ETF Investors Seeking Income, Inflation Protection

Scott Burns: Surveying the ETF investing landscape.

Hi, there! I am Scott Burns, Morningstar's director of ETF research.

Joining me today is Tony Rochte from the State Street Group. Tony is the director of the intermediary business with State Street.

Tony, thanks for being her.

Anthony Rochte: Great. Thanks, Scott.

Burns: When we look at the investing landscape, a lot of the themes that we hear from investors, that I hear from our subscribers, I'm sure you hear from your investors: I think number one right now is dividends. Dividends and income. What do you see out there right now that investors could be capitalizing on, maybe not, and just some other trends in that space?

Rochte: One of the things that we hear directly from our investors, be it financial advisor, be it institutional investors, they say, especially post 2008-2009, is they're looking for dividends. It's predictable; it's steady.

If you look at the Dow Jones Industrial Average back to 1926, almost a third of the total return, as you know, was attributable to dividends. So, more and more investors are almost rediscovering dividends.

In 2010, the third-fastest growing ETF in the industry was actually the SPDR Dividend ETF, symbol, SDY. It's a concentrated portfolio. It's a 60-stock portfolio, made up of names from the S&P 1500. What's interesting about SDY and the SPDR Dividend ETF is every single constituent has to have a dividend-paying history going back 25 years. So, sometimes individual names, as you know, are high-yielding simply because they are on the verge of bankruptcy.

Burns: Right.

Rochte: There is a reason. But this actually puts a quality screen in place and screens out any dividend that hasn't increased consistently over a quarter of a century, which makes it a very attractive ETF. Right now the yield is just north of 3%, and we're seeing a lot of demand for that.

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Burns: Well, I'd say the other thing just from a performance perspective, SDY, I believe it's 5-star, I know it bounces between 4-star and 5-star funds, meaning that in large-cap [value], which is the category that it sits in, it's outperforming 90% of all other funds out there, that's active or passive.

So, it's a great product that you guys have put out, and I do think when people are looking for dividend income, it's definitely something that should show up in their screens and something they should be considering.

Besides dividends, I think one of the reasons people are looking for dividends is because fixed income, there is not a lot of income in fixed income right now, and that's a big problem. That's a problem that's exacerbated by a lot of inflation fears right now. What are you seeing on the inflation front and some of the tools that you guys have produced to help investors deal with that?

Rochte: As we watch core inflation and you look in the emerging market countries, if you looked in China in the fourth quarter of 2010, we saw inflation rising somewhere between 4% and 5%. We see it in Latin America, particularly in Brazil. Certainly, we haven't seen inflation rear it's head in the U.S. yet, although we are starting to see signs.

But the real discussion with institutional investors, and this is what we hear from our client base, is international inflation protection. We launched several years ago WIP, which is a SPDR Deutsche Bank Inflation-Protected Government Bond Portfolio; it's a mouthful. It's simply an international TIPS portfolio, it's interesting, I think most…

Burns: With the ticker of WIP, so WIP, and there's the very large iShares TIP product, so TIP and WIP, is the way to think about that.

Rochte: Correct. What's interesting, though, is in the United States most investors understand TIPS from the late '90s. I think they were launched in the U.S. in '97, '98, somewhere in that timeframe. Inflation-protected bonds have actually been traded in Europe since the early '80s.

Burns: Right.

Rochte: So it's actually a very developed market, and when you look at the fact that you've got European exposure, you have Asian exposure, in addition, WIP actually provides almost a third of its exposure from the emerging-market countries. So, we've seen a lot of demand from many different types of clients.

I also think this concept was actually sourced from our institutional client base three or four years ago. They actually continued to ask us, do you have international inflation-protection, so, that's something we've seen a lot of activity in.

Burns: The other thing I think to just think about for that fund, too, is that the distribution isn't quite as regular as normal fixed income fund. I think that's kind of a perception error, that we want to make sure people understand about that. That if there is deflationary pressures, then WIP might not make a distribution, right?

Rochte: Right, and I think that's a great point. We talked earlier in one of your segments on the need to educate advisors and certainly all investors. One of the things about TIPS and inflation-protected bonds, there's no free lunch, right?

Burns: Right.

Rochte: It works for or against you. So if you are in a deflationary environment and you're building a portfolio for income, well that may be something to consider.

So without question, we see clients using this as a very small sleeve of a well-diversified fixed income or equity portfolio. But certainly, we wouldn't see clients using this in the absence of other vehicles.

Burns: Right. So one of the ways ... that a lot of investors are looking to protect themselves from inflation here in the U.S. (should it come to pass; we are still not seeing that yet, as you mentioned), there is a much stronger interest in emerging markets. I know you recently launched the emerging market dividend fund, EDIV is the ticker. What are you hearing from investors and how is that going into your product thinking right now?

Rochte: So one of the trends we've seen, clearly if you look at the top 10 ETFs in the industry, it's dominated by core emerging market ETFs, some $40 billion-$50 billion ETFs.

What's interesting, though, is the majority of the emerging market exposure the financial advisors are gaining is really though large-cap names, and when you look at the large-cap names in those emerging countries, they frankly are becoming more developed, as you know. They are exporting a lot of their goods and services to other parts of the world. What's interesting, though, is thinking about how to take advantage of the emerging consumer.

So, we all know about iPad. We all know where iPads are assembled. Most of the iPad's may be shipped elsewhere, but how many individuals in China are actually buying iPads today. So there's a whole trend to the emerging consumer, and with EDIV, and for example, in the SPDR China ETF, symbol GXE, it actually provides exposure to the small- and mid-cap part of the market to you, too, because small- and mid-cap names in China and in the emerging markets tend to actually be creating goods and services for their own consumers. So, this is a trend that we really thought a lot about from a product development standpoint.

We've launched certainly GXE, which is our China ETF, with that thinking in mind. It's very well diversified, a quarter small-cap, a quarter mid-cap, roughly half large cap; there is no other ETF in the industry that's that well diversified from a China perspective. And the same with EDIV. The SPDR emerging market dividend, we think, will give you more broad exposure and really reach into the emerging consumer base in those areas.

Burns: So are you limiting the cap weightings in EDIV then? So you're keeping it from being too large cap, from the Petrobrases and China Mobiles of the world from dominating?

Rochte: Right. Well we don't do it from a portfolio management standpoint. We certainly adhere to the index. So, yes, that's an attribute of the index. Correct.

Burns: I think that's something we're always telling investors and subscribers about is, to understand that just because a local economy is developing, it doesn't necessarily mean that it's reflected in the local stock market directly--it's very much more indirect.

Really you have to look it on a country-by-country basis as to what the exposures you are getting in emerging markets, especially with the nationalization of a lot of these really large multinational-type firms. I say the difference between Petrobras and Exxon is one has oil and one has probably better management, and I'll let viewers figure out which one's which.

Rochte: Right.

Burns: So Tony, thanks for joining me. That's great comprehensive review.

Rochte: Great. Thank you, Scott.

Burns: I am Scott Burns. For this and other ETF information, please check out Morningstar.com ETF Center and the Morningstar ETFInvestor newsletter.