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By Christine Benz and Shannon Zimmerman | 10-10-2012 03:00 PM

Watch for Overlap Among Low-Vol and High-Dividend Funds

Although fund shops often promote the strategies' differences, correlations between the two are high as healthy dividend payers also tend to be lower-volatility companies.

Christine Benz: Hi, I am Christine Benz for Morningstar.com. In the wake of strong performance from low-volatility stocks over the past decade, investors are increasingly looking at low volatility as a strategy. Joining me to discuss this phenomenon is Shannon Zimmerman. He is associate director of fund analysis for Morningstar. Shannon, thank you so much for being here.

Shannon Zimmerman: Good to be with you, Christine.

Benz: Shannon, let’s start by talking about what defines a low-volatility stock. What characteristics specifically are people looking at?

Zimmerman: Well, with the panel that I moderated at the Morningstar ETF Conference, I had Raman Subramanian from MSCI, Craig Lazzara from S&P, and Jeremy Schwartz from WisdomTree. WisdomTree doesn’t actually have a low-volatility strategy. We will talk about them when we get to the dividend portion of this segment.

But MSCI and S&P have very different methodologies. And so, you look at industrywide approaches to navigating this space, and people look at standard deviation sometimes over a certain period of time--a one-, two-, or three-year period. Or beta, and using beta as a marker for volatility and then going lower than the market to get your low-volatility exposure, that’s the more academically vetted approach to low volatility, which over time has really shown to deliver quite a premium for investors who can stick with it over the long haul.

Benz: You ran a study a couple of months ago where you looked low-volatility stocks over the past decade. Is there a data that stretches back even further that looks at the performance of the stocks during a broader variety of market environment?

Zimmerman: Sure. There is. In fact, the paper that looks at the longest time series focused on this low-volatility premium, it really is an anomaly. People think higher risk, higher returns, but this paper argued no. And it showed pretty conclusively that wasn't the case. It looked at the time series of 40 years.

You have to be patient; there are going to be periods for any strategy or any approach that you will experience underperformance. You have to always qualify, this is back-tested, looking at results in the rearview mirror. But for investors who were patient over that stretch of time, they did have a significant amount of outperformance relative to people who were just invested in the broader market.

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