement accounts. Think about their time horizon, again, from an advisor perspective. That could be a gross underallocation to an asset class that may have the highest probability of helping them attain their retirement goals.

How does LVHD fit into a portfolio?
We see people using LVHD broadly in two ways. One is as a potential return enhancer, and the other as a risk reducer. As a return enhancer, the idea here is that, since inception, this product has delivered about 20% less volatility than the S&P 500 ². That reduction in risk could allow an investor to add to their equity allocation without increasing overall portfolio risk.

An investor can move from something like a traditional 60 [equities]/40 [bonds] portfolio to something like a 70/30 portfolio with just about the same amount of risk.³ That means an investor can obtain more equity exposure while maintaining a similar risk profile, which can be beneficial from a long-term risk/return perspective.

Another way investors can leverage LVHD is as a risk reducer, by replacing a higher volatility equity allocation.”

This is especially the case with investors who are in or close to the decumulation phase.

What do you mean by “decumulation”? Retirees?
Yes, people who have retired or may be nearing retirement and may be starting to withdraw or are close to withdrawing underlying retirement income. So there, the investment objective shifts from growth towards drawdown protection and income generation. The risk management feature of LVHD can be critical for an investor in the decumulation phase or nearing retirement, as they may not have as much time to recover from a market downturn.

It’s really those two metrics—the income-producing return enhancer for those who want more equity exposure but don’t want to take on significantly more risk; or as a risk reducer, for those looking to rebalance their higher risk profile or that may be in or nearing the decumulation phase where risk reduction and income become more critical.

Past performance is no guarantee of future results.

Before investing, carefully consider a Fund’s investment objectives, risks, charges and expenses. You can find this and other information in each prospectus, or summary prospectus, if available, which is available at www.leggmason.com. Please read it carefully.

 An Exchange-Traded Fund (ETF) is a type of investment company that is bought and sold on a securities exchange. ETFs generally represent a portfolio of securities, derivative instruments, currencies or commodities. The risks of owning an ETF generally reflect the risks of owning the underlying securities or commodities the ETF is designed to track. ETFs also have management fees and operating expenses that increase their costs.

Equity securities are subject to price fluctuation and possible loss of principal. Dividends are not guaranteed, and a company may reduce or eliminate its dividend at any time. In rising markets, the value of large-cap stocks may not rise as much as smaller-cap stocks. Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks. The Fund may focus its investments in certain industries, increasing its vulnerability to market volatility. Derivatives, such as options and futures, can be illiquid, may disproportionately increase losses and have a potentially large impact on Fund performance. Distributions are not guaranteed and are subject to change.

Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, a forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. There is no guarantee that the manager’s strategy will be successful.

© Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC and QS Investors, LLC are subsidiaries of Legg Mason, Inc.

¹ Based on % contribution of price return and total return to the S&P 500, from 1930 to 2017. Source: Bloomberg.
² For period 12/31/2015 – 11/30/2018 as measured by annualized standard deviation of returns. Source: Morningstar.
³ For period 12/31/2015 – 11/30/2018 - assumes 40% LVHD, 30% S&P 500 Index,  30% Bloomberg Barclays US Aggregate Index, Source: Morningstar.