OCTOBER 2013
EXPERT OPINION
I N V E S T M E N T I N S I G H T S F R O M LY X O R A S S E T M A N A G E M E N T
Quality income index,
a new generation of highly promising indices
Lyxor is launching a new ETF combining quality and income to
embrace the full benefits of the European equity market: Lyxor
UCITS ETF SG European Quality Income. Review of a budding
range of high dividend yielding and defensive indices offering a
credible alternative to replace coupons with dividends in portfolios.
F r an ço i s M I L L E T
Product Line Manager ETF
& Indexing, Lyxor
> 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 capweighted indices no longer apply. They are replaced by
intrinsic, fundamental ways of measuring financial strength
and valuing portfolio securities, or 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.
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.
> Why do these smart beta indexations deserve to play
a growing role in portfolios’ core allocations?
Smart beta strategies allow to capture 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 last 10 years, the SGQI Europe index has
outperformed the Euro Stoxx 600 index by 3.3% on an
annualised basis with relative volatility 3.2% lower. These
> What is the stock-picking process based on?
Unlike most classic dividend indices, Quality Income
indices analyse first the fundamentals of each company in
the investment universe before looking to select the most
profitable and robust ones.
To avoid any subjective analysis, the Societe Generale
research team conducted by Andrew Lapthorne developed
a scoring model directly inspired by the nine-factors of
Piotroski (2000), examining each company’s profitability,
debt profile and operating efficiency. Without going into too
much detail on the criteria, here are a few considerations
> What is the stock-picking process based on?
Smart beta strategies allow capturing 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 last 10 years, the SGQI Europe index has
outperformed the Euro 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.
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OCTOBer 2013
EXPERT OPINION
I N V E S T M E N T I N S I G H T S F R O M LY X O R A S S E T M A N A G E M E N T
that should give you a better understanding of how
stocks with solid fundamentals are chosen. For example,
regarding company profitability, the methodology makes
sure that the improvement of profitability will be driven by a
growth in revenues rather than mainly rely on cost cutting
to, as such a strategy is hard to maintain over the long term
and reflects an ageing product cycle. Regarding financial
ratios, leverage must decrease. The analysis also assigns
a higher score to companies able to finance themselves
their own investments. Quantitative filters also rule out
companies whose improved net cash position results from
a capital increase. And finally, the business efficiency of
a company is judged on the basis of growth in operating
margin and the evolution of its turnover relative to assets.
> In Quality Income, what does the term "Quality" refers to?
The notion of Quality will put 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 and has 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.
> How do portfolios ultimately look?
The quest for the most robust and profitable stocks is
conducted in a universe that excludes financial companies,
whose cannot be applied the same selection criteria as other
sectors. The Quality Income approach also eliminates less
liquid stocks from the initial universe. For the SGQI (Global)
index, which underpins the first ETF in the range launched in
October 2012, only companies with a free float of more than
USD 3 billion are eligible. This index comprises 71 portfolio
securities.
For the index of European stocks, the SGQI Europe, the
minimum free float of each share has been reduced to USD
1 billion while a rule on average daily volumes has been
added to guarantee underlying liquidity. The SGQI Europe
index contains 50 stocks.
Structurally, Quality Income indices give a higher weighting
to the utilities, telecom and consumer goods sectors than
the MSCI World index. The fact that dividend policies are
more generous in certain areas of the world such as Europe
introduces a geographic bias. Indeed, the United States
and Japan are underweighted somewhat, while Australia
and Nordic countries are given more presence in the SGQI
Global than in the MSCI World.
> 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.
This communication is for professional clients and sophisticated retail clients in the uk
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