Dividend strategies get sophisticated as risk aversion and sustainability drives demand

As fixed-income yields languish at historically low levels, it is no surprise that investors are seeking income from high-dividend companies. But while caution lies behind most investments in dividend-based structured products and exchange-traded funds, they are becoming increasingly sophisticated in terms of stock selection and risk control. Hannah Collins reports

jeanlucbernardi

Dividend strategies get sophisticated as risk aversion and sustainability drives demand

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Dividend strategies get sophisticated as risk aversion and sustainability drives demand

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In an environment where investors are displaying seemingly contradictory demands for both yield and safety, strategies that provide exposure to equities with high dividend payouts have had to find a way to take account of the risk aversion that is common to many investors in the current climate. The result has been an increase in the defensive complexity of these strategies, enabling them to promise higher yields as well as risk mitigation.

"In the past, when thinking about yield investors would consider fixed income alongside equity investments," says Altaf Kassam, global head of equity market strategies at UBS in London. "But now, given how far both bond equity markets and bond yields have declined globally, investors are looking for equities of quality that also pay a decent, sustainable yield."

Citi, for instance, is seeing increased demand for structured products linked to dividend strategies, according to Jean-Luc Bernardi, the bank's London-based head of equity structuring for Europe, the Middle East and Africa. Interest is centred around two broad types of exposure, he says. There are those investors, mainly asset managers, who simply want to go long dividends in the form of a certificate or a note, and others, particularly in the private banking sector, who are looking for exposure to dividends in a slightly lower-risk format that includes an element of capital protection.

This desire for capital protection is confirmed by Laurence Black, New York-based director in equity funds structured markets at Barclays, who says most of the demand for dividend-based structured products is focused on those in a capital-protected format.

Product creators say there are other good reasons for including dividend exposure in a portfolio. "Dividends are often seen as a defensive play on the market because companies tend to refrain from cutting dividends unless it is absolutely necessary," says Bernardi. "A lot of companies take pride in their ability to pay dividends even in tough times."

We start by taking a quality universe based on balance-sheet strength and profitability, then attach an income stream by selecting companies with the best dividends from that universe

Dividends are also seen as having a natural floor that makes them more resilient than equities, he adds. A survey by Dow Jones Indexes earlier this year, for instance, found that 30 companies from the Dow Jones Industrial Average (DJIA) expect to increase their annual dividend payout by 8.4% year-on-year and 2.18% from the previous quarter.

The demand for dividend-based investments has even created a taste for buying options on companies that have fared poorly but are expected to bounce back, in the expectation that healthy dividend payments will follow. A Deutsche Bank report published in June suggested that most large-cap companies in the Stoxx Europe 600 Insurance Index have healthy balance sheets "which are supportive of maintaining (or even increasing) dividends over the next few years". Derivatives based on the index are recommended as a top trade by the report, as its constituents are not only trading at a low price but are also likely to be supported by an attractive dividend yield of around 5.8%.

And in a market update report in May, exchange-traded fund (ETF) provider iShares argued a case for dividends being a defence against an exit from the euro by Greece. Concluding that dividend stocks have generally been less volatile than the broader market, "in order to insulate equity portfolios, investors should consider increasing their exposure to dividend-paying stocks," states Russ Koesterich, iShares managing director, global chief investment strategist and author of the report. This dividend benefit is evident from recent market data, he says. "As of May 17, the S&P 500 was off roughly 8% from its May peak, while the Dow Jones Select Dividend Index and the Morningstar Dividend Yield Focus Index were down 4.5% and 2%, respectively," the report states.

 

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