Dear frustrated portfolio manager,
Are you fed up of playing second fiddle to that star trader
whose P&L is that bit more consistent? Is your client base
growing weary of those cookie-cutter strategy PDFs you send
them every month?
Perhaps you’re just bored of the identikit
portfolio you’ve been presiding over for what
feels like too long.
Well, there is an exciting new asset class that might be
able to soothe some of that angst. It’s liquid.
It’s exchange-traded. And it’s NOT
volatility. I speak of dividends – the best dealing
desk-recycled product since… never mind.
What are dividends, you ask? For our very specific purposes,
dividends are a derivative product which returns an amount
based on the aggregate dividend income paid in a year by a
company, or the companies in an index.
Eurex’s futures on the dividends of the Euro
Stoxx 50 constituents are now highly liquid – and
since June last year, options have also been available.
In September, this column examined some of the pitfalls in
dividend futures: the market’s seasonality,
one-sidedness, and consequent vulnerability to sudden crashes.
But such volatility is also a hunting ground for the savvy
Without wishing to exaggerate, dividends are like zero
coupon bonds on ecstasy.
How so? Both begin life at a discount to par. The lingo is
interchangeable – practitioners in both fields speak
of the "pull to par", "trading strips" and the "stickiness of
Both have a generally low beta, save for scary periodic
dislocations in value. And it’s no coincidence
that the options of both assets are priced using the Black-76
Why are dividends more exciting? With a ZCB, par value is
always 100, but dividends have no such cap on returns. It very
much depends on the alpha in the trade. But I’m
getting ahead of myself.
Having canvassed some of the great, the good and the
well-intentioned of the dividend world I can share with you
five trading ideas, hot from the fevered brains of investment
bankers eager to dish out these products.
These ideas, which range from the simple to the speculative,
incorporate dividend futures, options and in some places, both.
As an extra treat I’ve even done your due
diligence for you. Memorise the lines from the three boxes to
fool that vexing compliance officer into believing that
you’ve grown a sense of empathy.
No 5. Beta: Buy and hold
The entry level trade is simply to buy and hold. Salesmen
are using two recurrent narratives to convert long-only
investors to trade dividends:
Inflation Morgan Stanley, among others, is beating this
drum. The argument is that dividend yield growth tends to
exceed inflation. Therefore dividends, like gold, are an asset
class investors may reach for in inflationary environments.
There’s a flaw, or rather a 5% ceiling, in this
argument that I raise in idea No 4.
Diversification Dividends are liquid, have a risk-return
profile of their own and are easy to understand. For those
reasons some say they are a good diversifier for asset
managers. Anecdotal evidence suggests that pension funds are
among the long-only beta investors in dividends.
Due diligence: The three to six year bucket
As I have previously described in these pages (see
FOW September 2010), structured product flow can hit
dividend derivatives hard.
This is what happened after the May 6 Flash Crash,
which triggered lots of dividend trade unwinds by
structured products issuers. The effect was to create a
wave of selling in the listed market, which depressed
dividend futures prices for months.
The three to six year contracts are particularly
Deutsche Bank warns: "If structured products
issuance picks up there may be an oversupply of
dividends in the market… That’s one
reason why for risk-averse investors we prefer shorter
dated contracts, where fundamentals rather than
technicals are more of a driver of performance."
By "supply", the bank means interest in receiving
cash and paying the outcome of the dividend
A glut of supply that depressed prices would be a
problem for leveraged hedge fund traders obliged to
mark to market, but not quite so meaningful for
buy-and-hold asset managers.
Ironically, a boom in structured products –
the vehicles that spawned this asset class as a way to
recycle their byproducts – could be its
No 4. Alpha: Discretionary trading
Some say dividends are a value investment
that’s going cheap. This was ex-SocGen analyst
James Montier’s rationale when he first tipped
them in 2008. The one-sidedness of the market made it so.
Because all the structured products issuers wanted to sell
dividend risk, you could buy it cheap.
Three years later, that argument is not so compelling.
Stuart Heath, head of Eurex’s London office, says
growing liquidity has tightened up some of that dislocation in
value: "The growth in popularity means dividends are now more
or less a two way market. That pricing anomaly is not as
apparent as it was just 12 months ago."
To put some numbers to that statement, I spoke with Pamela
Finelli, managing director of equity derivatives strategy at
Deutsche Bank in London: "[Stuart] is referring chiefly to the
front of the curve. The discount on the December 2012 future is
currently 12% below perceived fair value. In early 2009 that
discount was more like 60%.
"Dividends are still underpriced but now the case for value
is a debate rather than an objective statement. A bearish
analyst may not believe the dividend discount is actually 12%,
and investors may not think the current discount is worth
pursuing, given the historical dislocation. We remain positive
on the December 2012 contract and still see an attractive
risk/reward at current levels."
When should the alpha-seeking investor trade? There are two
rules of thumb:
Seasonality The annual index contract feels a "pull to par"
during the year of expiry. Take the December 2011 contract.
Eighty percent of this year’s dividends for the
Euro Stoxx 50 companies were announced in February and March.
There’s a bit more relevant news flow in July and
then some more in October.
This tendency to converge with an expected value is the
"stickiness in value" one associates with a zero coupon
Hence, unless there is a major crash, December 2011 is now
more or less a dead trade, from a capital appreciation
perspective – the value is priced in.
Value investors should look to 2012 and beyond, where the
discount in value is still apparent.
The range According to a delta one analyst I spoke to, the
aggregate dividend yield for the Euro Stoxx 50 rarely strays
outside a range of 2.5% to 5%.
"If you divide the value of the active future (December
2012), 123, by the current index level, 2,847, you get 4.3%.
That’s near the top of the range. So to argue that
the future is 12% undervalued, or thereabouts, is
"A range – sounds like the perfect dynamic for a
call spread," I suggested.
"You’re not the first person to notice that," he
Next year’s futures are near the top of the
valuation band. The December 2013, trading at 116, or 4%, is
some 30bp cheaper using the range model.
Call spreads, particularly on contracts like December 2012,
which are near the top of the range, seem to be popular with
Due diligence: Share buybacks
Read up on the "dividend substitution effect".
Companies have many options when it comes to rewarding
shareholders and keeping up appearances. A firm whose
share price is falling might window-dress its earnings
a share rather than raise its dividend.
So be careful with your assumptions. Simply
identifying companies flush with cash does not
necessarily indicate forthcoming dividend growth. The
yield, inflated in times of share price deterioration,
is as much an indication as dividends per share.
No 3. Overwriting: The dividend
This strategy was much discussed at FOW’s
European Equity Options Trading Conference in April.
It’s quite simple to execute.
First, buy a future on the Euro Stoxx 50 dividend index.
Next, overwrite this position by selling a call option on the
same contract at a higher strike price, say 10%-15% above the
You will earn premium by writing the option, and if the
strike price is hit, you are covered because you have bought
dividends and can deliver them to the option holder, earning a
profit from the difference between the two prices.
The risk is that dividends fall below the futures price,
further than is compensated for by the option premium.
Due diligence: Even skewier than equities
The skew factor in dividends is even greater than it
is in equities.
Skew is the difference in price between out of the
money put options and call options. While
theoretically, options of the two kinds that are
equally far out of the money should be equally priced,
put options tend to be more expensive in equity markets
because they are more in demand.
This reflects the market’s bias towards
downside hedging, because most investors tend to be
long, and fear crashes.
That long bias is even more pronounced in dividends.
This creates some cases when dividend options have very
high volatility – which is both a risk and an
No 2. Targeted entry: Selling puts
As we have already discussed, dividends have a very
appealing risk/reward ratio.
Except when they don’t.
As you can see from the matrix below for May 2010, dividends
can both under-react (red) and over-react to stockmarket
movements. Look at the over-reaction on May 7 –
Dividend Black Friday. The December 2014 contract lost 13% of
its value, and the downdraft was even more pronounced in
contracts at the front end of the curve.
Such sell-offs are not unusual, and they can be much steeper
than in equities – contracts can fall by 50% or 60%.
Nasty crashes like this occurred in both 2008 and 2010.
These exaggerated sell-offs are dangerous for traders with
mark-to-market responsibilities, as they may be forced to close
their trades. However, they also create buying
Image:Under-reaction (in red) and over-reaction (green) of
December 2014 dividend futures compared with the Euro Stoxx 50
in May 2010
Source: Deutsche Bank
These periodic sell-offs make the skew in dividend options
even sharper. Puts become much more expensive than calls.
Taking what we know of the return to value after each crash,
patient options traders might be rewarded by waiting for the
right moments, and then selling put options when they are most
If dividend expectations fall, those put options will become
in the money and would probably be exercised. Thus, the
investor would be entered into a long dividend futures position
at a lower entry point, and therefore with greater upside. And,
thanks to skew, they would receive a relatively high premium
while waiting for this to happen. If the futures price
recovers, the puts are unlikely to be exercised.
No 1. Pairs trading: The liquidity
The Euro Stoxx dividend contract is a victim of its own
success. There are equivalents in the UK, Switzerland, Germany
and a somewhat active market in Japan. However, the Euro Stoxx,
despite its occasionally hair-raising sector demographics
– biggest sectors are banks and insurers and largest
single constituent is the oil company Total – is very
much the world’s index. Open interest is about
€8bn in the dividend futures and €2bn in the
That is, paradoxically, one reason why investors sell them
in times of crisis. When times are tough and you have margin
calls to service there is no use trying to cash out a thinly
traded S&P 500 contract – the bid-offer spread
will be extreme. You’re better off trading out of
the Euro Stoxx position where the quoted price will be a truer
indication of your P&L.
Liquidity – a hallmark of a properly functioning
market – increases the likelihood of a sell-off.
However, S&P dividend contracts currently imply 35%
dividend growth over the next five years. The Euro Stoxx
dividend futures are slightly backwardated, at -5%.
It’s not all down to fundamental differences
between US and European dividend behaviour. In neither region
can investors have visibility on what dividends companies
intend to pay in 2017. Who even knows what the constituents of
the indices will be in six years?
Hence, something else is puffing up S&P dividend swap
values. Deutsche Bank suggests it is structural buying. "It
stems from variable annuity hedging," says Finelli. "Dealers
are short put options, long-dated put options, and they need to
buy the corresponding dividends in the market to cover this
Whether you think Euro Stoxx dividends are objectively cheap
or not, compared with S&P 500 dividends, they seem a good
bet. A relative value trade, going long Euro Stoxx and short
S&P, might be a way to capture this value discrepancy,
though investors should be aware of the different structural
drivers of these markets.
More than a tax dodge
These ideas demonstrate that there is more to this asset
class than the tax trickery synonymous with OTC dividend swaps.
There are tons of potential trades that will come to the fore
as the options break into the mainstream.
Or leave aside the sophisticated trading ideas. We now live
in a world where mainstream equity income funds can cheaply
hedge against a disastrous fall in dividends – such as
that caused by BP’s suspension of its payouts
after the Macondo disaster – simply by holding some
puts. You can’t help but think it’s
only a matter of time before some of them do.
Despite the current dominance of futures, dividend options
may one day become more liquid than the futures they are based
Theo Casey is a Futures and Options Intelligence columnist.
He can be reached on Twitter @theocasey.