I should first apologise for what follows: I’m going to repeat one of my more annoying quirks by telling you about a new investment that is only open to institutions or the stinking rich.

A couple of weeks ago, BNP Paribas launched the first “dividend swaps” fund for investors with more than $250,000 – to allow them to speculate on the size of the dividend payouts made by the European megacaps listed on the DJ EuroStoxx 50 index. Dividend swaps are instruments that allow you to invest in dividend streams separately from equities, and profit if dividends exceed the expectations built in to the price of the swaps. But before you start groaning, let me explain why this is relevant to all of us.

Dividends are of huge long-term importance. They account for the vast majority of equity returns. Depending on who you talk to, anything between 50 per cent and 90 per cent of long-term returns can be attributed to dividend reinvestment and dividend growth. Capital gains contribute relatively little – in real terms, UK equities have only just washed their face, based on price performance alone.

Now, one group of people who understand the implications of this are the designers of structured products. They use clever structures to gear up returns by using that stream of dividend payouts. In fact, they accumulate such a large claim on future dividends that they desperately need to lay off that risk/return via futures markets – which is where dividend swaps come in.

The big investment banks have got lots of future dividends to sell but, until recently, very few buyers existed outside the hedge funds. BNP Paribas aims to redress that balance by buying futures contracts stretching from 2010 through 2014 for the constituents of the DJ Eurostoxx 50.

“Very interesting,” I hear you yawn… “but so what?” For the compelling part of the story, see the table below. It shows the estimated bundle of dividend payouts for the EuroStoxx 50 and the FTSE 100 indices, from 2009 to 2017.

You will notice a rather large fall from 2009 to 2010 and then a snail-like progression afterwards. You might come to two tentative conclusions: 1) gosh, that’s a big fall in estimated dividends in 2010; 2) crikey, these dividend swap guys don’t think dividends will grow over the next few years – even though everyone else is telling us that recovery is on its way. And you would be spot on.

This young market in dividend swaps is suggesting a bloodbath in dividends in 2010 and an L-shaped “recovery” afterwards (with the horizontal bit tilting upwards only slightly)!

But to BNP Paribas, 2010-2014 looks like a potential opportunity in dividend swaps – with the possibility for 50 per cent or greater returns.

I’m a much less sanguine. Every day brings new horrors on the dividend front in the UK – BT being just one example – so I can see the stream of dividends collapsing in front of me. Most of the FTSE 100’s dividend-cutters and non-payers will be spending the next two years sorting out their balance sheets and pension funds, preventing any sudden return to rude financial health.

So any notion that dividends are less volatile than earnings and share prices looks like history. In the good old days, dividends in Europe grew at an average annual rate of 1 to 1.5 per cent in real terms. BNP has written a paper on this – e-mail me if you want a copy. However, I’m not sure that this is true any more – I think the last 12 months have broken the spell of dividends as a source of returns.

Admittedly, the futures market may have over-
estimated the slump in dividends and under-
estimated the eventual recovery. But only by a little. The bigger story is that dividends will become more volatile, like earnings, and that volatility will weigh even more on long-term returns from shares. We’ll demand even more of a risk premium from shares to compensate us and that means even more risky markets as we perhaps begin to favour growth stocks over value stocks.

This raises some very big issues about equity income as a long-term investment strategy. It also provokes a more depressing thought: based on a forward dividend yield of just 3 per cent, the FTSE 100 will be hugely overvalued over the next one to two years!

adventurous@ft.com