Assessing high-dividend exposures during the coronavirus crisis

15 May 2020 | Markets and Economy

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Commentary by David Hsu, senior investment product manager

 

Dividends have always been an important part of the total return a shareholder receives on their investment, but given the low-to-no growth environment of the past decade, payouts have become an increasingly significant factor in determining share prices.

This had carried share price growth with it despite challenging economic conditions, providing income-seekers with a rising natural yield from their portfolios as well as growing the capital value of their investments.

Right now, however, dividends and buybacks are facing a significant headwind. Early forecasts estimate that at least 28%1 of dividend payments in Europe are at risk of being cut or suspended, owing to the economic and political response to the Covid-19 pandemic. There remains significant uncertainty around the full scale of the cuts but the early signs provide grim reading.

Don’t bank on it

Banks and energy companies are the two largest dividend-paying sectors in Europe2 and any significant cuts by either group would be a heavy blow to income-seekers. The European Banking Authority in March urged all banks under its jurisdiction to refrain from paying shareholders until at least October, while the European insurance regulator also issued guidance on withholding dividend payments.

The global oil industry was already in the midst of a production battle between the world’s largest exporters before the consequences of Covid-19 were truly felt. The industry’s supply and demand dynamics have taken an unprecedented shock, which saw the futures’ price of a barrel dip into negative territory on 20 April, 2020.

The damage is starting to be passed on to shareholders. For the first time since World War II, British-Dutch group Shell announced at the end of April it would be cutting its first-quarter dividend to weather the impact of the Covid-19 crisis. That followed Norwegian conglomerate Equinor’s (formerly Statoil) decision to cut its first quarter dividend by 67%.

Accessing high-dividend exposure

Many investors seeking exposure to high-dividend shares will be wondering what this economic turmoil means for their portfolios.

A good place to start is to look closely at how they access the universe. Several global high-dividend indices are available, but there are significant differences in how some of these benchmarks are constructed.

One important consideration is geography, as the distribution of dividends can vary widely by region.

The disruption caused by Covid-19 has come as European companies enter ‘dividend season’ when the bulk of dividends are paid in the second quarter of the year. In 2019, more than a third of European dividends were paid in the month of May (see chart below).

As the chart below shows, US and UK dividends are distributed more evenly throughout the year, which spreads the risk of cuts and cancellations and softens the income hit to shareholders. Selecting an index with broad global diversification can minimise the disturbance to expected income by reducing a portfolio’s sensitivity to regional shocks.

Coronavirus crisis overshadows Europe’s dividend season

Source: Factset, Vanguard.

 

Forward- or backward-looking approach?

Another crucial consideration—especially now there is much more uncertainty around the outlook for dividends—is the approach to screening dividends that an index uses.

Most providers of global high-dividend yield benchmarks use a historical method to screen high dividend-yielding shares. Applying this backward-looking methodology simply involves ranking the universe by dividend yield based on previously announced dividends. The index provider then includes the highest-yielding shares above a certain cut-off.

Rebalancing these indices is subject to dividend announcements by individual companies because, as its name suggests, this approach looks solely to the past. And as we are now seeing, the past is not necessarily an accurate guide to the future when it comes to dividend announcements in these uncertain times.

An alternative way to screen dividends is through a forward-looking approach, which is used by the FTSE All-World High Dividend Yield Index. Index providers using this method define the universe by ranking shares according to 12-month forward dividend per share estimates3.

These estimates, which are a global collation of analyst forecasts, factor in a company’s history of paying dividends, but they also—crucially—take into account future expectations. In the current environment, this can mean that the makeup of the index more accurately reflects the market outlook for dividends—information which is not conveyed by backward-looking indices.

However, it’s important to note that both forward-looking and historical screened indices are likely to see higher-than-normal turnover in their constituents as a result of the delayed and cancelled dividends caused by the coronavirus crisis.

Limiting sustainability risk

There are other key variations in high-dividend benchmarks. For one, there are different index weighting methodologies, which determine a constituent’s representation in the benchmark.

Weighting by dividend yield alone can provide a higher concentration of high-yielding shares in the index. But it can also expose investors to sustainability risk, as some companies distributing a large portion of earnings as dividends might not be able to maintain this over the long term.

A market cap-weighted approach, by contrast, poses less sustainability risk. This method first ranks constituents by dividend yield, but then further refines them according to their proportion of the investable market capitalisation.

No matter which index investors use to gain exposure to the high-dividend universe, it’s important to put the current dividend cuts into context.

A key point to remember is that capital not paid out as dividends can be used to support the business during a crisis, as is the case with many companies now, or reinvested to increase the company’s share price in the future. That may not be as relevant in the case of banks, which are under some obligations to support the wider economy. Nevertheless, broadly speaking, a little patience and discipline can bring rewards.

We suggest that investors remain diversified across their income-generating portfolios. They should also not deviate from their long-term investment objectives and remain patient for more certainty to emerge around earnings and dividends.

Find out more about our FTSE All-World High Dividend Yield UCITS ETF.

 

1 Source: MSCI, Morgan Stanley Research.

2 Source: MSCI, Morgan Stanley Research.

3 The FTSE All-World High Dividend Yield Index is calculated using the Institutional Brokers' Estimate System (I/B/E/S) 12-month forward dividend per share.

 

 

Investment risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

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The opinions expressed in this article are those of individual speakers and may not be representative of Vanguard Asset Management, Limited.

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© 2020 Vanguard Asset Management, Limited. All rights reserved.

© 2020 Vanguard Investments Switzerland GmbH. All rights reserved.

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