Maximizing Returns: Harnessing the Power of Dividend Futures

But there may be a way for investors to boost their dividend income without actually taking on the equity risk — by providing a bond-like income stream from stocks.

Dividend futures — and the funds that track them — are quickly becoming an asset class for risk-averse income seekers. Easy to buy and use, these futures contracts could add a level of income diversification to a portfolio.

Dividend stocks have been hit with a one-two punch over the last two years. And it’s all courtesy of the Federal Reserve. We all know the story: to combat rising inflation, the Fed raised rates. This has affected dividend stocks in two major ways.

For starters, higher interest rates have meant that traditional income products like bonds, cash and CDs are paying attractive rates. You can now get 4.5%+ risk-free in these asset classes. When rates were at zero, dividend stocks were pretty much the only game in town to get a meaningful yield. Now, investors have fled dividend-paying equities, with many dividend-focused indices underperforming throughout the year.

To make matters worse, stock market risks continue to rise.

The effect of higher rates has started to crimp the economy. As a result, earnings projections are expected to be lower, sales have been slipping, and valuations for the broader market have gotten that much more rich. Today, the S&P 500 can be had for a forward P/E north of 21×. That’s high by historical measures, and perhaps even more so when you consider rising recessionary risks.

To that end, dividend stocks are facing an uphill battle.

However, the key word in that sentence is “stocks.” Dividends continue to be plentiful, with many firms reaffirming their payouts during the current difficult environment. At the same time, dividend growth remains robust as well. Through June, the average firm in the S&P 500 has increased its payout by 4.74%.

The question for investors is how to separate the dividend from the stock? Thereby, gaining the income while reducing the volatility of the equity side. The answer lies within dividend futures.

Dividend futures are traded on the CME and function like zero-coupon bonds. With these derivative contracts, investors are essentially buying the potential of a full dividend payout at a future date for a discounted price today. For example, if stock XYZ’s current dividend is $0.76 per quarter, investors expect that payout in 90 days. But there is always some risk that it won’t deliver that payout. With that, the dividend futures contract can be had for $0.70. If XYZ pays its full dividend, investors will earn the difference between the actual payout and the payout. As time goes by, the futures contract generally, but not always, trades higher to meet the expected payout.

Dividend futures can be bought on a single stock, an entire exchange or index like the S&P 500, but they all function in the same way.

Why do this in the first place? It turns out that dividend futures are a great way to generate income that is very, very steady if held till expiration. Particularly, when focusing on the S&P 500 or similar broad index.

All dividend futures reference an index — dubbed the dividend points index — to determine their final values. The S&P 500 Dividend Points Index (DPI) tracks the cumulative amount of S&P 500 dividends paid during the year. At the end of the year, the DPI resets to zero and starts over. You can see by this chart from S&P Global what that looks like in practice.

Source: S&P Global

The key piece to focus on is that the peaks are nearly always higher than the previous year. That’s because the S&P 500 has historically grown its payout every year no matter what the economy is doing. Therein lies the secret to higher returns.

Using real-life data, if an investor had purchased the S&P 500 2021 dividend future, which traded at $56.70 on settlement day,-they would have received $60.14 a year later. The difference would have been profit for an investor using the dividend futures contract. According to S&P, by isolating the “dividend” from the stock, investors have been able to score an annualized 6.71% return over the last decade. That’s not too shabby at all and underscores how power dividends are to total returns. ¹

Even better is that by isolating the dividend from the share, futures contracts have been less volatile than the equity side of the equation if held the entire year.

For investors seeking an interest and a low volatile source of dividends, using dividend futures could be a great strategy.

Entering into the market is pretty easy, too. Any good brokerage account that allows options trading can be used to access these contracts. The CME now offers both futures and options tied to the S&P 500 Annual Dividend Index.

There is another way to score dividend futures, and that’s through ETFs. Investment group Pacer now offers two ETFs that use dividend futures to provide income opportunities for portfolios.

What’s interesting is that by using dividend futures, investors are also able to get a multiplier effect on their dividends. This has to do with the amount of capital required, since futures are traded on margin. With these ETFs, investors are able to get an extra boost via the options overlay.

Keep in mind, dividend futures and ETFs are not the same as the new group of covered call ETFs, which may or may not use dividend futures and swaps in their construction. However, these funds don’t isolate the dividend from the equity return like dividend futures.

These ETFs were selected based on their exposure to dividend futures. They are sorted by their YTD total return, which ranges from 2.5% to 15.1%. They have expenses between 0.60% and 0.79% and assets between $913K and $315M. They are currently yielding between 4.6% and 5.7%.

Overall, whether you go it alone or via one of the new ETFs on the market, with more set to launch, dividend futures offer an interesting bet on dividend growth. By isolating the dividend from the stock, investors have a chance to participate in some hefty income and strong returns. These futures contracts could be just what your portfolio is looking for.

Dividend stocks have been a hard sell for many investors. But the actual dividends have been

¹ S&P Global (June 2019). The Case for Dividend Futures Contracts