A s the low interest rate environment lingers, more capital is entering income-oriented instruments to counter meager deposit rates. A fitting tool for this purpose is the dividend-paying ETF, which aims to generate a stable stream of income while minimizing costs. This trend plays to the strength of Vanguard – winner of this year’s Outstanding Achiever in the High Dividend ETF category – which is recognized for its edge in manufacturing low-cost products. BENCHMARK sat down with Yan Pu, Head of Portfolio Review in Asia, to talk about income investing and ETF market development.

BENCHMARK (BM): Vanguard’s expertise in delivering income at a low cost has once again won applauds. Besides your below market-average expense ratio, what are the other factors behind the success of your ETF products?

Yan Pu (YP): Thank you. We are grateful for the honor. As a pioneer in indexing for more than four decades, Vanguard draws on its deep experience and strong systematic selection, weighting, and rebalancing capabilities to manage its ETFs. As a result, our products were able to track the benchmark tightly, which is one of the key characteristics that define “successful” passive products.

In addition to lower-than-peers expense ratios, our high dividend ETFs feature strong liquidity, as evidenced by their high turn over and trading volume. Thanks to our strong relationships with brokers and solid market making support, our ETFs offer a tight bid ask spread, which also contributes to the popularity of our product.

BM: Among your most popular offerings are high-dividend ETFs. However, as global interest rates gradually rise, do you think investors’ appetite for dividend plays will be affected? And how will rising rates impact on investors’ asset-class preferences?

YP: This is a common question among dividend investors of late. Although interest rates are rising gradually, there is still a notable spread between the yield of high dividend and broad-market fixed-income strategies. To look to reduce a portfolio’s sensitivity to and potential losses from rising interest rates, especially in today’s environment, investors may consider substituting dividend-oriented equities for bonds. That said, though, dividend-oriented equities tend to have greater interest rate sensitivity than other equities, experiencing greater price declines when interest rates rise and greater price increases when rates fall.

Also, the downside is that substitution, or replacing bonds with high-dividend strategies, may expose investors to unintended consequences, such as losing the diversification benefits provided by bonds. It is also worth emphasizing that the potential drawdown risk of dividend oriented equities far exceeds that of bonds.

BM: On top of the potential bond-to equity shift you just mentioned, what kinds of major changes should dividend investors expect in the equity market, where valuations are already elevated? How should they position for these changes?

YP: Our research indicates that dividend oriented equity strategies are best viewed from a total-return perspective, taking into consideration returns from both income and capital appreciation. Global equity has already rewarded patient investors with a 15.5% annualized return over the 8 ½ years since the lows of the financial crisis.

With this in mind, our equity outlook for 2018 and beyond is modest, at best. Elevated valuations, low volatility, and secularly low interest rates are unlikely to be allies for robust financial market returns over the next five years, with downside risks more elevated in the equity market than in the bond market, making our equity outlook highly guarded.

In our view, the solution to this challenge is not shiny new objects or aggressive tactical shifts. Rather, our market outlook underscores the need for investors to remain disciplined and globally diversified, armed with reasonable return expectations and low-cost strategies.

BM: In low-cost strategies, ETFs are fitting choices. However, size begets size in the ETF market – the largest ETFs often enjoy more capital inflows thanks to their higher brand recognition. What should market players do to bring about a healthier ETF market development?

YP: To usher in a healthier ETF market development, we should understand investors’ needs for high-quality, high-value products. They often invest in investment products that will help them meet long-term goals and objectives. If a market participant consistently offers appropriate products for investors to achieve their goals, brand recognition can be built over time. Therefore, ETF issuers should focus on how to offer products with quality and value and give investors a good investment experience. BM

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