At a Glance
- Demographic shift, low yield environment create a quest for dividends
- Open dividend futures contracts up more than 100 percent in 2017
In the wake of the global financial crisis in 2008, policymakers and central banks around the globe turned to historic and unprecedented monetary policies amid efforts to stimulate economic growth and stave off disinflationary pressures.
The subsequent moves to negative interest rates among advanced nations and the low interest rate level in the United States heightened investor focus on and search for yield.
Dividend stocks have stolen the spotlight among investors starved for yield and are rapidly becoming a significant pseudo-asset class, driven in part by the still-low interest rate environment.
Over the last 15 years there has been greater awareness in the investment community regarding the importance of dividends and the role they play in contributing to total equity return, says Aye Soe, managing director of research and design at S&P Dow Jones Indices. “Price return can be negative or positive, but dividend return is always positive. It’s starting to gain growing recognition as a unique sub asset class.”
“There is a real search for yield and income. We have an aging population. The current low yield environment, together with the demographic shift and the massive number of Baby Boomer’s retiring has created urgency and a real quest for dividends and income,” Soe adds.
Though the S&P 500’s record highs have dominated investors’ attention this year, high dividend yielding stocks have outperformed the S&P 500 over several periods since the financial crisis. In fact, the S&P 500 Low Volatility High Dividend Index returned 9.29 percent over the past three years, over a full percentage point more than the S&P 500 during that span.
Part of the stellar returns in dividend stocks is due to a portfolio rebalancing in the search for yield, says Stewart Warther, U.S. Equity & Derivative Strategist at BNP Paribas. “Rates are so low and credit spreads so tight that some investors may be using high dividend paying stocks as a fixed income alternative,” Warther says.
It has paid off. Cash-rich companies have been increasing dividends, amid record S&P 500 cash levels. Over the last seven years, dividends paid by S&P 500 companies have nearly doubled and the number of S&P 500 companies paying a dividend has grown from 365 to 419, according to Factset data.
Dividend Futures Born Out Of Swaps Market
In the early 2000s, institutional investors, mainly investment banks – began hedging their future dividend stream via over-the-counter dividend swaps.
Dividend futures, which at their core allow investors to trade on the expected dividend outlook, were a natural evolution. CME Group launched its S&P 500 Annual Dividend futures and S&P 500 Quarterly Dividend futures contracts in November 2015. This followed a thriving and active dividend futures market in Europe.
The first dividend future launched in June 2008 by Eurex on the Euro Stoxx 50 dividends, and now dividend futures are traded on the CME and in Asia at Hong Kong Exchanges and Clearing on the Hang Seng index.
“In the past investors who needed to hedge out dividend risk had to go to the OTC market and use swaps,” Soe says. One of the biggest benefits of dividend futures are the elimination of counter-party risk. “When you do a swap in the OTC market it’s between two parties and theere’s a risk that the other party maydefault,” Soe notes.
Heavy Usage among European Money Managers
“If you look at other markets, dividend futures have grown dramatically. The product is particularly popular in Europe,” Warther says. Recent trading data bears that out. CME Group’s dividend futures are reached more than 100,000 in open contracts for the first time on August 23. Total open interest is up 104 percent since the beginning of 2017.
“We have seen dividend futures really taking off in Europe,” agrees Soe. “Institutional investors have really embraced hedging strategies utilizing dividend futures.”
Dividend Futures: The Basics
Dividends contribute a large portion to total equity returns and make a significant contribution to the value of an investment. Dividend Index futures provide investors with tools to hedge or express a view on the U.S. dividend market, regardless of the price movement of the S&P 500 index.
Buying a dividend future is different than buying a dividend yielding stock. With a purchase of a dividend future one is “simply buying the dividend payment itself, and as a result taking a concentrated risk at a single maturity within a single year,” Warther says.
CME Group offers both quarterly and annual dividend futures contracts. The annual contracts currently attract larger open interest and volume and is based on the S&P 500 Dividend Points Index (Annual), which tracks the accumulation of dividends on an annual basis and resets to zero after the expiration of the leading December contract.
A Range of Users and Uses
Institutional users include banks that issue structured products, hedge funds, pension funds and asset managers, or any money manager that is concerned about dividend income fluctuations.
Pension funds, as an example, have unique liability streams and dividend futures can be utilized to hedge out dividend fluctuation risk. “Pension funds biggest risk is the inability to meet their liability stream for retirees. If you have dividend fluctuations you cannot properly project to meet their needs,” Soe says.
Here are a few of the uses and strategies around dividend futures:
Risk Management – to hedge dividend risk embedded in derivatives or a portfolio of dividend paying stocks.
Trading Dividend Yield. “To trade dividend yield, investors can go long a dividend future, and hedge the remaining equity exposure by going short the underlying index, such as the S&P 500. “This is a popular way to harvest dividend yield while removing the equity market risk,” Soe says.
Dividend Stripping. A portfolio manager can synthetically sell dividend futures to buy more cash equities. This strategy can be executed when the expected capital appreciation is greater than dividend income, Soe explains.
The use of dividend futures in the U.S. remains in the early stages, and has not yet achieved the critical mass seen in Europe. As asset managers and pension managers in the U.S. become more familiar with dividend futures market mechanics, their growth is expected to increase in the U.S. as well.
“During the 2008 financial crisis many firms cut dividends or omitted altogether. If we are to go through another market environment like that, dividend futures will be much needed to hedge out dividend risk,” Soe concludes.