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 nice.
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 Day".
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It's out of date.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 stock contracts.
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 realised.
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...
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 legs.
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 market.
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 investing.
But you'd be wrong to think pure dividend investing is similarly staid.
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 they were.
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 must consider.
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 7?
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 to be.
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 price movements.
Now for the more compelling explanation of Dividend Black Friday.
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 on dividends.
Now they were weighing on the market the other way, wanting to receive a fixed amount and sell dividends. Naturally prices plummeted.
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 speculative investors.
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 much.
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 drawn.
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 time.
Theo Casey is editor of The Fleet Street Letter and a columnist for MoneyWeek