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Transcript
Seeking a Smoother Ride August 2013 Invesco PowerShares strategist Taylor Ames shares the recipe for creating ETFs that aim to reduce unpredictability in an investor’s portfolio As a senior equity product strategist at Invesco PowerShares, Taylor Ames helps to cover PowerShares’ low-volatility ETF lineup. Over the past three years, money has steadily come into the firm’s S&P 500 Low Volatility ETF, which has attracted more than $4 billion in assets since its 2011 launch. More recently, Standard & Poor’s used a similar formula to create low-volatility indexes that specialize in a smaller area of the market--mid-cap stocks, for example. PowerShares then launched two low-volatility ETFs that seek to track these indexes. Ames recently spoke with Morgan Stanley Wealth Management’s Tara Kalwarski about how the low-volatility indexes were created and where they fit in an appropriate investors’ overall portfolio. The following is an edited version of their conversation. Tara Kalwarski: You work on strategy and research for 60 to 80 products. In today’s market environment, what are investors looking for? Taylor Ames: What’s been popular for the last couple of years is this idea of low- volatility investing. The years 2008 to 2009 really changed the mindset of investors; mitigating risk and trying to [manage risk] on the downside have become paramount. We now have five different products that are based on S&P low-volatility indexes. Kalwarski: How do you determine which stocks are the least volatile within a broad index like the S&P 500? Ames: The S&P 500 Low Volatility Index, compiled by Standard & Poor’s, starts with all of the stocks in the S&P 500 and looks at the standard deviation of each stock’s volatility over the last year. The index then takes the 100 stocks that have exhibited the lowest volatility and weights them [inversely to] their volatility: the lower the volatility, the higher the percentage of the portfolio is allocated to the equity. The index reruns that screen quarterly. That's the entire methodology. There are no other constraints; the index basically goes wherever volatility tells it to go. I think one of the reasons these products have been so successful is because of the simplicity of the methodology. Kalwarski: Are there any common characteristics of the 100 stocks currently in the mix? Do certain sectors tend to be more prevalent than others? Ames: Right now the index has a pretty high allocation to utilities and consumer staples. You typically get high-quality companies that have dividends, so it’s not surprising that those sectors would be well-represented. That said, while the index happens to be heavily into utilities and consumer staples now that may not always be the case. Kalwarski: And what are the return expectations of these types of low-volatility products? Ames: Obviously we can't predict what [a product is] going to do. But the idea here is that the product may not fall as far when the markets sell off. Conversely, if the markets rally heavily, we may experience some underperformance. That's what the product seeks to do. Over time, you may potentially outperform the broad market index because you mitigate some of the losses. Kalwarski: How does an ETF that seeks to track the lowvolatility index fit into a broadly diversified portfolio? Ames: I think Financial Advisors are realizing that volatility could be its own asset class. A lot of FAs are now using these ETFs as a core asset class, meaning [a class of assets] that they're always holding within their equity allocation as a way to help build a stable foundation--similar to how they always hold [ETFs that seek to track] the S&P 500. And what Standard & Poor’s research has found is that lowvolatility investing [can] work across the board. In addition to the S&P 500 Low Volatility ETF, we have one for mid caps and small caps. And we also have developed international and emerging-market low-volatility products. Kalwarski: You mentioned that the U.S. product has a lot of utilities. Are there any characteristics of the non-U.S. ETFs that you think are worth noting? Ames: It’s a very similar story across the board. If you own one of these products, you’ll tend to invest in more defensive sectors like consumer staples or utilities. But that’s not always going to be the case. All of these portfolios track indexes that have the ability to rotate in and out of sectors as a reaction to market movement; on the international side there’s the ability to respond to market movement by rotating in and out of countries. Kalwarski: What are the risks of investing in these ETFs? Ames: [We’re] not using any sort of derivatives or anything like that. Our ETFs track indexes that are made up of stocks that are very widely held, known and traded, like the S&P 500. [One of] the [key] things that [suitable] investors need to know is that if the market runs up--and runs up quickly-there is a pretty good chance that [they] may underperform. [There may also be other investment risks associated with the underlying securities in the ETF.] Ames: We've seen inflows coming across in all types of market environments. Since 2011 we've had times where the market rallied pretty significantly, times when it pulled off pretty significantly and times when it’s been flat. Yet our inflows have been pretty consistent. Kalwarski: What are the biggest challenges of maintaining or marketing this type of product? Ames: The ideas of low-volatility investing and lowvolatility indexes are fairly new. So we're still going through an education phase with investors where we explain why low-volatility investing [potentially] makes sense and why the index performs as it does. Kalwarski: Is there any market scenario that would require out-of-quarter rebalancing? Ames: In creating the index, S&P looked at a bunch of methods. [It] considered an index of 50 to 250 stocks [and] also looked at what would happen if the index were rebalanced monthly or annually. And what S&P found is that the quarterly rebalance was the best of all worlds. You're able to rebalance pretty quickly but not so quickly that you're catching false moves in volatility. Kalwarski: So it's almost reflective of the age-old advice to regularly rebalance your portfolio--but not too often or too infrequently? Ames: Exactly. We believe that over time, quarterly rebalancing and an index of only 100 low-volatility stocks will serve investors best. Kalwarski: Do you think there are broader applications of this type of strategy across other assets classes--fixed income or commodities, for example? Ames: We’ve created some strategies in the alternative space, but it’s more of a low-correlation idea, not specifically low volatility. We haven't seen anything in the fixed- income or the commodities spaces as of yet, but that certainly could be something that comes out in the future. Kalwarski: The low-volatility products have seen significant inflows since you launched in 2011. Do you think this would slow if there were better signs of a sustained upmarket? 2 Equity securities’ prices may fluctuate in response to specific situations for each company, industry, market conditions and general economic environment. Companies paying dividends can reduce or cut payouts at any time. Fixed Income Securities are subject to interest rate risk, credit risk, prepayment risk, market risk, and reinvestment risk. Fixed Income Securities, if held to maturity, may provide a fixed rate of return and a fixed principal value. Fixed Income Securities prices fluctuate and if sold prior to maturity, may be worth more or less than their original cost. Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Please consult your tax advisor before implementing such a strategy. International investing involves certain risks, such as currency fluctuations, economic instability and political developments. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economics. An investment in an exchange-traded fund involves risks similar to those of investing in a broadly based portfolio of equity securities traded on exchange in the relevant securities market, such as market fluctuations caused by such factors as economic and political developments, changes in interest rates and perceived trends in stock prices. The investment return and principal value of ETF investments will fluctuate, so that an investor's ETF shares, if or when sold, may be worth more or less than the original cost. The investor should note that funds that invest exclusively in one sector or industry involve additional risks. The lack of industry diversification subjects the investor to increased industry-specific risks. The investor should note that funds that invest in lower-rated debt securities involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default. Investors should carefully consider the investment objectives and risks as well as charges and expenses of an exchange traded fund before investing. To obtain a prospectus, contact your Financial Advisor or visit the fund company’s website. The prospectus contains this and other information about the exchange traded fund. Read the prospectus carefully before investing. The views and opinions expressed herein do not necessarily reflect those of Morgan Stanley. The information and figures contained herein has been obtained from sources outside of Morgan Stanley and Morgan Stanley makes no representations or guarantees as to the accuracy or completeness of information or data from sources outside of Morgan Stanley. Morgan Stanley is not responsible for the information, data contained in this document. 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