Providers are missing opportunities to deliver attractive structured products linked to dividends, says a structured products and index boutique in London.
Banks are failing to exploit a rich source of capital appreciation and income in the dividends space, according to structured products and index boutique Parala in London.
“It would be easy for a structurer to offer clients access to the dividends stream directly," says Steven Goldin, managing partner at Parala. “Banks could potentially offer clients access to the dividend streams of blue-chip companies with no capital at risk or provide a growth and income product combining capital appreciation and access to the dividends streams.”
Demand for structures linked to dividends first appeared in 2005 when a significant number of product launches in Europe were linked to the Dow Jones Select Dividend Family . Despite their popularity, the products themselves “missed the point of providing capital appreciation and dividend access to investors,” says Goldin. “ Products were almost entirely linked to the price return versions of these indices whereby the investment banks kept the dividends and providing a higher participation in the price component of the index. However, dividends represent about 30% of a stock's return and there is a lot of value in having exposure to the dividends.”
Goldin says that offering investors price risk linked to dividends is both profitable and relatively simple. There are dividend point indexes to provide transparency and there is an active dividend swap market, which means people can hedge their risk at the point of the trade, he says.
Banks claim that hedging dividend uncertainly is a big challenge, but Goldin believes that “the main challenge is a psychological one.” Banks already have the expertise and tools to manage more complex risks than the uncertainty of future dividend distributions and distributors would benefit from expanding their horizons beyond price return products”, he says.
In terms of index providers, Goldin says the challenge in the past was that the selection of the companies with dividends was based on historical rather than forward-looking dividends. Additionally, both dividend growth and dividend yield based indices underwent some significant changes at the constituent level. Banks naturally preferred more stability at the constituent level and a selection criteria based on forward-looking dividends.
Goldin says the headline scare about companies cutting dividends last year was driven by a misunderstanding about where dividends were being cut. The issue was mainly one sector, not the broader market. “If you look back at the height of the credit crisis, there were more companies increasing dividends than cutting them in virtually every sector with one exception – finance,” he says.
Recently, a lot of money has been was flowing into products linked to very high dividend yield indexes particularly ETFs , he says. Another area is dividend growth, which includes blue-chip companies that increase dividend growth year on year and could be attractive to some investors, says Goldin. Dividend alternatives is another key area, and involves investments that generate income with a lower correlation to traditional equities that would include master limited partnerships that typically pay out high dividends linked to their physical assets and preferred securities which both Warren Buffet and the US government invested in at the height of the financial crisis.
Goldin predicts that banks will continue to offer what they have in the past, which is price return only products linked to higher dividend indexes, as opposed to a combination of dividends and capital appreciation. “I don’t see the trends changing,” he adds. “I do think that there is a massive opportunity for a high-credit-rated investment bank to come out with products that offers a pure dividend stream to investors and offers superior yields to bank deposit – that would be a huge win.”
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