A rash of equity income funds is breaking out, but with corporate earnings likely to be stunted by a global recession and forecasts of drastic dividend cuts, investors may ask what they are likely to deliver.
“When the turn comes, most of us are not going to be clever enough to be there,” says Neil Dwane, chief investment officer for Europe at RCM, the equities arm of Allianz Global Investors.
“It’ll be dramatic …but till then, you just want to be parked in something that’ll float when the tide comes in but [that] is worth being in in the meantime.”
Equity income funds seek to invest in high-yielding companies likely to sustain and to increase dividend payments to provide a rising income. Because there is pressure on companies not to cut dividends except in extreme circumstances, this income is viewed as being relatively resilient, especially compared with the returns possible from capital growth in volatile times.
Current circumstances, however, certainly qualify as extreme. Dividends will come under enormous pressure this year, research by ING Wholesale Banking finds, pointing out that of the 59 large-cap European stocks that have declared dividends so far this year nearly half have either cut their dividends or omitted them entirely.
Dividend swaps, ostensibly an indicator of future dividend levels, forecast even worse falls in the amount of money companies will pay to shareholders.
“What’s being priced in right now is a 31 per cent drop from 2008 to 2009, and then a 48 per cent drop from 2009 to 2010,” says Éamonn Long, an analyst at Barclays Capital, speaking of the dividend swaps on the Dow Jones Eurostoxx 50.
“Thereafter there’s very little growth indicated.”
If an investor were to buy a basket of shares to replicate the index at current prices, he explains, these dividend levels would imply a yield of 5 per cent this year and 3 per cent next year, and then stay at about that level for the foreseeable future. That does not appear so attractive.
While some of the fall could be put down to the expectation that banks and other financial institutions will not pay dividends for the foreseeable future, that is unable to account for all of it.
“Another way of looking at what’s being priced in for 2010,” says Mr Long “is that it looks like saying no bank, no insurance and no auto company will pay dividends – and there will be a 38 per cent cut in other sectors. In historic terms, that’s extreme.”
That degree of decline in dividends has not been seen since the early 1930s in the US, when the Depression began.
How reliable are swaps as an indicator of the future? Like any market in which hedge funds and banks’ proprietary trading desks were large participants, swaps markets have been subject to a great deal of downward pressure due to forced selling by these participants.
The yield may also not fall to such uninteresting levels, even if the swaps are forecasting accurately. If share prices were to fall further, the yield would go up. This would make equity income funds more attractive for new investors.
Most vendors of equity income funds would also point out they are selling actively managed funds, intending to avoid companies likely to cut or omit dividend payments.
“There are still plenty of large, well-managed companies that will be able to maintain their dividends even in a recession,” says Edward Bonham-Carter, chief executive of Jupiter, in a note to investors. “Being able to buy their shares on high yields looks significantly more attractive than the returns investors can get elsewhere.”
US investors not wishing to pay for active management now have the option of an exchange traded fund on the Standard & Poor’s High Yield Dividend Aristocrats Index, which filters the S&P 1500 for companies that have increased their dividends every year for 25 years.
A similar index to track international stocks has also been launched.
In the UK especially, where equity income investment has long been a much larger part of the retail savings culture, such funds are popping up like mushrooms.
Former building society LV has launched one. Invesco Perpetual, long known for its UK equity income products, has launched a global fund, and Axa Framlington has brought out an equity income product to invest in UK blue chip stocks.
RCM intends to break fresh ground with its imminent UK and European equity income funds by marketing them Europewide.
“Equity income has been one of the sweethearts of the UK savings market – but we’re trying to bring continental investors in,” says Mr Dwane.
The concept of equity income investing is unfamiliar to many mainland European investors, partly because of their strong tradition of fixed-income investing, partly because there is no long history of dividend payment by large companies in many European markets.
“Until recently, Allianz didn’t have a dividend you would cross the street for,” Mr Dwane points out, speaking of RCM’s parent company. “As their investor bases have internationalised, pressure has led European managements to adopt a more international shareholder friendly standard.”
While European corporate managements have come around to the value of cash dividends to shareholders, UK managements may find their ability to increase dividends limited by a recent ruling from the Pensions Regulator.
Companies struggling with lower cash flows will have to give pension fund contributions priority over dividends.
“There is no reason why a pension scheme deficit should push an otherwise viable employer into insolvency,” the regulator said last week. “But the pension recovery plan should not suffer, for example, in order to enable companies to continue paying dividends to shareholders.”
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