The Search for Low(er) Beta Equities: Round 3

After an anti-climactic Round Two which saw no low(er) beta equity fund emerge with any type of advantage, the search returns, this time with dividend-focused ETFs. Will they make a difference? Does a special allocation to low(er) beta or dividend funds make sense in a RP portfolio?


Thank you to reader CF for nudging me to this - a look at dividend-focused funds and see if they might make a positive contribution to a Risk Parity portfolio. Sure, returns might be one way to do that, but more than that, this comparison is part of my search for an equity fund that will behave differently than other equity funds and help smooth out the ride. I began this search looking at VPU (a utilities fund). PFF (a preferred shares index fund) and USMV (a US equity minimum volatility fund) in round one. The conclusion there was VPU was the best for Risk Parity, but USMV was nice in terms of total return.

Preferred Asset for Low(er) Beta Equities: first round
This one is really an experiment - comparing three equity funds, VPU, PFF and USMV, with somewhat low correlation with the S&P 500. Putting them through their paces to get a sense of whether low(er) beta equity funds may be another arrow in the RP quiver.

I then kept VPU and compared it with VDC (a consumer staples fund) and PGF (another preferred shares fund, but this one focused on financial stocks, not utilities stocks as PFF was). This test one was a wash, with VDC comparing well to VPU, but it also caused me to re-think whether the hunt for the best low(er) beta equity fund was even worth it.

The Search for Low(er) Beta Equities: Round 2
VPU won the last round in my search for low(er) beta equity funds against PFF and USMV, and now faces off against two more contenders: a consumer staples sector fund (VDC) and a financial industry preferred shares fund (PGF)... And the winner is…it’s complicated.

Now in round three, I’ll go over my last group of possibilities for a complementary equity fund: dividend funds. To do this, I’m going to leave the question of whether dividend funds offer an inherent advantage at all (I’m on the record as a “no” vote, for the same reasons articulated by Ben Felix and John Williamson), and then just test what they do for a Risk Parity portfolio.

  • Do they make a difference for diversification?
  • Do they lead to shallower drawdowns while still maintaining similar overall returns?
  • Will a significant allocation to them boost a portfolio's perpetual withdrawal rate?
  • Are they special enough to warrant your mental energy thinking about them?

The Candidates

VPU

Vanguard’s Utilities ETF, Fund page, Barchart Summary. Pretty simple: it invests in utilities, has a low-ish correlation with other equities, and delivers good but unremarkable returns. Winner of the first round, basically tied in round 2, and also beat out VNQ in an earlier test, so at this point, it has to be the touchstone to which I compare the others. Still on the fence about whether it is really needed in a RP portfolio, though.  

VBR

Vanguard’s Small-cap Value Fund, Fund page, Barchart Summary. This one is in here mostly because it’s the ingredient in the Golden Butterfly portfolio that I have been swapping out to test the others. Just for the record, this isn’t my preferred asset for small-cap value (that would be AVUV), and not even my favorite Vanguard fund for investing in small-cap value (that’d be VIOV), but it has the longest history and is the most common choice for this asset class.

VIG

Vanguard’s Dividend Appreciation ETF, Fund page, Barchart Summary. Included this as its the basic vanilla dividend fund, with the highest AUM among dividend-focused funds. It is among the broader dividend funds, with 289 equity holdings, all among the S&P 500, so its focus is exclusively large-cap.

SCHD

Schwab U.S. Dividend Equity ETF, Fund page, Barchart Summary.  This has a narrower focus on just top 100 dividend paying stocks, resulting in a higher dividend rate compared to VIG at first glance. Again, focused on only large-cap stocks, with a heavy slant towards value (86%) compared to growth (9%), with the rest intermediate and long-term Treasuries.

SPHD

Invesco S&P 500 High Dividend Low Volatility ETF, Fund page, Barchart Summary. A really interesting fund that wasn’t on my radar until I did my initial screen, this one combines two filters: dividends and volatility. Holds just 51 equities. I’m intrigued by this and eager to see how it fares; it is a good complement to USMV (tested in Round One), and also seems to be an improvement over VIG.

As for the basics of each fund:

All five look good in terms of expense ratio, with only SPHD slightly elevated beyond the others. If it has a better profile and higher returns, then that may be justified, as we’ll see. SCHD’s expense ratio at just .06% looks appealing here. If you do want higher dividends, then you’d get them here for the same cost as Vanguard’s basic fund.

How Will I Decide?

I’ll use the same criteria to make a decision as I used in rounds one and two:

  1. The lower correlation with the stock market the better, though I can’t expect the correlations will be as low as gold or commodities. Less than .5 would be awesome, less than .6 would be decent, and higher than that, well, we don’t really get much diversification benefit from holding it. Less correlation with the S&P and even small-cap value will lead to diversification benefits, namely a stronger perpetual withdrawal rate
  2. …as long as returns are decent, of course. Using a total return perspective, I really want to see how RP portfolios with each of these will fare. With this test, we’re getting farther away from any reasonable standard of low correlation, so really, the question might turn into whether the returns are strong enough to make up for higher correlations.

First Criterion: Correlation

Here are the correlation numbers for these three funds compared with a slate of equities funds (total US stocks, Large-cap Growth, Small-cap Value, total International stocks). The timeframe goes back to November, 2012:

The numbers are pretty straight-forward: the three new dividend funds aren’t even close to being low(er) beta equities. VPU does qualify, as we know from earlier comparisons, and it is likely the only one of these providing a true diversification benefit. At this point, I could stop the analysis, actually. These dividend funds just aren’t low beta, and the better comparison would be with other equity funds.

But we’re already here, so we might as well go ahead to criterion two…

Second Criterion: Total Performance

To run the backtest, I used the skeleton of the Golden Butterfly portfolio, but then did different things with the 20% normally allotted to small-cap value. In one case, I kept it and in the other four, I allocated it to the other candidate in the search, so it looked like this:

  • 20% VFINX: Vanguard S&P 500 Mutual Fund
  • 20% TLT: iShares Long-term Treasuries
  • 20% VFISX: Vanguard Short-term Treasury Fund
  • 20% IAU: iShares Gold Trust
  • Then 20% in either VPU, VBR, VIG, SCHD, or SPHD
    The primary backtest comparing goes back to November, 2007 (here is the link for VPU, VBR, and VIG, here is the link for SCHD and SPHD):

All five are pretty close to one another, all things considered. SCHD has the highest return and the best Sharpe Ratio, so it wins this test. VPU is the worst of the five in terms of both CAGR and Sharpe, but the portfolio with it does do the best in terms of smoothing out the downturns. This is diversification at work, and is presumably what you’d be looking for. If you were just looking for total return, then you might dispense with this whole low beta criterion, and just go for VUG, which beat SCHD by a hair. For that matter, the 3X leveraged UPRO would have blown everything out of the water.

Ideally, I would like to have a bit longer of a backtest, as well. SCHD and SPHD both started just after the Global Financial Crisis, and within a year of each other, so that will just have to do. I can look at VIG, though, in a backtest back to January, 2006:

If you thought the last one was really close, then check out this one. Looks like you’d have been slightly better off with VIG, but this is really a tie among these three.  

So…What’s the Preferred Asset for a low(er) beta equity fund?

Bit of a trick question: still VPU, since none of the others are low beta and wouldn’t have that much diversification impact on your portfolio. Only VPU has correlation numbers low enough to mean you’d get a risk reduction benefit from holding it in a RP portfolio. When you’re considering VIG, SCHD and SPHD, you’re really talking about equity funds that should be compared to your various S&P 500 funds, total stock market funds, factor-weighted funds, leveraged equity funds, and a whole lot more, and that’s the subject matter for another blog post.

That doesn’t mean that VIG, SCHD, and SPHD are bad things to hold, and if you have other reasons for them, then certain;y you'd hear no warning signals from over here in Risk Parity land. If you, for whatever reason want a special allocation to dividend funds (and to be clear, I wouldn’t), then SCHD is clearly the best: highest returns, low expense ratios, and a very focused dividend play. But I can’t see any special reason to recommend SCHD or the others from a Risk Parity point of view in particular.

That echoes the conclusion I have come to after these three rounds searching for a low(er) beta equity fund, whether it be VPU, USMV, SCHD or the rest. I have a positive outlook on those three funds (above any of the competitors I’ve looked at) but I’m not convinced that there really is a special role for them in a Risk Parity portfolio. They are all “good” funds, but they don’t really do anything special to your portfolio that can’t be replaced by other good funds.

To return to the four big questions asked earlier:

  • Do they make a difference for diversification?

No, not really. VPU and PGF are pretty much the only ones among the eight that have correlation numbers in the range I was looking for (.5 or below).

  • Do they lead to shallower drawdowns while still maintaining similar overall returns?

Not really. PGF’s returns are unimpressive, and VPU’s are good but not great and don’t test out better than many other funds you could have instead. USMV and SCHD did have very impressive returns, and I could understand people getting excited about them, but those have essentially no diversification benefit.

To do that, you’d need both low correlation and high returns, and none of the eight delivered both. If I had to choose, VPU would be the one I would look to, especially if I were very leverage averse and in search of very steady equities. That’s a very tepid vote of confidence, though.

  • Are they special enough to warrant your mental energy thinking about them?

No, I can't say that they are. I’m glad I did the research and feel better now that I can cross these out of something t o be on the lookout for. The first 1000 failed lightbulbs were useful for Thomas Edison (and overlooked assistants who probably actually invented the stuff!) in figuring out what DIDN’T work. I can relate.

So, after all the spilled ink, I’m going to do something I didn’t expect to do on my “Preferred Assets” page: I’m not going to name any for a low-beta equity fund, and instead, will put it a new category of random funds that may have upside, but aren’t crucial for Risk Parity.


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Disclaimer: In real life, I don’t own shares of any of the dividend funds I have compared here (VIG, SCHD, and SPHD). I do own shares in VBR, though, as well as a few other funds mentioned in passing, such as VTI and VUG. Keep in mind that this site is intended for financial education, and this write-up is to explain how you might want to think about this particular asset class and why I use it in my portfolio. It's not a recommendation that you do the same.