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Supplements » ETFs Report 2013

SPONSORED PROFILE: Quality Income Index

Francois-MilletQuality income stocks is an attractive new equity asset class which has grown out of the uncertainties in the markets in the past five years. François Millet of Lyxor explains.

­­­Uncertainties in the macroeconomic environment in Europe and in equity markets in general in the past five years have highlighted the attractiveness of a new equity asset class: quality income stocks. Such securities typically represent the most stable and respected companies in Europe, offering a proven ability to generate performance, protect capital and grow over time.

The rationale and construction of this stock selection has been developed by Andrew Lapthorne, global quantitative research strategist at Societe Generale Corporate & Investment Banking, who argues: “Stock market fashions and trends may come and go. But buying well higher quality companies that pay sensible and sustainable dividend yields is an investment strategy that has stood the test of time. In our opinion, such companies should form the backbone of any sensible equity portfolio.”

In this context, Lyxor launched a new ETF combining quality and income to embrace the full benefits of the European equity market: Lyxor UCITS ETF SG European Quality Income, to provide exposure to high dividend yielding and defensive indices that offer a credible alternative to replacing coupons with dividends in portfolios. This ETF has been issued following the success of Lyxor’s recently launched SG Global Quality Income ETF.

What are smart beta indices?
In many ways, it is interesting to see how the development of the financial crisis coincides with the emergence of a new investment trend among institutional towards innovative indices, generically referred to as “smart beta”.

These strategies, based on academic research carried out since the 1970s, break with the traditional approach to building an index portfolio. In the smart beta universe, references to the traditional and more volatile market cap-weighted indices no longer apply. They are replaced by intrinsic, fundamental ways of measuring financial strength and valuing portfolio securities by weightings based on the notion of risk, as in the case of maximum risk diversification “ERC” indices.

Launched in 2012, the Lyxor Quality Income indices belong to this first group of fundamental indices. The concept, developed by Societe Generale CIB’s research teams, states in a few words: selecting through a rigorous methodology companies renowned for their economic and financial solidity, as well as their generous dividend policy since dividends prove to be the prime source of equity returns.

How can these smart beta indexations play a role in portfolios’ core allocations?
Smart beta strategies allow the capture of alternative sources of systematic risk premia and generally aim to improve the risk/return ratio through an investment cycle. Lyxor’s Quality Income ETFs are no exception. They are designed to be a stable allocation on which to build a portfolio.

Over the past 10 years, the SGQI Europe index has outperformed the Stoxx 600 index by 3.3% on an annualised basis with relative volatility 3.2% lower. These figures are very close to those of the SGQI Global index, which has outperformed the MSCI World index by an average of 4.3% per year with volatility 3.36% lower. Both indices also offer more attractive risk/return profiles than minimum volatility and quality indices tracking their respective investment universes.

In Quality Income Index, what does the term ‘Quality’ refer to?
The notion of quality puts greater emphasis on financial solidity factors than the traditional notion of value. The analysis uses an indicator held in high esteem in the world of credit analysis: distance to default. Merton introduced the concept of distance to default in 1974 as part of the structural approach to valuing risky debt, which has subsequently been used in credit risk models and even by rating agencies.

In simple terms, the model described by Merton assumes that shareholders hold a contingent claim on the company after paying back its creditors. The equity value of a firm will depend on its distance to default itself linked to the market value and the volatility of a firm’s assets.   

The methodology uses this filter to keep only the most financially robust companies. Stocks whose annualised dividend is expected to be more than 4% are then added to the index. These Quality Income indices are equally weighted, thereby avoiding any concentration risk. Furthermore, the methodology requires the selection to be revised every quarter.

Why invest in these indices through an ETF?
For institutional investors, investing in this strategy through an ETF gives easier access and offers liquidity in case the market suffers a period of heavy turbulence, allowing for a quick withdrawal. The strategy can also be managed on a discretionary basis.

As with any smart beta strategy, the portfolio’s turnover is slightly higher than that of the original index, and on top of the liquidity constraints imposed on the construction of the index, Lyxor’s experience of tracking indices can be used to optimise tracking error and costs.

François Millet is product line manager for ETFs at Lyxor

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