The Market for Dividends and Related Investment Strategies (corrected)

A market for dividends paid on major equity indices and paid by large companies has developed around the world. This market, in a manner similar to that of the U.S. Treasury strip market, allows investors to invest in future dividend cash flows independent of investing in the equities. Since 2004, dividend swaps have been a major profit contributor for multistrategy and macro hedge funds because market-implied dividends have been trading at high discounts and dividend growth has been strong. This article contains a discussion of current instruments and market dynamics, investment strategies and methods of forecasting dividends, and potential benefits and problems in this market.In Europe, the United States, and Asia, a market has developed for dividends paid on major equity indices and by large companies. This market emerged around 1999 as banks and dealers started actively trading dividend risks among one another following increasing volumes in equity derivatives globally. For equity derivatives, especially those with long maturities, the dividend assumption can be crucial for competitive pricing and dividend surprises pose a risk. Between 2001 and 2003, because of an excess supply of index dividends, market-implied levels of OTC dividend trades were at deep discounts relative to subsequently realized levels and often implied negative or zero future dividend growth. This discount soon stimulated interest in the market from institutional investors, especially hedge funds, and trading volumes have increased considerably since 2004. A Greenwich Associates survey of equity derivatives use in Europe for 2007 shows growth in the number of investors trading dividend swaps from 16 percent of the surveyed investors in 2006 to 19 percent in 2007. In the United States, the proportion of users increased from 16 percent in 2006 to 20 percent in 2007.The dividend market allows investors to invest in future dividend cash flows independent of stocks; in this way, dividend strips are similar to U.S. Treasury strips. Dividends are traded mainly through swaps. Dividend swaps are OTC derivative contracts that enable investors to take a view on the sum of dividends that will be paid by an underlying stock or equity index in a predetermined period. Dividend markets are liquid for indices with a liquid forward/futures market for the price index, which usually occurs because an index is being used as the underlying asset for derivatives and (retail) structured products. Similarly, single-stock dividend swaps are tradable for stocks with sufficiently liquid forward markets and/or options. Despite rapid development in recent years, the dividend market is relatively young and is dominated by hedge funds; because the dividend market is an immature market with limited participation, mispricings are more likely in it than in a mature market. Investors can profit from mispricings of the dividends for indices or single stocks if they are able to forecast dividends of a company or at an index level with higher accuracy than the market. In addition, a risk premium will be priced into the market-implied levels for dividends with long maturities, which provides a positive carry. Because investors can trade ordinary dividends only for a predetermined period, a company’s propensity to pay dividends—both the timing of cash flows and the choice of alternative payouts, such as share repurchases and special dividends—plays a central role in forming views about likely growth in the dividend market. Since 2004, dividend swaps have been a major profit contributor for multistrategy and macro hedge funds because market-implied dividends have been trading at high discounts and dividend growth has been strong.Equities may be more volatile than justified by dividends. Prices are driven not only by expectations for growth in dividends, earnings, or cash flow until perpetuity but also by the equity market risk premium and many additional factors. Dividend swaps or strips allow investing in single future cash flows with a fixed maturity and payouts linked directly to the income statement. As a result, we think the dividend market provides investment opportunities with attractive risk–return trade-offs for fundamental investors. In addition, a well-functioning dividend market should, as does the credit default swap market, serve as an independent reference market for pricing and trading dividend risks in forwards/futures, options, and structured products.Problems of the market are limited liquidity and the additional complexity of forecasting index dividends resulting from changes in index composition and the rules of various index providers. The dividend decision also introduces principal–agent risks if companies do not have a clear, well-communicated dividend policy or if they deviate from it.As liquidity in dividend swap markets increases, as contracts become increasingly standardized, and as regulation permits long-only managers to incorporate more derivative exposure in their funds, we expect the dividend market to develop further. Market participants should have a strong incentive to forecast dividends proactively and eliminate mispricings, which we suspect may result in banks, hedge funds, and institutional investors dedicating more resources to dividend trading and fundamental research.