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Structured Products: How Low Volatility, High Dividends Bring Benefits

Structured Products: How Low Volatility, High Dividends Bring Benefits

Apr. 25, 2016

Apr. 25, 2016

The sharp drawdowns seen in equity markets since 2007 have pushed institutional money managers to seek relative portfolio protection against unpredictable moves, without giving up on the total returns provided by the asset class. The experience in these last years has shown the long-term benefits of holding portfolios of stable businesses with predictable cash flows. The availability of new and easy-to-use instruments to pursue such strategies has helped many investors achieve the goal.

Low-volatility strategies are characterized by relatively small drawdowns and low beta, which generate outperformance in falling markets. They also have the added benefit of avoiding the inflated prices of many high volatility stocks, which tend to attract investors seeking leveraged exposure to the market. High dividend stocks, meanwhile, offer a value style and stable, long-term returns shown to beat the market over time. 

It is this combination of protection and consistent returns that’s appealing for investors with a long-term horizon such as pension funds and insurers.

STOXX responded to such demand by introducing the STOXX Select and STOXX Diversification Select Indices last October, a series of more than 40 indices tracking equities with low volatility and high dividends within major STOXX benchmarks.

Here’s a look at their rationale and methodology:

Step-by-step approach

The STOXX® Select and STOXX® Diversification Select Indices are derived from traditional STOXX benchmarks, using a step-by-step approach:

 - An initial data screen of the whole universe of stocks excludes those with low liquidity and those for which daily pricing and dividend yield data is not available
 - The remaining stocks are ranked in a volatility screen, and those with the highest volatility are excluded
 - A final dividend screen ranks stocks for their dividend yield. Those stocks with the top payments are included in the index 

In the STOXX Diversification Select cases, an extra correlation filter is applied immediately after the data screen to exclude stocks that tend to perform in lockstep.

Low-volatility anomaly

The indices give investors access to improved performance, particularly in periods of market stress. This stems, in part, from a well-researched low-volatility anomaly under which portfolios of low-volatility stocks have produced higher risk-adjusted returns than those with high-volatility constituents in most situations analyzed. As an example, the EURO STOXX 50® Low Risk Weighted Index, a version of the flagship EURO STOXX 50® Index that weighs constituents by the inverse of its volatility, has returned 5 percentage points more than the traditional Eurozone equities benchmark in the past five years.

Combining low volatility and high dividend is also particularly effective in avoiding dividend traps, i.e. when a stock shows an inflated dividend yield as a result of a sharp drop in the share price.

Indices in action

A returns analysis shows the Select and Diversification Select indices outperform in the medium- to long-term horizon, all while lowering risk and volatility and enhancing returns attributable to dividends. 

Since June 2004, the STOXX® Global Select 100 and the STOXX® Global Diversification Select 100 indices have gained an annualized 9.4% and 8.7%, respectively, compared to 5.7% for the broader STOXX® Global 1800 Index. Price gyrations in the period were more subdued in the first two indices, with the STOXX Global 1800 Index posting a maximum drawdown that exceeded that of the STOXX Select and Diversification Select measures by at least 10 percentage points. Meanwhile, the gross dividend yield for the STOXX Select was 5% and that of the STOXX Diversification Select 4%, topping the 2.3% yield for the STOXX Global 1800 Index. 

 

 

1) Source: STOXX backtested data as from Jun. 21, 2004 to Jan. 29, 2016.  Annualized figures since inception. Sharpe ratio calculated by using the LIBOR rate. Gross Dividend Yield calculated as annualized performance since inception of the GR version minus the price version one.

Fit for structured products issuers

The STOXX Select and STOXX Diversification Select Indices provide the same transparent and rules-based investment process that have made other STOXX benchmarks such as the EURO STOXX 50 popular underlyings for structured products, exchange-traded funds and derivatives.

The new indices are particularly useful for structured products, as their low volatility helps bring down the price of the option included in those financial instruments. This option is usually a call that provides the extra return should the underlying perform by the time of expiration. The cheaper the option, the more money can be invested in it. And so, the larger the exposure the investor gets to his or her bet, and the higher the return if things go as planned.

In a recent article, PULSE ONLINE reported on structured products as an attractive option for sophisticated investors.

 

 

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