Investing in Dividend Strips Using Dividend Derivatives

January 27, 2017

Robert A. Gillam, CFA Chief Investment Officer McKinley Capital Management, LLC
Gregory S. Samorajski, CFA Director of Investments McKinley Capital Management, LLC
Martino M. Boffa, CFA. Director of Investments McKinley Capital Management, LLC

Executive Summary

In this paper, McKinley Capital Management, LLC (“McKinley Capital” or the “firm”) introduces the emerging market for single stock and index based dividend strip investing. The firm analyzes the mechanics and documents the rapid growth of the market. This McKinley Capital Research article explains how the creation of dividend derivatives is rooted in the structure of customized equity-type offerings. Like zero-coupon bonds, structured equity products and dividend derivatives allow for the efficient structuring and trading of specific cash flows through time. The firm explains how dividends are expected to perform as a passive investment and provides data to support that expectation. Finally, McKinley Capital makes the case for active investing in dividend strips and demonstrates its expertise since 2010 — when it initiated active dividend strip investment management.

Introduction to the Dividend Derivatives Market

Dividend derivatives were created in the late 1990s to offer investors the opportunity to invest in index level and specific dividends of select companies. Similar to zero coupon bonds, dividend derivatives facilitate the stripping of the first five to ten years of future company dividends. Unlike zero coupon Treasury bonds, the amount of future company dividends is unknown — creating an opportunity for superior earnings and payout analysis. Typically, dividend derivatives are tied either to specific company dividends, or to index based dividend levels. Dividend derivatives first appeared in the form of swaps. In 2008, in an effort to reduce counterparty risk, and concentrate liquidity, dividend futures were introduced. Both forms plus options are widely used in today’s markets. The purchaser/seller of a dividend future pays/receives the current market price for a specific future dividend, and, in-turn, receives/pays the actual amount of dividends paid by the company in the future. The buyer of a dividend derivative earns a positive return when the price paid at initiation is less than the amount actually paid by the company. The seller of a dividend derivative profits when the actual dividend amount the company pays is less than the market price at initiation. Specific company dividend futures can trade several years forward. At the index level, derivatives are often available up to eight or more years forward.

The dividend derivatives market developed as investment banks — primarily in Europe — increased the issuance of structured equity products. The characteristics of these products typically leave the banks with forward dividend exposure up to seven years out. Due to regulatory and risk considerations, banks often welcome the opportunity to sell or hedge future dividend exposure. Such bank activity creates natural sellers of dividend derivatives, with a resulting potential return for buyers.1 Hedge funds and proprietary trading desks were early investors in dividend strip products. As the market evolved, dividends, and related derivatives, have developed into a separate asset class with broadened investor recognition. Since 2010, McKinley Capital has offered investments in dividend and dividend derivatives.

The Euro Stoxx 50 was the first index to support listed dividend futures. Launched in 2008, the success of this product led to the launch of dividend derivatives based on the FTSE 100, the S&P 500, the Nikkei 225, and other equity indexes. The year 2010 witnessed the inauguration of single stock dividend futures on the Euro Stoxx 50 members. Subsequently, there has been a steady increase in the number of stocks with listed dividend futures. Today, several hundred single stock dividends trade on European and other exchanges. Due to increased market demand, the volume and open interest in dividend derivatives of all types continue to grow. For example, Figure One shows the Eurex listed dividend derivatives volume and open interest growth from 2012 to 2016.

Figure One

Investing in Dividends Using Dividend Derivatives

The price of an equity security can be modeled as the present value — discounted at a risk-adjusted rate — of all future dividends. Therefore, investing in dividends may be considered to be similar to a hybrid investment in equities and bonds. Dividend futures typically settle against the value of company or index level dividends actually paid in a calendar year. For example, ENI 2018 dividend futures will ultimately settle against the value of dividends the company pays in 2018.2 In order to provide positive expected returns for buyers, dividend futures often trade at a discount to consensus analyst dividend expectations. For example, on October 26, 2016, one major dealer forecasted 2019 Euro Stoxx 50 dividends at 135.1 index points. At the same time, the market price for the futures contract was 104.8 index points. If the analyst estimate is actually realized in 2019 — an uncertain proposition, the annualized return to an investor purchasing the contract at 104.8 would be 8.4%.3

As a general principal, near-term dividend payments are more certain than later dividend payments. Distant dividend payment uncertainty is probably related to overall equity market conditions and changes, while any near-term uncertainty is likely more firm specific. For this reason, market participants often expect futures volatility to increase with time to contract maturity. To test these assumptions, McKinley Capital measured and analyzed the returns for index based, constant maturity futures contracts from January 2007 through December 2016. Tables One through Five show the summary statistics for the S&P 500, Euro Stoxx 50, FTSE 100, Nikkei 225, and the Hang Seng Chinese Enterprise Index dividend futures contracts. Table Six shows the simple average across the five index based dividend futures. It is apparent, that over this time period, volatility and beta did, in fact, increase with time to maturity for each dividend index contract. Since the goal of dividend investing is to diversify traditional styles, the nearest contracts might offer the best opportunities for passive dividend strip investing.4

For all of the indexes except the S&P 500, the one year constant maturity contract outperformed each of the more deferred contracts, and also the underlying equity index — see Figure Two in addition to Tables One through Six. These return results are explained in part by the rather weak non-U.S. equity market environment experienced over the last ten years — low beta was better. However, it is also due to the “pull-to-realized” effect. Some of the return to the purchase of dividend futures arises from the convergence of the futures price to the dividend forecast, and ultimately to the realized dividends. However, this convergence seems to accelerate as the contracts approach maturity. The result is often greater return potential for the shortest contracts. To exploit these effects, McKinley Capital focuses most of its dividend purchases on the first few index and specific stock dividend contracts. Table Seven and Figure Three show the potential benefits of adding dividend positions to otherwise traditional stock and bond allocations (based on the last ten years of returns).

Table One – S&P 500 Dividend Market, Jan 2007 – Dec 2016

Equity Index Const 1 Yr Const 2 Yr Const 3 Yr Const 4 Yr Const 5 Yr All Years
Annualized Return 6.9% 2.9% 2.6% 3.3% 2.6% 2.5% 2.9%
Annualized St. Dev. 15.3% 7.9% 12.4% 13.2% 14.4% 15.5% 12.2%
Sharpe Ratio 0.46 0.30 0.21 0.25 0.20 0.19 0.23
Beta vs. Equity Index 1.00 0.28 0.54 0.58 0.65 0.71 0.55
Max Drawdown -50.9% -25.0% -48.3% -49.2% -52.2% -54.9% -45.7%

Source: FactSet, Bloomberg, BNP Paribas 1/5/17. Analysis by McKinley Capital Management, LLC, 1/5/17.

Table Two: Euro Stoxx 50 Dividend Market, Jan 2007 – Dec 2016

Equity Index Const 1 Yr Const 2 Yr Const 3 Yr Const 4 Yr Const 5 Yr All Years
Annualized Return 1.9% 6.4% 2.6% -0.6% -2.2% -3.0% 0.9%
Annualized St. Dev. 18.4% 10.9% 21.6% 24.2% 24.7% 24.7% 20.5%
Sharpe Ratio 0.15 0.56 0.20 0.07 0.01 -0.03 0.11
Beta vs. Equity Index 1.00 0.28 0.84 1.01 1.06 1.06 0.85
Max Drawdown -53.7% -25.4% -63.9% -70.9% -71.0% -70.0% -61.8%

Source: FactSet, Bloomberg, BNP Paribas 1/5/17. Analysis by McKinley Capital Management, LLC, 1/5/17.

Table Three: FTSE 100 Dividend Market, Jan 2007 – Dec 2016

Equity Index Const 1 Yr Const 2 Yr Const 3 Yr Const 4 Yr Const 5 Yr All Years
Annualized Return 5.3% 6.8% 3.5% 1.8% 0.5% 0.1% 2.9%
Annualized St. Dev. 14.1% 12.4% 20.0% 20.4% 21.0% 21.4% 17.7%
Sharpe Ratio 0.38 0.53 0.24 0.15 0.09 0.08 0.21
Beta vs. Equity Index 1.00 0.32 0.74 0.88 0.90 0.96 0.76
Max Drawdown -39.7% -23.3% -59.2% -64.0% -66.3% -66.4% -56.1%

Source: FactSet, Bloomberg, BNP Paribas 1/5/17. Analysis by McKinley Capital Management, LLC, 1/5/17.

Table Four: Nikkei 225 Dividend Market, Jan 2007 – Dec 2016

Equity Index Const 1 Yr Const 2 Yr Const 3 Yr Const 4 Yr Const 5 Yr All Years
Annualized Return 2.9% 7.9% 5.1% 4.7% 4.8% 4.3% 5.6%
Annualized St. Dev. 20.7% 11.6% 21.5% 24.6% 25.4% 26.1% 21.3%
Sharpe Ratio 0.20 0.65 0.31 0.28 0.28 0.27 0.33
Beta vs. Equity Index 1.00 0.31 0.59 0.72 0.81 0.87 0.66
Max Drawdown -57.2% -37.3% -68.9% -73.7% -74.4% -75.3% -67.6%

Source: FactSet, Bloomberg, BNP Paribas 1/5/17. Analysis by McKinley Capital Management, LLC, 1/5/17.

Table Five: Hang Seng Dividend Market, Jan 2007 – Dec 2016

Equity Index Const 1 Yr Const 2 Yr Const 3 Yr Const 4 Yr Const 5 Yr All Years
Annualized Return 2.2% 7.0% 3.4% 2.8% 3.4% 3.8% 4.6%
Annualized St. Dev. 30.5% 17.6% 20.6% 23.2% 25.3% 30.4% 21.5%
Sharpe Ratio 0.20 0.42 0.23 0.20 0.23 0.25 0.28
Beta vs. Equity Index 1.00 0.18 0.27 0.39 0.50 0.64 0.39
Max Drawdown -66.4% -33.1% -47.7% -56.1% -59.7% -63.1% -51.9%

Source: FactSet, Bloomberg, BNP Paribas 1/5/17. Analysis by McKinley Capital Management, LLC, 1/5/17.

Table Six: Global Diversified Dividend Market, Jan 2007 – Dec 2016

Equity Index Const 1 Yr Const 2 Yr Const 3 Yr Const 4 Yr Const 5 Yr All Years
Annualized Return 4.5% 6.7% 4.2% 3.2% 2.7% 2.6% 4.0%
Annualized St. Dev. 16.5% 8.1% 15.5% 17.6% 18.5% 19.3% 15.4%
Sharpe Ratio 0.30 0.74 0.30 0.23 0.19 0.19 0.28
Beta vs. Equity Index 1.00 0.34 0.72 0.84 0.89 0.93 0.74
Max Drawdown -53.6% -21.2% -52.4% -58.9% -60.7% -61.4% -52.1%

Source: FactSet, Bloomberg, BNP Paribas 1/5/17. Analysis by McKinley Capital Management, LLC, 1/5/17.

Figure Two: Constant One Year Dividends vs. Global Equity Market, Jan 2008 – Nov 2016

Figure Two

Source: FactSet, Bloomberg, BNP Paribas 1/5/17. Analysis by McKinley Capital Management, LLC, 1/5/17.

Table Seven: Global Multi-Asset Class Performance, Jan 2007 – Dec 2016

50% Equity,
50% Bond
43% Equity,
43% Bond,
15% Dividend
35% Equity,
35% Bond,
30% Dividend
Annualized Return 4.2% 4.6% 4.9%
Annualized St. Dev. 9.8% 9.2% 8.6%
Sharpe Ratio 0.40 0.46 0.52
Max Drawdown -30.9% -29.1% -27.5%

Source: FactSet, Bloomberg, BNP Paribas 1/5/17. Analysis by McKinley Capital Management, LLC, 1/5/17.

Figure Three: Return-Risk Relationship, Addition of Dividend Allocation to Equity/Bond Portfolios, Jan 2007 – Dec 2016

Figure Three: Return-Risk Relationship, Addition of Dividend Allocation to Equity/Bond Portfolios, Jan 2007 - Dec 2016

Source: FactSet, Bloomberg, BNP Paribas 1/5/17. Analysis by McKinley Capital Management, LLC, 1/5/17. The indexes used for the blends for the equity and bond portions were the MSCI World Index and the Bloomberg Barclays Global Aggregate Bond Index respectively.

The Case for Active Dividend Investing and the McKinley Capital Edge

As already discussed, dividend futures often trade at a discount to analyst expectations. However, the level of discounts vary substantially over time, across indexes and companies, and by time to maturity. This situation highlights the options available for active investing utilizing a skilled adviser.

Unique to dividend futures investing is the phenomenon that skill in forecasting earnings and dividends is directly translated into gains and losses. In traditional equity investing, earnings forecasting skill is only rewarded when stock prices move in tandem with earnings surprise. However, P/E expansion or contraction can, at times, offset successful earnings and dividend forecasts. Not so with dividend futures. The contract price is ultimately set to equal the actual dividend payment, not the stock price. As a component of its regular investment process, McKinley Capital has developed a skills set designed to generate superior earnings and dividend forecasts. Such proficiencies provide the firm with the ability to seek higher returns in the dividend derivative markets. The following discussion and examples illustrate how an adviser might analyze single stock dividend futures trades.

The actual dividends paid by a company are driven by two factors: (1) the company’s capacity to pay dividends; and (2) the company’s willingness to pay dividends. Capacity to pay dividends refers to the company’s ability to generate enough cash to pay dividends. The investment decision involves the fundamental analysis of free cash flow, earnings forecasting, and dividend coverage. Analysis of a company’s willingness to pay dividends includes a study of the company’s stated dividend policy, management comments, dividend track record, and shareholder structure.

Example 1: Long ENI SpA 2018 Dividend Futures

On April 1st, 2016, ENI SpA 2018 dividend futures closed at EUR 0.48. Previously, in March 2015, ENI lowered its dividend from EUR 1.00 to EUR 0.80 — earlier than its peers. Some market participants were apparently concerned that ENI would not maintain even the lowered dividend level given low oil prices. The market price for the 2018 contract subsequently fell to EUR 0.40 per share. Other market participants might have seen some upside even if the price of oil did not recover. Some of those mitigating factors might have been ENI’s cost cutting programs, decline in E&P capex, disposal plans, and strong cash preservation measures resulting from the sale of stakes in Saipem, Galp, and Snam. ENI had a robust balance sheet. During its March 2016 Investor Day, the company emphasized that a EUR 0.80 dividend was the floor, and announced a progressive outlook. Throughout 2016, management continued to confirm that ENI would fully cover capex and dividends even with oil prices at current levels. As the market slowly regained confidence, the 2018 dividend futures price began to trend towards the EUR 0.80 company commitment. In this case, by January of 2017, the buyers of futures would have been in a gain position, while the sellers would have been in a loss position.

Figure Four: Long 2018 ENI SpA Dividend Futures

Figure Four: Long 2018 ENI SpA Dividend Futures

Source: Bloomberg, 1/3/17. Contract prices shown are examples of the potential profit an investor could have made if the contracts were purchased and sold at these prices. Profitability does not include trade costs, margin, or other fees.

While active managers usually emphasize the purchase of dividend derivatives, there are also opportunities for hedge accounts and certain funds to short sell. Predicting dividend cuts can be a challenge. Companies facing the prospect of declining earnings, sometimes seek to maintain unsustainable dividend payments for several years before finally capitulating to a dividend reduction.

Example 2: Short RWE AG (“RWE”) 2016 Dividend Futures

Some dividend analysts have forecasting models which, at times, identify negative catalysts, and signal negative prospects for future company dividends. In those cases, short positions can be considered. RWE’s 2016 dividend was trading at EUR 0.45 on November 10, 2015. Some analysts might have suspected that RWE’s earnings would fall under pressure, and that RWE would not be able to maintain its dividend. Some of the contributing factors included: lower power prices in Central Europe; weak operating performance in the U.K.; and, a higher tax rate. Some analysts saw a stretched balance sheet, with political risk abounding, especially risk related to German nuclear liabilities. In fact, RWE suspended its dividend on February 17, 2016. Following the dividend suspension, futures short sellers would have been in a gain position, while buyers of futures would have been in a loss position.

Figure Five: Short 2016 RWE AG Dividend Futures

Figure Five: Short 2016 RWE AG Dividend Futures

Source: Bloomberg, 1/3/17. Contract prices shown are examples of the potential profit an investor could have made if the contracts were purchased and sold at these prices. Profitability does not include trade costs, margin, or other fees.

McKinley Capital offers its clients several vehicles through which to gain active exposure to dividend investments. Available in several jurisdictions, the firm manages an unleveraged European regulated UCITS Fund, which incorporates dividend investing through futures as a primary strategy.5 The goals of the Fund, managed since September 30, 2010, are middle to high single digit returns, low volatility, and low return correlation to traditional equity and fixed income indexes. The actual returns have been consistent with those goals. Since early 2015, McKinley Capital has managed separate accounts focusing on dividend futures only.6 Because of the separate account feature, leverage levels are determined by each individual client. Finally, the firm is able to design custom dividend derivatives investment programs to meet specific client needs. These programs can range from passive dividend investments without leverage to leveraged active dividend strategies. McKinley Capital stands ready to discuss these exciting new investment markets with you.

Figure Six: McKinley Capital Dividend Growth Strategy (Gross) Growth of One Euro Since Inception

Figure Six: McKinley Capital Dividend Growth Strategy (Gross) Growth of One Euro Since Inception

Source: McKinley Capital, 1/24/17. Past performance is not indicative of future results.

Table Eight: McKinley Capital Dividend Growth Strategy Performance (EUR), Ending December 31, 2016

QTD 1 Year 3 Year 5 Year Since Inception
(9/30/2010)
Dividend Growth – UCITS Composite (Gross) -1.31% 0.02% 4.66% 7.03% 6.34%
Dividend Growth – UCITS Composite (Net) -1.63% -1.37% 3.01% 5.29% 4.61%
EONIA Total Return Index -0.09% -0.33% -0.11% 0.01% 0.17%
Difference (Gross) -1.22% 0.35% 4.77% 7.02% 6.17%

Source: McKinley Capital, 1/24/17. Past performance is not indicative of future results. This is not an offer to buy or sell the Dividend Growth UCITS Fund.

McKinley Capital Management, LLC is a SEC registered investment adviser. The Dividend Growth – UCITS Composite includes fully discretionary funds or Undertakings for Collective Investments in Transferable Securities (UCITS) that invest in a combination of stock index and individual company equity dividend futures and/or swaps, other derivatives, all capitalization growth stocks and short term or cash equivalent fixed income securities to create a portfolio that can capture earnings growth, dividend payouts and yields. The strategy may employ up to 100% leverage. Since the inception of the strategy, net derivatives exposure has averaged 65.7% of the value; however, during January 2012 the net derivatives exposure was 99.9%, which greatly increased the sensitivity to dividend payments and increased the potential for realized gains and/or losses. The benchmark is the EONIA Total Return Index. The EONIA Total Return Index (the Euro Overnight Index Average) reflects the effective daily interbank interest rate for the Euro Zone, calculated as the weighted average of unsecured lending in the Euro market. The index is presented as a point of reference comparison and not as a similarly constructed benchmark. Returns include the effect of foreign currency exchange rates which are obtained from a third party provider.

McKinley Capital Management, LLC claims compliance with the Global Investment Performance Standards (GIPS®). To receive a list of composite descriptions of McKinley Capital Management, LLC and/or a presentation that complies with the GIPS standards, contact Vinay Sharma, CFA, CIPM at (907) 563-4488, or write McKinley Capital Management, LLC, 500 C Street, Suite 500, Anchorage, AK 99516.

1 Goldman Sachs, Global Dividend Swap Monitor, October 26, 2016, 8-9.
2 Many European companies pay a large dividend shortly after fiscal year results are announced — for example in February 2018 for a company with a fiscal year
ending on December 31, 2017. Some companies also pay a smaller dividend late in the year in advance of the next fiscal year results — for example in October
2018 for the same company. In this case, both dividends are included in the settlement price of the 2018 futures contract.
3 Golman Sachs, “Dividend Monitor”, 12.
4 The deferred contracts can, however, be used by active managers to create additional spread trading opportunities.
5 The Fund is not currently available in all jurisdictions or open to all investors. This is not an offer to buy or sell the Fund. The Fund does not use leverage.
Futures require only a small margin amount to support positions. The extra cash is invested through supplemental market neutral strategies in an attempt
to increase returns above those offered in the short-term European money markets. For most investors, Fund returns are earned and reported in Euros. Fund
offering documents are located at www.mckinleycapitalfundsplc.com.
6 Please contact McKinley Capital to discuss the limitations on direct dividend derivatives investing by U.S. investors.

Disclosure

McKinley Capital Management, LLC (“McKinley Capital“) is a registered investment adviser under the U.S. Investment Advisers Act of 1940. McKinley Capital is not registered with, approved by, regulated by, or associated with the Financial Conduct Authority (“FCA”), the Prudential Regulation Authority (“PRA”), the Securities & Futures Commission of Hong Kong or the China Securities Regulatory Commission. Additionally, none of the authorities or commissions listed in the previous sentence has commented on the firm, the content of any marketing material or any individual suitability assessments.

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