Nervous investors opt for dividend diversification

The bond market environment left many fund and pension managers searching for higher yields, also in the stock market. Yet dividend strategies have changed in the post-crisis world.

Bond markets today look nothing like they did before the financial crisis. Yields on safe government securities are low for long-term bonds and are virtually non-existent for shorter maturities. To make things worse, the safety of the asset class is being called into question by many investors.

The crisis in peripheral Europe has lasted longer than many expected, as restructuring talks over Greece have intensified, rather than abating, one year after its bailout.

In addition, Standard & Poor’s move to lower the rating outlook for the US has startled markets. This mix of issues for government bonds has pushed investors away into corporate bond and credit markets that have rallied significantly over the last couple of years.

As high yields are scarce in the bond market, investors turned to stocks. According to index provider STOXX, its Europe 600 index currently has a dividend yield of 2.6%. Stock markets in Spain offer even higher dividend ratios.

Looking at the yield curve of the German Bund, arguably the safest government security in Europe, investors would need to buy a bond with a maturity of at least six years to match the overall dividend yield of the European stock market.

Boost to dividend strategies

Fund flows to dividend-focused strategies have increased significantly as a consequence. In the ETF world, the V anguard Dividend Appreciation fund attracted about $1bn in the first quarter of 2011, pushing the assets under management to over $5.8bn.

BlackRock, the world’s largest asset manager, has added two new dividend strategies to its product line, as did Fidelity with its Fidelity European Dividend Fund. Investment banks from Goldman Sachs to Credit Suisse have advised clients to capitalise on dividend strategies, leading to inflows into the sector in a sub-par environment for equity funds.

Value investors such as James Montier, behavioural finance expert and member of the asset allocation team at the US investment firm GMO, focus on the longer term when it comes to dividends and stocks. “To those with an attention span measured in longer than milliseconds…dividends are a vital part of return,” he says.

According to Montier’s calculations, 75% of stock returns can be attributed to dividend yield and dividend growth over a five-year horizon, with the bulk stemming from the growth of earnings payouts.

This is true across regions, Montier argues. Not only in the US were dividends an important part of investor profits over the longer term, but in Europe 80% to 100% of the total returns achieved since 1970 have come from dividends. Focusing on dividends thus means to focus on the long term.

Yet, for Stuart Rhodes, fund manager of the M&G Global Dividend Fund, dividend investing is not just about the hunt for yield. He says: “High dividend yields are not an automatic signal of value.”

M&G managers caution investors about buying the highest yielding stocks. Simon Bailey, deputy fund manager at M&G, notes: “High dividends can be a danger, they mean that the market is sceptical about the sustainability of the dividend stream, and this scepticism is often warranted. If you chase high yield, you might end up in unattractive parts of the market.”

There are several “natural biases”, when it comes to stocks with high yields. Many of them, such as energy conglomerates, exhibit little growth. The same is true for many telecom companies. That is why Rhodes expects a lot of added value from active stock selection, as funds should actively filter out those stocks displaying underlying weakesses which stop them from growing dividends.

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