ETF Expert Corner

Mike LaBella Explains Legg Mason’s Low Volatility High Dividend ETFs

September 20th, 2016 by ETF Store Staff

In part 2 of our series spotlighting Legg Mason’s ETFs (listen to part 1 here), Mike LaBella – Portfolio Manager at QS Investors, explains a low volatility high dividend approach to investing.



Transcript

You can listen to our interview with Mike LaBella by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: About a month ago, Mike LaBella, Portfolio Manager at QS Investors, joined us on the program to spotlight Legg Mason's diversified core ETFs. QS Investors is the sub advisor on Legg Mason's ETF lineup. Today, Mike is back to spotlight Legg Mason's low volatility high dividend ETFs, and Mike is joining us via phone today from New York. Mike, great to have you back on the show.

Mike LaBella: It's great to be here.

Nate Geraci: Mike, low volatility and high dividends have been, perhaps, the two most popular factors investors have looked to take advantage of this year. I thought to begin with today, for listeners who may not fully understand these factors, we should probably set the table just a bit, and let's start with a low volatility factor. Can you maybe explain what this is in layman's terms and talk about what investors should expect from stocks exhibiting lower volatility?

Mike LaBella: Sure. The low volatility factor, or the low volatility anomaly, is the fact that, when you actually look at stock return performance, what's been observed over time is that lower risk stocks tend to outperform higher risk stocks. For those listeners who know traditional financial theory or CAPM, the Capital Asset Pricing Model that goes against financial theory in terms of, if you take on more risk you should be compensated for that. What's very robust about this factor is that this observation of these lower-risk stocks outperforming higher-risk stocks is observed, not just in the U.S., but it is observed internationally. If you go to different countries like the U.K. or Japan, including emerging markets, and it has even been observed through history when you go back in different time periods. There's been observations of how these lower volatility stocks have outperformed their higher volatility ones. The reason for this is thought to be two-fold. One is that investors oftentimes overpay for growth so, in the hunt for the next Apple or the next Google, they get very excited about a particular security, and then that growth fails to materialize and they end up getting a lower return. The other reason that's oftentimes explained for the low volatility anomaly is math. It's the fact that, when something is more volatile and it potentially could draw down more, for example, the stock declines 50%, the stock then has to go up 100% to regain that same value, so if you go down less by reducing that volatility, then you don't have to go up as much to regain it, so that's called volatility drag.

Nate Geraci: Okay, and then what about higher dividend yielding stocks? Why might this be a good screen?

Mike LaBella: Higher dividend stocks have also been observed that, and this goes back to really Investing 101 for many people who have been investing over the long run is that, if you look at stable dividend-paying companies, they tend to outperform over the long run. Again, just like low volatility stocks, this has been observed in different environments, as well as in different countries. Once again, very important in why the high dividend factor has been getting a lot of attention is, in a low interest rate environment where people have been struggling to get income from traditional fixed income, these dividend-paying companies really provide a very favorable way to get attractive income.

Nate Geraci: Before we talk about Legg Mason's low volatility high dividend ETFs, what's the benefit of combining low volatility with high dividends?

Mike LaBella: We think about it in terms of common sense. One of the biggest critiques of low volatility strategies is that they don't take into account fundamentals or evaluations. While these strategies have become very popular in recent years and have done very well, for evaluation standpoint, some of them may be looking a little expensive. You can see some of the low-vol strategies trading at a premium to the market, trading about 25 times price to earnings. You go to the market, which is trading close to 20 times. When you add a dividend screen, where these companies are paying consistent dividends and then if you do, what we call, sustainable dividends, making sure those companies have the earnings or profitability to support those dividends, it brings a fundamental layer into this universe, and that can serve as a screen to really make these valuations or fundamentals much more attractive in the low volatility space.

Nate Geraci: We're visiting with Mike LaBella, Portfolio Manager at QS Investors. Let's look at the two Legg Mason ETFs offered in this space, the Legg Mason Low Volatility High Dividend ETF, ticker symbol LVHD, and the Legg Mason International Low Volatility High Dividend ETF, ticker symbol LVHI. Walk us through how these ETFs go about selecting individual holdings.

Mike LaBella: Both these ETFs tend to do the same thing, and that's to provide stable income and take into account market risks, or that low volatility component, so it really serves that function of giving investors that option for income, but also taking into account the increased market volatility that we've seen. Both use a screening process. Using the U.S. as an example for LVHD, what we do is, we screen the largest 3,000 companies in the U.S., and we look for stability characteristics, such as does the company pay a consistent dividend? Are they projected to continue to pay that dividend? We then look at sustainability metrics, such as profitability and earnings. Can they afford to pay that off? That's a very important component because many companies that pay dividends in today's world often do so without the earnings to back them up, so you have to wonder how sustainable those dividends are. Once we do that, we then look at the risk side of the equation. We then screen for the companies that are paying those dividends, but have the lowest price volatility and then the lowest earnings volatility to make sure that these are stable businesses with more predictable incomes that really just reinforce that draw-down protection component of this strategy. Then we re-balance on a quarterly basis, refreshing as the market environment's changing and as these company fundamentals change, as well.

Nate Geraci: Mike, are there any limits in terms of sectors or individual stockholdings, any concentration limits in the portfolio?

Mike LaBella: One of the things you do want to do with this is make sure that you instill a certain amount of diversification within the portfolio, and we do that with some portfolio construction constraints. We constrain stocks to be no more than 2.5% of the portfolio. We constrain individual sectors to be no more than 25%. We constrain REITs to be no more than 15% of the portfolio and, for the international strategy, we constrain any one country to be no more than 15% of the portfolio.

Nate Geraci: Mike, for comparison purposes, just at a high level, what is the composition of a low volatility high dividend portfolio look like versus the broad market, just in terms of the types of stocks held?

Mike LaBella: If you think about some of the stocks that you think may be a little bit less vulnerable to a recession or you think might be a little more low volatility, it's the kind of stocks you'd think about if you looked inside your kitchen. You see things like Procter and Gamble, you see things like Philip Morris, AT&T, UPS, so it's these types of well-established business models, these companies that have very strong balance sheets, are paying dividends, are probably a bit more mature along the growth trajectory, and that could be very different from what you see compared to the S&P 500 or the Russell 3000. Those indexes are much more heavily tilted towards growth areas, things like Apple and Google, information technology, and those potential areas. When you look at these low volatility or the high dividend strategies, you are going to see different sector tilts, particularly towards the more defensive sectors, like consumer staples, utilities, telecoms, and things like that.

Nate Geraci: The Legg Mason International Low Volatility ETF is currency hedged. Can you talk a little bit about that? Why hedge the currency risk in this ETF?

Mike LaBella: We've done a lot of research on currency hedging, and it's been a hot topic over the last several years where we've seen significant dollar appreciation. The U.S. is in line to continue to raise rates where the rest of the world is easing rates, and that's having big implications, but we don't view this as a tactical consideration. We view this as strategic. The reason we do that is, for this low volatility high dividend suite, it's really about wealth preservation. The first objective is not to lose money. When we think about international investing, which has some very attractive opportunities, one of the things people are concerned about is the increased volatility. One of the reasons volatility is greater abroad is that, when an investor buys an international stock, they don't just get that international stock, but they also get the currency such as, if it's in the U.K, for example, they get a British pound or sterling exposure. The driver of that currency is going to be different than the driver of the underlying stock, so it increases the risk profile. An example of this is, if you think about Brexit, a couple of months ago, the U.K. stock market, going back to that day in June, went down only about 2.5%. It actually went down less than the S&P 500 that day but, for a U.S. based investor who also had the currency risk, they lost over 11% that day because the pound significantly declined, so it really adds excessive risk during these market stress moments. What we found is, by hedging out that risk, over the long run, we're able to reduce the volatility without harming any of the investment returns over the long run.

Nate Geraci: Again, we're visiting with Mike LaBella, Portfolio Manager at QS Investors. They're the subadvisor on Legg Mason's ETFs. Mike, I mentioned earlier how both low volatility and high dividend stocks have been popular places for investors to put money to work over the past couple of years. Is there any concern that, perhaps, too many investors are crowding into these stocks and stretching valuations? Is it possible there's actually more risk in low volatility than investors might otherwise expect?

Mike LaBella: It's definitely a concern, and there's been a lot of talk about it. The way we view it is, first you have to compare the size of the universe and the fact is that, while these strategies are becoming more popular, they're still significantly smaller flows than if you would have compared it to traditional market cap weighted ETFs. That's been the major trend in the last 20 years, people moving towards these market cap weighted ETFs that, as I mentioned before, are very different from the weighting schemes of these low volatility ETFs. With that said, it doesn't mean you want to look at valuations and completely ignore valuations, and that's why we think that it's really important to combine low volatility with a sustainability factor, evaluation factor like high sustainable dividends. That's one of the key differentiators of the LVHD suite is that, not only are we picking the lowest volatility companies in the universe, we're first screening for those fundamental factors. If you look from a valuation standpoint, while our fund has done very well this year, up double digits, it's done so with a PE of only about 16 times price to earnings. That's trading at a discount both to the market, as well as to many of those low volatility strategies. You just have to be thoughtful about how you access a lot of these investment factors.

Nate Geraci: Mike, we have about two minutes left here. Along the same lines, as I'm sure you're well aware, so-called smart beta ETFs have continued to grow in popularity. This is one of the fastest growing segments of ETFs. I'm curious. As more investors look to take advantage of these different factors, whether we're talking about low volatility, high dividends, value, momentum, whatever the case may be, does the fact that more investors are pursuing these strategies make them less likely to work in the future? Do potential premiums get arbitraged away?

Mike LaBella: It's a great question, and it really goes back to the underlying investor has to understand what they're investing in and they have to understand, is the anomaly occurring because of some sort of behavioral inefficiency that's going to persist? With low volatility, again talking about, do we think that people are going to change their behavior and not get overly excited about companies like Tesla or the next Apple. That's something that's likely going to be pretty sticky. If you think about another very popular factor, like value. Value is something we've known about since the 1930s and has been very popular, but it still persists to this day and outperforms over the long run, and one of the primary reasons for that is, these things are risk factors, right? They can have long periods of time where their performance could deviate from a traditional cap-weighted benchmark, and many investors in that period of time who aren't disciplined may decide to sell in those particular periods of time, and that is really how this anomaly can continue to persist. It's something that investors have to continually reevaluate but, most importantly, have to do their research and their homework on to make sure that the factors that the investment strategy they're in is, indeed, something that's sustainable and likely to persist.

Nate Geraci: Mike, 30 seconds. Where do these two low volatility high dividend ETFs fit in an investor's portfolio? Are these core holdings?

Mike LaBella: It depends on what the underlying objective is but, if you're looking at something for bringing down your total equity volatility, say you have a little bit of a shorter time horizon, but you still want equity exposure, we can see these strategies as core holdings. If you're somebody who has a bit more time on the horizon, isn't as concerned about volatility, you can use these as more of an alpha strategy as a satellite position to kind of increase your return over the cap weight over longer periods of time.

Nate Geraci: Mike, with that, we'll have to leave it there. A pleasure having you back on the program. We certainly appreciate your time today.

Mike LaBella: It was great to be here. Thanks for having me back.

Nate Geraci: That was Mike LaBella, Portfolio Manager at QS Investors, and you can learn all about Legg Mason's ETF lineup by visiting leggmasonetf.com, that's leggmasonetf.com.