The shiny new toy in equity investing is dividend
futures. But this product does a lot more than it says on the
tin, argues Theo Casey - not all of it
This article was published by www.FOintelligence.com
, the futures and options news and data service. Copyright
Euromoney Institutional Investor PLC.
In the hackneyed stock market axiom investors are advised:
"Sell in May, go away and don't come back till St Leger's
The rationale is that the summer months are a bad time to
hold equities - either because crashes tend to happen
then, or because light trading from June to August leads to
trendless price action.
It's out of date. There is no summer lull nowadays - in
fact, companies are posting their second quarter results and
giving guidance for the second half.
Yet a similar law might still apply in a much younger,
related market. In this case, rather than coming back on St
Leger's Day, in September, that is when speculative investors
tend to sell.
Talk of the town
Speculating in expected dividends is the "new" idea that
everyone is talking about. Trading in the annual contracts -
notably the Euro Stoxx 50 Index Dividend Futures at Eurex and
NYSE Liffe's FTSE 100 contract - has been rising among fund
managers and institutional investors. Eurex also offers single
In this cash-settled market, one party pays a fixed amount
to receive from the other in December a sum linked to the value
of dividends paid out by the company or companies during a
given year. That fixed amount trades up and down according to
market expectations of the eventual payout.
The current year contract tends to approach its settlement
value as the year wears on, and dividend expectations become
But although this market is widely perceived as a value
opportunity, it has some peculiarities that can give the unwary
investor a nasty shock.
The bullish case for dividends, while legitimate, is fraught
with caveats, as investors who've been active in this volatile
market will attest.
Dividend futures were first listed in June 2008. In February
2009 James Montier, the behavioural finance expert, cast the
spotlight on them.
Then an analyst at Societe Generale, he tipped dividends as
a great opportunity for value-seekers: "A new opportunity has
arisen... [Dividend futures] appear to be priced for an
environment worse than the Great Depression! It sure looks like
an asset fire sale to me. A combination of forced selling and
oversupply has driven prices to excessively low levels."
Since then, the market's popularity has gone from strength
to strength. In less than a decade dividend trading has spread
from over-the-counter swaps to futures to options.
It's travelled from Europe to the US and Asia. The growth
has been remarkable, and brokers are convinced this market has
The Euro Stoxx 50 product now has about Eu6bn of open
interest, and is though to make up about half of the European
dividend swap market.
According to Fund Strategy, Patrick Armstrong of
Armstrong Investment Management, Ben Funnell of GLG and Ben
Gill of the L&G Diversified Absolute Return Trust are among
fund managers that have taken this opportunity to the retail
Flash crash, b'gosh
Dividends have often been seen as the humdrum part of equity
investing - something for widows and orphans, but not for
serious investors. In fact, they're a considerable nuisance for
some sophisticated strategies, such as convertible bond
But you'd be wrong to think pure dividend investing is
The market has swings and quirks that participants are only
beginning to try and understand.
Take the 'flash crash' of May 6. The mainstream media may
not have noticed, but amid the euphoria of the market snapping
back on May 7, dividend traders were tearing their hair. The
day has even been dubbed 'Dividend Black Friday'.
Prices fell precipitously, from 105.60 for the Euro Stoxx
2011 contract to 93.50. And unlike the equity market, they did
not recover quickly - in fact, they are still not back to where
Three more savage falls in May, June and early July took the
contracts below 85 at one point, before they finally began to
rally, breaking above 100 in August. Back in January, they had
traded at nearly 120.
Generic risks: seasonal and limited
The dangers should not be exaggerated. Some of the risks
with dividend futures are generic ones common to many
instruments, such as wide spreads and illiquidity in far-dated
contracts. But dividends also pose specific problems that one
First, seasonality. Interest in dividend futures often rises
during February to May, when dividend payments start to be
made. By August and September there is a lot of certainty in
the current year contract, in this case 2010, as about 80% of
expected payments have been made.
So investors start looking forward to 2011, 2012 and beyond.
Many roll out of the front year into the next, leading to some
selling pressure. But any fall in price should be arbed away by
people buying the contract for a reasonably safe payout.
There are stock-specific risks, too. Futures only capture
one means of returning capital to shareholders: ordinary
dividends. Special and extraordinary dividends, scrips and
buybacks earn you nothing. So if companies change their
behaviour, you could lose out.
Take this from Ben Gill, a fund manager at L&G: "You
can't do this in big sizes. It's more interesting for people
who don't have mark-to-market risk."
To put it another way, the market can fall prey to
mispricing. Sources involved in the market concede this is a
fair criticism. "The more we have buy and hold participants,
the more stable this market will be," says one.
This problem is not unusual in asset classes still finding
their feet. According to a recent report in Fund
Strategy, Gill is long the 2012 contract and believes it
has significant upside potential. But the stance taken by such
investors is a fundamental one. They have to be content with
being 'long and wrong' for potentially the contract's entire
term until expiry.
The punchline: what did happen on May
There is another issue investors must think about, which
lies behind much of the mark-to-market risk and mispricing.
There are several theories about why dividend futures fell
so hard and fast on Friday May 7.
The first is pretty innocuous - that hedge funds were
deleveraging and dividends were simply one of the affected
asset classes. That created a bid drought, and with little
liquidity, the only way was down.
Denizens of the dividend market
Hedgers Many structured equity
investment products are inherently long dividend risk.
The banks that provide them therefore fear dividends
turning out higher than expected. They use swaps and
futures to hedge their exposure, agreeing to pay a
fixed amount in return for whatever dividends turn out
The heavy presence in the market of structured product
dealers - who originally invented the product in its
OTC form - is widely acknowledged.
Convertible bond funds also use the instruments to
hedge their exposure by paying the fixed side of the
swap or future.
Fundamentalists and speculators Those that
make outright plays, studying analysts' forecasts and
betting that dividends will turn out better or worse
than the futures market predicts. A growing niche,
especially for investors without mark-to-market
concerns. Many speculators also arbitrage curve
steepness between contracts for different years. At the
moment the near-dated, more actively dated contracts
are backwardated, while the less liquid instruments for
three years and beyond are in contango.
Cashflow managers Investors wishing to
crystallise expected dividend cashflow early. The
appeal of this strategy in uncertain times was brought
home by BP's recent decision to scrap dividends for the
rest of 2010.
The second theory is more revealing. According to one hedge
fund manager, active in this market, it was forced selling by
structured products dealers that pushed prices lower.
One can liken this market to Japanese equities, where
structured products play a uniquely large part, primarily
because of the demand for income-giving products after so many
years of near-zero interest rates.
Much like in Japan, European structured products dealers
need to hedge vega (sensitivity to volatility) and, where
relevant, dividend risk.
As these dealers tend to be on one side of the market -
paying fixed sums to receive dividends - the quantity of
hedging they need to do can move the market. Therefore even the
ebb and flow of money in and out of structured products can be
felt in the dividend market.
Unlike in Japanese equities, there is no widely reported
monitor of structured product trading activity in dividend
futures. This can leave investors blind to the real causes of
Now for the more compelling explanation of Dividend Black
The previous day's exceptional trading pushed many equity
structured products past triggers, into automatic wind-down.
Dealers then had to scramble to unwind their hedges, including
Now they were weighing on the market the other way, wanting
to receive a fixed amount and sell dividends. Naturally prices
Interestingly, although the 2010 contract did not budge
much, as its outcome is fairly secure, the 2011, 2012 and 2013
futures move in lockstep.
Whatever you believe about what caused the slump, one thing
is inescapable. Dividend futures have not bounced back as
swiftly as equities.
The imbalance between sellers and buyers is evident in how
long the dislocation in value has lasted. This market has a
natural and well established group of sellers - the structured
products dealers - and a relatively new group of
Hence this article's somewhat facetious title. When the
great September roll happens, will these speculators stay with
the product by selling out of 2010 and buying 2011? Or might
some of them head for the exit, permanently?
For all the advantages the product may have, on May 7
dividend futures were shown to be every bit the "accidental
asset class" that the Financial Times described them
as in 2007.
To be clear, I am not a bear on this product. Quite the
opposite. In my day job as a retail investment journalist, I
actually recommended dividend futures in July, via the Lyxor
Euro Stoxx 50 Expected Dividend ETF.
This was in the run-up to the bank stress tests, which I
believed would mark an inflection point in sentiment for some
of the fund's major holdings. It's a position that is so far
serving investors well.
Nonetheless, this market is still green. That it was
possible to take advantage, two months later, of a palpable
value opportunity created by the flash crash - that
it had not been arbitraged away by then - demonstrates as
Structured products exacerbate downward moves in
stockmarkets. In the case of the dividend market, they appear
to incite them.
If, to quote JP Morgan's Michael Cembalest, the equity
market structure is "highly polarised" then the dividend
futures market is radically so.
As GMO's Jeremy Grantham extols: in a rational market,
structural selling pressures unrelated to value create
mispricing opportunities, into which sensible money will be
This is what happened to equities in the wake of the flash
crash. Fast forward three months and the mispricing, albeit to
a lesser extent, still persists in dividend futures.
Good news if you're the kind of investor who thrives on
mispricings. But if you bought the 2012 contract in February or
March, you may be sitting on a paper loss for a long
Theo Casey is editor of The Fleet Street Letter and a columnist