Dividend Futures Contracts

I have written about managed futures before, but recently a wholesaler from Pacer brought up a market I was not too familiar with, dividend futures.  Pacer utilizes these contracts in their QDPL fund, which aims to provide cash distributions equal to 400% of the S&P 500 ordinary yield.  This is a unique strategy and one that I found interesting so I thought I would look more into how these dividend futures contracts work and how it allows Pacer to pay such a high distribution at such a consistent rate.  On the Pacer side, they reduce some their exposure to the S&P 500 by 11% and then use that capital to purchase collateral for 4x greater participation in dividends.  This strategy would be a consideration as a replacement in a covered call strategy or strategies within that realm. 

Overview of fund's strategy

Their main selling point on this is that over a 35-year period, over 50% of the S&P 500’s total return has come from dividends and reinvestment.  This strategy allows investors to gain more exposure to the amount of actual future dividend payments without the impact of price changes in stocks.  Although we have been able to find yield easier in fixed income over the past 2 years, it is still hard to find income in equities, especially without making some sacrifices such as giving up on the upside with covered call strategies, or experiencing sector concentration in high dividend paying stocks.  In order to understand the strategy from Pacer, we need to understand dividend futures themselves and the benefits they provide.

Dividend Futures

Dividend futures are exchange-traded, cash-settled futures contracts that allow investors to get exposure to the amount of actual future dividend payments.  Therefore, a long position on a dividend future contract means an investor agrees to pay a prespecified price today in exchange for receiving a future payment equal to the actual dividends paid during a specified period – which in this market – is typically a calendar year.  So if an investor enters into a contract 12/18/2020 in a S&P 500 2021 dividend future at $56.70 and the S&P 500 actually ended up paying dividends throughout 2021 totaling $60.14, the investor makes an additional gain on that additional dividend amount received.

To speak in layman’s terms, these contracts entitle the investor to the dividend component of a stock or index without having to own the stock or index itself.  If the dividends paid are more than expected, you also receive that difference in a long position.  If dividends paid are less than expected, you pay that difference in a long position.

Dividend Futures Pricing

There is a flaw in this market that I don’t think a lot of people are aware of after doing some digging.  The futures market implies that there is virtually no dividend growth and that makes absolutely zero sense to me.  Dividends have historically grown at 7% a year on average for the S&P 500.  Goldman Sachs Chief U.S. equity Strategist has seemed to caught onto this and he is estimating that dividends will grow at 5% for the coming years.  Analyst expectations are about that amount as well.  This means that if you enter into the contract, not only are you gaining exposure to the dividend component without owning the stock, but it almost seems like it is nearly impossible for the actual dividends to NOT beat the amount entered into at the time of contract inception.  Not only would Pacer be 4X the yield of the S&P, but they would also realize gains on entering into a long dividend futures contract when the dividend actually received is higher than the futures price entered into.

I talked to Chris from Pacer about this and his two cents were insightful if true.  This market has a lot of supply and little demand because it is overlooked.  Covered call strategies are one of the hot strategies right now so a lot of firms are implementing those rather than utilizing dividend futures.  The retail investors simply do not know about it (which is not uncommon to hear Wall Street keeping secrets).  According to Pacer, only 20% of contracts available are getting entered into which could be why you can get into them so cheap.  Nothing is ever guaranteed and the risk will always be there that dividends do not grow but I find that highly unlikely, especially in a time where companies are cash rich.  Cutting dividends is often a death wish and last resort from companies because it signals weakness.  A dividend cut is often subsequently accompanied by the stock price dropping and doing so at heavy rates.  Why more funds are not utilizing this is beyond me, I can only assume that this is due to covered call strategies being hot, PMs simply not wanting to get involved in a more complex market, or something is just frankly not adding up and is too good to be true.

A clear discount in the market

How Pacer 4X’s the Yield

Pacer enters into these contracts by increasing the exposure 4X to the dividend component of the S&P 500’s returns.  They do this through the use of that 11% taken from deconstructing the index and using cash or Treasuries to enter into the contracts. Because you are giving up some of the price exposure, the beta is going to be reduced in the portfolio.  Essentially, this strategy has been able to work because there is disagreement between the futures price and consensus estimates on obtaining a dividend risk premium (dividends not paying out what was expected).  This dividend risk premium forces the futures market to trade at a discount to analyst expectations, meaning if you enter into a dividend futures contract, you are already guaranteeing payment of that amount, plus the likelihood that dividends actually being paid is higher has been extremely favorable.  Regardless on whether or not dividends end up being higher or lower than what the futures market is priced at, because Pacer allocates four times the dividend component, they will always provide cash distributions four times the amount of the S&P 500.