European ETF house Lyxor has just updated its range of dividend-focused quality income trackers with a new product targeting the Japanese market - you can see our fund profile here. This new fund builds on the work of Societe Generale strategist Andrew Lapthorne, consistently voted one of the best quantitative thinkers in the City. Over the last few years he's quietly built a small stable of quality income indices which are now the focus of a range of Lyxor ETFs. ETF Stream caught up with Andrew Lapthorne this week to explore the thinking behind his quality income range - and his new Japanese ETF.

Lapthorne joined Société Générale in London in November 2007 and heads up the quantitative analysis team. Andrew spent 11 years at Dresdner Kleinwort, beginning as a quant analyst in 1996. Prior to moving to Société Générale, he was global head of quantitative research. The team has created and runs a variety of systematic quantitative strategies, the most popular being the Global and European Quality Income Strategies. His team were ranked number one in the last Extel survey and he has also ranked as number one individual analyst for the last nine years.

ETF Stream: The new Japan ETF is based on the existing quality income index. What's the idea behind the Quality index range?

Andrew Lapthorne: The origin of the idea was to target higher dividend yield stocks whilst at the same time avoiding dividend cuts, which tend to be more common in the higher dividend yielding market. The end result was a portfolio with a higher dividend yield, a stable income stream with significantly less overall volatility and downside risk than the overall market in the long run.

ETF Stream: What's the methodology behind this Japan index?

AL: The concept remains the same, we are looking for good quality companies capable of sustaining an above average dividend yield and are using Piotroski F-score (a fundamental measure of a firm's quality) and Merton's Distance to Default (a measure of balance sheet risk) to assess this quality. The only significant change is because dividend yield is materially lower in Japan than it is globally, we are having to target a dividend yield that is above average, in this instance within the top 40% of the Japanese market instead of the 4%-plus we target in the European and Global versions.

ETF Stream: Most equity investors by now accept that dividends matter, but how much do they (dividends) matter for total returns over long periods of time?

AL: In real terms, reinvested dividends account for around 75% of total after-inflation returns since 1969. This differs slightly from market to market. Over this timeframe reinvested dividends have represented 42% of total real returns in Japan, but over the last 10 years, the dividend yield has provided the vast majority of the total return.

ETF Stream: As you apply your methodology to different regions, which regions look more attractive than others?

AL: I'm fairly agnostic when it comes to a regional view, preferring the models to guide the way. On the one hand, Europe looks to have the higher dividend yields, but payout ratios there are elevated; in the US companies tend to be of higher quality, but dividend yields are low and valuations extreme. Meanwhile in Japan, whilst higher dividend yields are difficult to achieve, companies look more reasonably priced.

ETF Stream: Why is Japan much more attractive now?

AL: It is fair to say that Japan has been a difficult place to hunt for quality income stocks. The country's equity market has spent a long time dealing with the consequences of the late 1980s bubble, together with low GDP growth and deflation. Problems that are no longer unique to Japan. Today, however, Japanese companies are more profitable than at any time during the last 30 years. Balance sheets are robust and whilst average dividend yields are not as high as, say, in Europe, the dividend cover is amongst the best in the world. I would also add that courtesy of years of disappointment, Japan equities remain a relatively unloved asset class, meaning that Japanese companies are trading at discounts to their European and North American peers.

ETF Stream: What's your take on alternative dividend methodologies used by other issuers (i.e. simple dividend weighting)?

AL: A company with a higher dividend yield is either there by design (i.e. the company is a mature business that is paying a higher dividend yield as compensation for less exciting growth prospects) or it has a higher dividend yield by accident (i.e. its share price has collapsed). Differentiating between the two forms the vital element in any equity income strategy, as such methodologies solely based on dividend tend to deliver disappointing results.

ETF Stream: Dividends tend to favour value stocks but value stocks have been a real underperformer over the last few years - shouldn't investors be focusing on momentum?

AL: The dividend yield is actually one of the worst performing of all standalone value metrics, so we prefer to focus on free cashflow measures which have performed better in recent years. The notable exception is the US where value strategies have suffered in the face of the strong outperformance of growth stocks. This is very much reminiscent of the 1990 tech bubble, when we experienced similar underperformance. Following a momentum-based strategy would have done better, but momentum often involves a substantial increase in trading cost and can suffer extremely volatility, the opposite of what we are trying to do with quality income. That is not to say momentum signals are not useful. Quite the opposite, they feature a lot in many of our quantitative strategies, but they need to be deployed in the context of a multi-factor strategy than simply on a stand-alone basis. Actually, the same applies again to dividend yield, on its own it's not that useful but in combination with quality it becomes far more useful.