The Beauty of Simplicity: The S&P 500 Low Volatility High Dividend Index

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1 May 2015 CONTRIBUTOR Priscilla Luk Senior Director Global Research & Design The Beauty of Simplicity: The Low 1: INTRODUCTION investment strategies have inspired widespread academic research, and they have been adopted extensively by market participants. In response to the demand for benchmarks in this investment arena, S&P Dow Jones Indices offers a series of dividend strategy indices, which are all designed to meet specific needs. Launched in 2003, the Select is designed to capture U.S. companies that pay high dividends with sustainable dividend growth and payout ratios. The S&P High Yield and the, which were launched two years later, are designed to measure the performance of companies within the S&P Composite 1500 and the that have consistently increased dividends over the past 20 and 25 years, respectively. The Dow Jones 100 TM was launched in 2011, seeking to measure the performance of the highest-yielding U.S. companies with a consistent dividend payment history that are supported by robust financial strength. In October 2012, S&P Dow Jones Indices launched the Low Volatility High, which is a unique, rules-based dividend strategy index that is designed to deliver high dividend yield and low return volatility in a single index. The index uses a simple two-step screening process to incorporate not only high dividend yield, but also the well-known low-volatility strategy. Historically, indices that employ the low-volatility strategy have tended to outperform their benchmarks on a risk-adjusted basis. In this paper, we first study the benefit of combining low volatility and high dividend strategies in a single index. We then take a closer look at the characteristics of the Low, including sector composition, dividend yield, and historical return. Finally, we compare the Low to other S&P Dow Jones Indices that are focused on the U.S.

2 The Beauty of Simplicity: The Low May : LOW VOLATILITY MEETS HIGH DIVIDEND YIELD IN THE LOW VOLATILITY HIGH DIVIDEND INDEX 2.1. Performance of High--Yielding Stocks with Different Volatilities To study the return characteristics of high-dividend-yield equities in the U.S., we divided the companies in the S&P Composite 1500 that paid dividends into hypothetical quintile portfolios sorted by dividend yield, and we measured their historical return and volatility. All of the quintile portfolios were rebalanced annually in December based on historical dividend yield, and portfolio stocks were equally weighted. Based on the monthly total returns between December 1994 and December 2014, the highest-yielding quintile portfolio (Q1) delivered the best annualized return, but with a much higher volatility than the lower-yielding quintile portfolios (Q2, Q3, Q4, and Q5). As a result, the highest-yielding quintile portfolio did not offer better returns after adjusting for risk (see Exhibit 1). Exhibit 1: Historical Average Annual Return, Annual Volatilty, and Risk-Adjusted Return of the Quintile Portfolios from the -Paying Companies in the S&P Composite 1500 (Sorted by Yield) Average Annual Return (LS, %) Annual Volatility (RS, %) Risk-Adjusted Return Q1 Q2 Q3 Q4 Q Q1 Q2 Q3 Q4 Q5 Highest-Yield Portfolio Lowest-Yield Portfolio Highest-Yield Portfolio Lowest-Yield Portfolio Source: S&P Dow Jones Indices LLC. Data based on hypothetical quintile portfolio returns between December 1994 and December Past performance is no guarantee of future results. Charts are provided for illustrative purposes. The high volatility of the highest-yielding quintile portfolio (Q1) may be the result of including high-yield stocks that have had a recent, sharp price drop. Since dividend yield increases when price decreases, any negative company or industry occurrence that causes a sharp price decrease will drive up the stock s dividend yield. These stocks tend to be more sensitive to news announcements and have more volatile price movements, which could contribute to the high level of volatility in the highest-yielding quintile portfolio (Q1). Since a sharp price drop would also drive up a stock s historical volatility, excluding high-volatility stocks from the high-yield portfolio may help to avoid the effects of price shocks. To study the performance of high-dividend-yielding stocks with different volatilities, we divided the highest-yielding quintile portfolio into five hypothetical, volatility-sorted quintile subportfolios and measured their returns. All volatility subportfolios were rebalanced annually in December based on historical 252-day return volatility, and all portfolio stocks were equally weighted. The result showed that portfolios with historically high volatility (SQ4 and SQ5) had more-volatile returns in the year after the portfolios were formed. Historically, the higher-volatility, highyield portfolios (SQ4 and SQ5) underperformed the lower-volatility, high-yield portfolios (SQ1, SQ2, and SQ3) on a risk-adjusted basis (see Exhibit 2). This result is consistent with the well-documented low-volatility anomaly, whereby high-volatility stocks tend to underperform low-volatility stocks on a risk-adjusted basis. This result also 2

3 The Beauty of Simplicity: The Low May 2015 implies that simply excluding high-volatility stocks from a high-dividend-yield portfolio may improve portfolio return on a risk-adjusted basis. Exhibit 2: Historical Average Annual Return, Annual Volatilty, and Risk-Adjusted Return of the High-Yield Quintile Subportfolios from the -Paying Companies of the S&P Composite 1500 (Sorted by Volatility) Average Annual Return (LS, %) Annual Volatility (RS, %) Risk-Adjusted Return 5.0 SQ1 SQ2 SQ3 SQ4 SQ SQ1 SQ2 SQ3 SQ4 SQ5 Least-Volatile Portfolio Most-Volatile Portfolio Least-Volatile Portfolio Most-Volatile Portfolio Source: S&P Dow Jones Indices LLC. Data based on hypothetical quintile subportfolio returns between December 1994 and December Past performance is no guarantee of future results. Charts are provided for illustrative purposes Adapting the Low-Volatility Strategy to a High--Yielding Portfolio Unlike other S&P Dow Jones Indices that use consistent dividend history criteria or multiple fundamental measures to select index members, the Low applies just two simple screens for volatility and dividend yield in the stock-selection process. The index is formed by first selecting the 75 companies in the with the highest historical dividend yield. Then, the 50 highest-yielding stocks with the lowest historical volatility are added to the index. To demonstrate the value added by combining the low-volatility and high-dividend-yield screens historically, we created three hypothetical, high-dividend portfolios and measured their historical returns for the period from January 1990 to December High-yield portfolio: 75 stocks from the with the highest dividend yield. 2. Low-volatility/high-yield portfolio: 50 lowest-volatility stocks selected from the high-yield portfolio. 3. High-volatility/high-yield portfolio: 25 highest-volatility stocks selected from the high-yield portfolio. All portfolios were semiannually rebalanced in January and July, and all portfolio members were equally weighted. Returns of the portfolios are provided in Exhibit 3. 3

4 The Beauty of Simplicity: The Low May 2015 Exhibit 3: Risk/Return Summary of the Hypothetical, High- Portfolios Period Annualized Return (%) 75-Stock/High-Yield Portfolio 50-Stock/Low- Volatility/High-Yield Portfolio 25-Stock/High-Volatility/High- Yield Portfolio 3-Year Year Year Year Since January Annualized Volatility (%) 3-Year Year Year Year Since January Risk-Adjusted Return 3-Year Year Year Year Since January Month Max Drawdown (%) Since January Source: S&P Dow Jones Indices LLC. Data based on hypothetical portfolio returns between January1990 and December Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance of the Low. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. Over the entire period studied, the 75-stock/high-yield portfolio outperformed the significantly, but with higher return volatility and a greater 12-month maximum drawdown. With its low-volatility screen, the 50- stock/low-volatility/high-yield portfolio achieved almost the same annualized return as the 75-stock/high-yield portfolio, but with 17% less volatility and a smaller 12-month maximum drawdown. In contrast, the 25-stock/highvolatility/high-yield portfolio was 82% more volatile and had a much greater 12-month maximum drawdown than the 50-stock/low-volatility/high-yield portfolio, but the higher risk was not compensated with higher absolute returns. Of the three hypothetical portfolios, the 50-stock/low-volatility/high-yield portfolio delivered the highest risk-adjusted return and had the most-significant maximum drawdown reduction compared with the. This result demonstrates the benefit of combining the low-volatility and high-dividend-yield screens in selecting index members. The simple low-volatility screen not only acted as a quality measure to avoid including high-yield stocks with sharp price drops; it also captured the low-volatility factor, which has delivered persistent risk-adjusted outperformance, historically. 4

5 The Beauty of Simplicity: The Low May : PORTFOLIO AND RETURN CHARACTERISTICS OF THE LOW VOLATILITY HIGH DIVIDEND INDEX 3.1. Sector Exposure As of year-end 2014, the Low is diversified among 10 sectors and has higher concentrations in the utilities and consumer staples sectors, since companies from these sectors have historically paid higher dividends. Compared to the, the Low has more weight allocated to the utilities and consumer staples sectors, while information technology and healthcare are its most underweighted sectors (see Exhibit 4). The sector bias is mainly caused by the concentration gradient of high-dividend-yielding stocks in different sectors and the index s dividend-yield weighting method. Exhibit 4: Sector Weights of the and the Low 25% 20% 15% 10% 5% 0% Low Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, Chart is provided for illustrative purposes. The sector allocation of the Low has changed more dynamically than that of a typical high-dividend-yield portfolio due to its low-volatility screen. The weighting of the financials sector was reduced to zero during the recession of the early 1990s and the global financial crisis in , as these were times when financial stocks experienced high volatility and severe price drops. Utilities stocks were also completely excluded from the index during the Enron crisis in early 2003, when most utilities stocks were unusually volatile (see Exhibit 5). 5

6 The Beauty of Simplicity: The Low May 2015 Exhibit 5: Historical Sector Weight of the Low 100% 90% 80% 70% Enron Crisis Utilities Telecommunication Services 60% Materials 50% 40% 30% 20% 10% 0% January 1990 Early 1990s Recession January 1991 January 1992 January 1993 January 1994 January 1995 January 1996 January 1997 January 1998 January 1999 January 2000 January 2001 January 2002 January 2003 January 2004 January 2005 January 2006 January 2007 January 2008 Global Financial Crisis January 2009 January 2010 January 2011 January 2012 January 2013 January 2014 Information Technology Industrials Healthcare Financials Energy Consumer Staples Consumer Discretionary Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, Chart is provided for illustrative purposes Yield The Low has historically offered high dividend yield. From December 1990 to December 2014, the index had a long-term median dividend yield of 4.5% and always stayed above 3.5% much higher than the, which had a long-term median dividend yield of 1.9% and a maximum yield of 3.8% during the same period. Historically, the dividend yield gap between the two indices has ranged from 1.8% to as high as 4.6%, with a median value of 2.4% (see Exhibit 6). Exhibit 6: Historical Yield of the and Low 9 8 Low Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance of the Low. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance Historical Performance During the past 20 years as of year-end 2014, the Low has outperformed the by 3.4% annually, with a 9% volatility reduction and smaller maximum drawdown. The index has also had a significantly higher risk-adjusted return than the over the last 5-, 10-, and 20-year horizons. Even excluding the compounding effect of dividend income and comparing just the price returns, the 6

7 The Beauty of Simplicity: The Low May 2015 Low has delivered slightly better absolute and risk-adjusted returns than the S&P 500, with lower volatility and smaller maximum drawdown (see Exhibit 7). Exhibit 7: Return/Risk Summary of the and Low Period Annualized Return (%) Low Volatility High Price Return Low Volatility High Total Return 3-Year Year Year Year Annualized Volatility (%) 3-Year Year Year Year Risk-Adjusted Return (%) 3-Year Year Year Year Month Maximum Drawdown (%) 20-Year Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance of the Low. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. As the Low has had less-volatile performance than the, it is expected to underperform in bull markets and provide a level of downside protection during bear markets. Based on monthly total returns over the last 20 years, the Low has outperformed the 72% of the time during down markets, but it has only underperformed 57% of the time during up markets. As the level of underperformance during up markets (0.6%) has been much less than the level of outperformance during down markets (1.7%), the Low has consistently outperformed the over the long term (see Exhibit 8). 7

8 The Beauty of Simplicity: The Low May 2015 Exhibit 8: Capture Ratios and Average Monthly Return of the and Low Over the Last 20 Years 80% 70% Capture Ratio: Percent of Time When the S&P 500 Low Outperformed the in the Last 20 Years 72% 4.0% 3.0% 2.0% Average Monthly Return (Last 20 Years) 2.8% 3.4% 0.6% 60% 1.0% 50% 43% 0.0% 40% 30% 20% 10% -1.0% -2.0% -3.0% -4.0% Low Volatility High -2.1% -3.8% 1.7% 0% -5.0% Up Market Down Market Up Market Down Market Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, Past performance is no guarantee of future results. Charts are provided for illustrative purposes and reflect hypothetical historical performance of the Low. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. 4: COMPARISON WITH OTHER S&P DOW JONES DIVIDEND INDICES Finally, we compare the Low to other S&P Dow Jones Indices focused on the U.S. For readers who are also interested in how the Low is different from the Low Volatility, please see the Appendix Objective and Stock Selection Mechanism Besides screening for high-dividend-yield stocks, quality measures can help dividend strategy investors to avoid dividend yield traps. 1 Historical dividend policy, dividend growth, dividend payout ratio, and other fundamental ratios that measure companies earnings and financial strengths are commonly employed in dividend strategies. For example, the and the S&P High Yield emphasize consistent dividend history rather than high dividend yield in their stock selection criteria. The indices only include companies that follow a dividend policy of increasing dividends consistently for the past 25 or 20 years, respectively. yield is not part of their stock selection criteria. The 100 and the Select are designed to provide dividend sustainability and high dividend yield. Companies must have produced 10 or 5 years of dividend history, respectively, to be eligible for inclusion. Other fundamental measures also factor into the member selection process. Unlike the S&P Indices, the Low emphasizes high dividend yield and disregards consistent dividend history as a requirement for inclusion. The Low uses a simple two-step screening process to select members, accounting for volatility and dividend yield, while the Dow Jones Indices leverage consistent dividend history and multiple fundamental ratios. As explained in section 2, the low-volatility screen used by the Low not only acts as a quality measure to ensure that stocks with sharp price drops are excluded from the index, but it also captures the low-volatility anomaly. 1 yield traps refer to companies that promise high dividends or used to pay high dividends but do not have strong cash flow to support the dividend payments. These companies have historically high dividend yield, but it is not sustainable. 8

9 The Beauty of Simplicity: The Low May 2015 Since price volatility changes more frequently than the fundamental measures of a company, the Low is rebalanced semiannually, while other S&P Dow Jones Indices are rebalanced annually. To maximize the dividend yield of the index, members of the Low are weighted by their dividend yield (see Exhibit 9). Exhibit 9: Construction of S&P Dow Jones Indices in the U.S. S&P High Yield Parent S&P 1500 Number of Members Size Criteria Liquidity Criteria Eligible Criteria Additional Member Selection Factors Weighting Method Sector Diversification Criteria Float-adj. Market cap above USD 3 billion 3-month ADTV above USD 5 million Minimum 25 consecutive years of increasing DPS history 100 Broad Stock Market (excluding REITs) Select (excluding REITs) Low Floating Floating N/A Each GICS sector weight is restricted to 30% Float-adj. market cap above USD 2 billion 3-month ADTV above USD 5 million Minimum 20 consecutive years of increasing DPS history N/A Float-adj. market cap above USD 500 million 3-month ADTV above USD 2 million Minimum 10 consecutive years of dividend payments Highest cash flow-tototal debt, return on equity, dividend yield and 5-year dividend growth rate N/A 3-month ADTV above 200,000 shares Minimum 5 consecutive years of dividend payments; nonnegative 5-year DPS growth; 5- year dividend payout ratio not greater 60% Highest dividend yield N/A N/A 75 highestdividend-yielding stocks with minimum trading days above 252 Lowest historical return volatility Equal yield Market cap yield yield N/A Each ICB industry weight is restricted to 25% N/A Number of stock from each GICS sector is limited to 10 and each GICS sector weight is restricted to 25% Rebalance Annual Annual Annual Annual Semiannual Frequency Source: S&P Dow Jones Indices LLC. Table is provided for illustrative purposes Yield Due to differences in their stock-selection criteria and member weighting methods, the S&P Dow Jones Indices offer different ranges of dividend yields. The more stringent the dividend history requirement and quality filters, the fewer high-yield stocks that are eligible for selection. The, which most strongly emphasizes consistent dividend history, had a dividend yield of 2.2% as of year-end 2014 the lowest among all the S&P Dow Jones Indices. In contrast, the Low, which lacks a dividend history requirement, offered the highest dividend yield compared to other S&P Dow Jones Indices. The index offered a dividend yield of 3.6% as of month-end December % above that of the (see Exhibit 10). 9

10 The Beauty of Simplicity: The Low May 2015 Exhibit 10: History Requirement and Yield of the S&P Dow Jones Indices in the U.S Yield (%) Consistent History Requirement (# of Years) Perecentage Years NA Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, Past performance is no guarantee of future results. Chart is provided for illustrative purposes Historical Performance S&P High Yield 100 Select Low During the period studied, the Low offered the highest dividend yield among all the S&P Dow Jones Indices, and it also captured the benefit of a low-volatility strategy. But how exactly did this simple low-volatility/high-dividend methodology, with no dividend history criteria or fundamental quality screens, result in higher returns and lower risk compared to the other dividend indices? Based on monthly price returns for the period from December 1999 to December 2014, the Low delivered historical returns, volatility, and maximum drawdown that were similar to the other S&P Dow Jones Indices, before the inclusion of dividend income (see Exhibit 11). 0 10

11 The Beauty of Simplicity: The Low May 2015 Exhibit 11: Risk/Return Summary of S&P Dow Jones Indices in the U.S. (Before Inclusion of Reinvestment Income) Period S&P High Yield 100 Select Low Annualized Return (%) 3-Year Year Year End 1999 Annualized Volatility (%) Year Year Year End 1999 Risk-Adjusted Return Year Year Year End month Max Drawdown (%) End Source: S&P Dow Jones Indices LLC. Data from December 1999 to December Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance of the, S&P High Yield, Select, 100, Low and the Low Volatility. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. However, when dividend income reinvestment return was included, the Low delivered the best historical absolute return of all the S&P Dow Jones Indices, as shown in Exhibit 12. Based on monthly total returns for the period from December 1999 to December 2014, the Low had the highest absolute and risk-adjusted returns among all the S&P Dow Jones Indices. Its historical volatility was less than that of two other S&P Dow Jones Indices, and its historical maximum drawdown (12-month) was less than that of three other S&P Dow Jones Indices (see Exhibit 13). 11

12 The Beauty of Simplicity: The Low May 2015 Exhibit 12: Annualized Price Return and Income of the S&P Dow Jones Indices in the U.S. Total 10.3% 10.4% 11.3% 9.9% 11.6% 4.2% Return 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 7.4% 2.7% 6.5% S&P High Yield 7.5% 3.7% 3.5% 100 Source: S&P Dow Jones Indices LLC. Data from December 1999 to December Past performance is no guarantee of future results. Chart is provided for illustrative purposes and reflects hypothetical historical performance of the, S&P High Yield, Select, 100, Low and the Low Volatility. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. Exhibit 13: Risk/Return Summary of the S&P Dow Jones Indices in the U.S. (After Inclusion of Reinvestment Income) 5.6% 4.2% Select 6.6% 4.7% Low 2.3% 1.9% Return From Share Price Appreciation Return From s (Reinvested) Period S&P High Yield 100 Select Low Annualized Return (%) 3-Year Year Year End Annualized Volatility (%) 3-Year Year Year End Risk-Adjusted Return 3-Year Year Year End month Max Drawdown (%) End Source: S&P Dow Jones Indices LLC. Data from December 1999 to December Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance of the, S&P High Yield, Select, 100, Low and the Low Volatility. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. 12

13 The Beauty of Simplicity: The Low May Sector Exposure To understand how the Low differs from other S&P Dow Jones Indices in terms of sector allocation, we compared the sector weights of all the S&P Dow Jones Indices as of December 2014, as shown in Exhibit 14. Compared to other dividend indices, the Low Volatility High had relatively high exposure to the utilities and financials sectors and low exposure to the industrials and consumer discretionary sectors. As the Low is most strongly focused on high dividend yield, its sector exposure is more dependent on the concentration gradient of high-dividend-yield stocks across sectors. This contrasts with the S&P Indices, which disregard dividend yield in their stock selection criteria. Exhibit 14: Sector Composition of the S&P Dow Jones Indices in the U.S. 3.3% 3.4% 8.1% 8.0% 6.8% 12.4% 3.1% 3.1% 4.3% 11.0% 11.4% 7.0% 4.1% 10.2% 14.0% 5.6% 14.4% 15.1% 16.9% 12.3% 9.8% 18.5% 9.7% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Energy Materials Industrials Consumer Discretionary Consumer Staples Healthcare Financials Information Technology Telecommunication Services Utilities Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, Chart is provided for illustrative purposes. Among all the S&P Dow Jones Indices, the Low had the lowest sector concentration risk, based on sector composition as of December The Low had the lowest maximum sector weight and lower Herfindahl-Hirschman (HHI), which implies greater sector diversification, than the Select,, and 100 (see Exhibit 15 source line). Exhibit 15: Sector Concentration of the S&P Dow Jones Indices 9.1% 14.1% 10.5% 11.1% 6.4% 15.4% 4.2% 13.6% 8.9% 22.4% 17.2% 7.5% 23.9% 2.4% 1.9% 16.9% Low Select 100 S&P High Yield 6.8% 11.5% 21.1% 7.5% 13.2% 1.8% 36.4% 19.9% 12.8% 3.5% 3.1% 13.2% 19.8% 2.2% 3.1% 8.5% 0.5% 11.1% 1.7% 1.9% 2.0% 20% 19% 18% 17% 16% 15% 14% 13% 12% 11% 10% Dow Jones U.S. Select HHI on Sector Weight (Lower Number Implies Higher Sector Diversification) Dow Jones U.S. 100 Low Volatility High S&P High Yield 40% 35% 30% 25% 20% 15% Utilities, 36.4% Dow Jones U.S. Select Maximum Single Sector Weight Consumer Staples, 23.9% Consumer Staples, 22.4% Dow Jones U.S. 100 Financials, 21.1% S&P High Yield Utilities, 19.8% Low Volatility High Lower Diversification Higher Diversification Higher Single-Sector Exposure Risk Lower Single-Sector Exposure Risk Source: S&P Dow Jones Indices LLC. Data as of Dec. 31, Past performance is no guarantee of future results. Charts are provided for illustrative purposes. Note: The Herfindahl-Hirshman (HHI) is calculated as the sum of the square of 10 sectors weighting. A higher number implies lower diversification (higher concentration) and vice versa. 13

14 The Beauty of Simplicity: The Low May Factor Exposure Based on results from the Fama-French Three Factor model, the Low had significant market, large-cap, and value exposures for the period between December 1999 and December It had higher large-cap exposure and lower market beta than most of the other S&P Dow Jones Indices. As the low-volatility screen ruled out deep value stocks produced by sharp price drops, the Low Volatility High had a lower value bias than the Select, the S&P High Yield, and the 100 (see Exhibit 16). Exhibit 16: Factor Exposure of the S&P Dow Jones Indices Factors S&P High Yield 100 Select Low Market T-Stat Size T-Stat Value T-Stat R-Squared Value Select Large Cap 100 S&P High Yield Small Cap 0.55 Low Volatility High Growth Source: S&P Dow Jones Indices LLC. Data from December 1999 to December Past performance is no guarantee of future results. Chart and table are provided for illustrative purposes and reflect hypothetical historical performance of the, S&P High Yield, Select, 100, and Low. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. 5: CONCLUSION "Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-ofdifficulty doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables" (Warren Buffet, Letter to shareholders, 1994). While each of the S&P Dow Jones Indices has different characteristics and attributes, with a simple twostep constituent screening method accounting for price volatility and dividend yield, the Low Volatility High is designed to capture the benefit of high-dividend and low-volatility strategies. Combined, these strategies have achieved higher dividend yield and better risk-adjusted returns than other S&P Dow Jones 14

15 The Beauty of Simplicity: The Low May 2015 Indices that use dividend history criteria and multiple fundamental quality screens. In this way, the S&P 500 Low has set an example of simple and effective index innovation. APPENDIX Comparison with the Low Volatility The Low is a U.S. market dividend strategy index that uses a low volatility screen as a quality measure. On the other hand, the Low Volatility serves as a benchmark of low volatility strategies in the U.S. market. While both indices incorporate low volatility strategies, their ultimate goals are different. The Low s stock selection and member weighting criteria are designed to maximize the dividend yield of the index, while those of the Low Volatility are designed to minimize the volatility of the index. See Exhibit 17 for a list of differences in their index construction mechanisms. Exhibit 17: Construction Mechanisms of the Low and the Low Volatility Mechanism Low Volatility Low Parent Number of Members Eligibility Criteria Minimum trading days above 252 Member Selection Factors 100 stocks with lowest historical return volatility 75 highest dividend yielding stocks with minimum trading days above stocks with lowest historical return volatility Weighting Method Inverse of volatility figure yield Sector Diversification Criteria N/A Number of stock from each GICS sector is limited to 10 and each GICS sector weight is restricted to 25% Rebalance Frequency Quarterly Semiannually Source: S&P Dow Jones Indices LLC. Both the Low and the Low Volatility are well diversified among the 10 sectors. Compared to the, the Low holds more weight in the utilities and consumer staples sectors, which tend to have a higher concentration of high-dividend payers. Compared to the, the Low Volatility holds more weight in the financials and utilities sectors, as companies from these sectors tend to have lower return volatilities than other sectors. Exhibit 18: Sector Composition of the Low, the Low Volatility, and the S&P 500 Sector Low Low Volatility Weight Bias Compared Weight Bias Compared Sector Weight (%) Sector Weight (%) Sector Weight (%) to (%) to (%) Energy Materials Industrials Consumer Discretionary Consumer Staples Healthcare Financials Information Technology Telecommunication Services Utilities Source: S&P Dow Jones Indices LLC. Data as of December Past performance is no guarantee of future results. Table is provided for illustrative purposes. 15

16 The Beauty of Simplicity: The Low May 2015 While the Low Volatility is not designed to capture high-dividend-paying stocks, its sector bias to the financials and utilities sectors results in a higher dividend yield than the. Nevertheless, the Low, which is designed to measure the highest-dividend-yielding stocks, tends to have a significantly higher dividend yield than the Low Volatility (see Exhibit 19). As one might expect, the Low Volatility, which is designed to track the least-volatile stocks from the, has much lower beta than the Low. Based on the Fama- French Three Factor model, the Low has more significant value bias but slightly less large-cap bias than the Low Volatility (see Exhibit 19). Exhibit 19: Yield and Factor Exposure of the Low Compared to the Low Volatility Yield Low Low Factors Volatility Market T-Stat Size T-Stat Value T-Stat Low Volatility Low Volatility High R-Squared Source: S&P Dow Jones Indices LLC. yield data as of Dec. 31, Factor exposure analysis based on data from December 1999 to December Past performance is no guarantee of future results. Chart and table are provided for illustrative purposes and reflect hypothetical historical performance of the Low Volatility and the Low. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. Historical Performance Based on monthly price returns from December 1990 to December 2014, the Low delivered similar historical returns as the Low Volatility before inclusion of dividend income. However, when dividend income reinvestment return was included, the Low delivered higher absolute returns compared to the Low Volatility. Since the S&P 500 Low Volatility had lower beta than the Low, it exhibited lower return volatility and smaller maximum drawdown, historically. During up markets, the Low had a higher capture ratio and average monthly return than the Low Volatility, and vice versa for down markets. After adjusting for risk, the Low offered slightly higher returns than the Low Volatility (see Exhibits 20 and 21). 16

17 The Beauty of Simplicity: The Low May 2015 Exhibit 20: Risk/Return Summary of the, the Low Volatility, and the Low Annualized Price Return (%) Annualized Total Return (%) Period Low Volatility Low Period Low Volatility Low 3-Year Year Year Year Year Year Year Year End 1990 End 1990 Source: S&P Dow Jones Indices LLC. Data from December 1990 to December Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance of the Low and the Low Volatility. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. Exhibit 20: Risk/Return Summary of the, Low Volatility and Low (cont.) Period Low Volatility Annualized Volatility (%) Price Return Low Period Total Return Low Volatility Low 3-Year Year Year Year Year Year Year Year End 1990 Risk-Adjusted Return End Year Year Year Year Year Year Year Year End Month Max Drawdown (%) End End 1990 End 1990 Source: S&P Dow Jones Indices LLC. Data from December 1990 to December Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance of the Low and the Low Volatility. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. 17

18 The Beauty of Simplicity: The Low May 2015 Exhibit 21: Capture Ratios and Average Monthly Return of the, the Low Volatility, and the Low Over the Last 20 Years 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Capture Ratio: Percent of Time When the Low Volatility and the Low Volatility High Outperformed the 31% 43% Up Market Low Volatility 84% 72% Down Market Low Source: S&P Dow Jones Indices LLC. Data from December 1994 to December Past performance is no guarantee of future results. Charts are provided for illustrative purposes and reflect hypothetical historical performance of the Low and the Low Volatility. Please see the Performance Disclosures at the end of this document for more information on some of the inherent limitations associated with back-tested performance. 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% 2.3% 2.8% 3.4% Low Volatility Low Up Market Average Monthly Return -1.7% -2.1% -3.8% Down Market 18

19 The Beauty of Simplicity: The Low May 2015 ABOUT S&P DOW JONES INDICES S&P Dow Jones Indices LLC, a part of McGraw Hill Financial, Inc., is the world s largest, global resource for index-based concepts, data and research. Home to iconic financial market indicators, such as the and the Dow Jones Industrial Average TM, S&P Dow Jones Indices LLC has over 115 years of experience constructing innovative and transparent solutions that fulfill the needs of institutional and retail investors. More assets are invested in products based upon our indices than any other provider in the world. With over 1,000,000 indices covering a wide range of assets classes across the globe, S&P Dow Jones Indices LLC defines the way investors measure and trade the markets. To learn more about our company, please visit LIKE WHAT YOU READ? Sign up to receive updates on a broad range of index-related topics and complimentary events. 19

20 The Beauty of Simplicity: The Low May 2015 PERFORMANCE DISCLOSURES The Low (the ) was launched on September 17, The (the ) was launched on May 2, The S&P High Yield (the ) was launched on September 15, The Select (the ) was launched on November 3, The Dow Jones U.S. 100 (the ) was launched on August 31, The Low Volatility (the ) was launched on April 20, All information presented prior to the Launch Date is back-tested. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect on the Launch Date. Complete index methodology details are available at S&P Dow Jones Indices defines various dates to assist our clients in providing transparency on their products. The First Value Date is the first day for which there is a calculated value (either live or back-tested) for a given index. The Base Date is the date at which the is set at a fixed value for calculation purposes. The Launch Date designates the date upon which the values of an index are first considered live; index values provided for any date or time period prior to the index s Launch Date are considered back-tested. S&P Dow Jones Indices defines the Launch Date as the date by which the values of an index are known to have been released to the public, for example via the company s public Web site or its datafeed to external parties. For Dow Jones-branded indices introduced prior to May 31, 2013, the Launch Date (which prior to May 31, 2013, was termed Date of Introduction ) is set at a date upon which no further changes were permitted to be made to the index methodology, but that may have been prior to the s public release date. Past performance of the is not an indication of future results. Prospective application of the methodology used to construct the may not result in performance commensurate with the back-test returns shown. The back-test period does not necessarily correspond to the entire available history of the. Please refer to the methodology paper for the, available at for more details about the index, including the manner in which it is rebalanced, the timing of such rebalancing, criteria for additions and deletions, as well as all index calculations. Another limitation of using back-tested information is that the back-tested calculation is generally prepared with the benefit of hindsight. Back-tested information reflects the application of the index methodology and selection of index constituents in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the equities (or fixed income, or commodities) markets in general which cannot be, and have not been accounted for in the preparation of the index information set forth, all of which can affect actual performance. Additionally, it is not possible to invest directly in an. The returns shown do not represent the results of actual trading of investable assets/securities. S&P Dow Jones Indices maintains the and calculates the levels and performance shown or discussed, but does not manage actual assets. returns do not reflect payment of any sales charges or fees an investor may pay to purchase the securities underlying the or investment funds that are intended to track the performance of the. The imposition of these fees and charges would cause actual and back-tested performance of the securities/fund to be lower than the performance shown. For example, if an index returned 10% on a US $100,000 investment for a 12-month period (or US$ 10,000) and an actual asset-based fee of 1.5% was imposed at the end of the period on the investment plus accrued interest (or US$ 1,650), the net return would be 8.35% (or US$ 8,350) for the year. Over a three-year period, an annual 1.5% fee taken at year end with an assumed 10% return per year would result in a cumulative gross return of 33.10%, a total fee of US$ 5,375, and a cumulative net return of 27.2% (or US$ 27,200). 20