In 2018, volatility made a surprise comeback. After being flat for most of 2017, the VIX Index, Wall Street’s barometer for volatility, spiked at the beginning of February to reach its highest level in two years. Volatility has mostly declined since then, but with central banks applying the brakes, investors are bracing themselves for a new era of increased volatility.
Historically, defensive strategies such as dividend exchange-traded funds have offered downside protection during periods of increased market uncertainty. So far this year, however, this hasn’t been the case. From January to April, most US dividend ETFs, including Morningstar Medallists – Gold, Silver and Bronze rated funds – underperformed the S&P 500.
SPDR S&P US Dividend Aristocrats ETF (UDVD), which carries a Morningstar Analyst Rating of Silver, was down 3.32% compared with a fall of 0.55% for the S&P 500. The fund selects companies that have increased their dividends for 20 consecutive years.
What Caused the Bad Performance?
The last bout of volatility revealed one of the biggest risks of dividend-oriented funds, namely, their sensitivity to rising rates. Interest rates influence dividend-oriented strategies in two ways. First, when rates fall, investors pile into dividend-oriented strategies to make up for lost income.
Conversely, when rates rise, fixed-income assets look more compelling. Second, interest rates tend to rise when the economy is strengthening and fall when it’s weakening. When the economy expands, cash flows for dividend payers don’t rise as quickly as they do for their cyclical peers, providing a smaller offsetting effect to cushion the blow of rising interest rates.
The recent volatility spike was fuelled by fears of rising rates on the backdrop of increasing inflation. As such, it’s not surprising that most dividend-oriented ETFs trailed behind their cap-weighted peers in the first half of 2018. In March, the Fed raised its benchmark interest rate to a range of 1.5%-1.75%, but with inflation hovering around 2%, further rate hikes are on the table.
With rising interest rates, short-term debt is finally offering more meaningful income. The current average yield to maturity for iShares $ Treasury Bond 1-3 years UCITS ETF (IDBT) is 2.49%, up from 1.29% from the year before. In other words, for the first time in a decade, dividend-oriented equity funds are competing for investors’ money with fixed-income strategies.
Low Volatility Did Better
Similarly to dividend funds, minimum- and low-volatility funds are also overweight in rate-sensitive sectors. As such, they will tend to underperform when rates are rising and outperform when they are falling. While minimum-volatility funds underperformed the S&P 500 from the beginning of the year, they managed to outpace the benchmark since the VIX began to climb in February.
As always, investors seeking exposure to strategic-beta ETFs are advised to understand how these funds are constructed and what their biases are. While two funds may claim to offer exposure to low volatility, their portfolios may be completely different.
For example, Silver-rated iShares Edge S&P 500 Minimum Volatility ETF (SPMV) attempts to construct the least-volatile portfolio with stocks from the S&P 500. Because the fund’s overall goal is to reduce risk, it may hold average- to high-volatility stocks if they increase the diversification benefits of the overall portfolio.
As such, the fund should outperform the market when volatility is elevated, even on the backdrop of rising interest rates. Comparatively, if rates are rising but volatility is low, the fund may struggle to outperform owing to its defensive posture.
Bronze-rated PowerShares S&P 500 High Dividend Low Volatility ETF (HDLV) targets the highest-dividend-yielding stocks in the S&P 500 but keeps risk in check by filtering out some of the riskier names from this group and by capping individual stocks. While the fund offers exposure to yield and low volatility, its primary focus is to provide dividends.
In fact, the fund’s 12-month yield was 3.47%, compared with 2.04% for SPDR S&P US Dividend Aristocrats. Clearly, the PowerShares ETF offers an aggressive approach to dividends and uses the low-volatility screen to mitigate risk. From January through to the end of April, the PowerShares ETF underperformed SPDR S&P US Dividend Aristocrats by 2.08%.
Playing Defensive with Multi-Factors
The current rising rate environment in the US is a testament to the cyclicality of factors. Factors have and will continue to experience their own unique cycles. Stretches of market-beating performance will invariably be followed by prolonged droughts. With that in mind, diversifying across complementary factors, those that have lower correlations to each other, makes sense. It can result in a more stable risk/reward profile than any single-factor fund in isolation.
Investors seeking exposure to US multi-factor equity funds may look to Bronze-rated iShares Edge MSCI USA Multifactor ETF (IFSU) and UBS MSCI Select Factor Mix ETF (USFMD). The iShares fund offers stronger factor tilts by using an optimiser, while the UBS fund equally weights six single-factor indexes. Not surprisingly, these ETFs have outpaced their dividend and low-volatility counterparts so far this year.
The single most compelling reason to opt for a multi-factor strategy is that it will minimise the biggest risk of all: that investors will bail on a factor, manager, or strategy when they experience an inevitable period of underperformance. Staying invested is perhaps the most reliable defensive strategy of all.
