Hedging your dividends

Kathleen Brooks
FOR the first time since 2007 institutional investors are ranking higher dividends as a top priority for investing in equities. According to the latest BofA Merrill Lynch Global Research Report fund manager survey, released yesterday, 27 per cent of fund managers would rather see firms distribute their cash as dividends to shareholders, compared with 23 per cent who would rather companies spent the cash bolstering their balance sheets as they did during the financial crisis.

Chasing dividends is sure to remain a priority for savvy institutional investors while the economic situation remains unpredictable. But with sterling so weak, they face the problem of exchange rates eroding returns.

To take the example of the pound against the dollar, sterling has fallen 25 per cent against the US currency since 2008, and the pound looks certain to remain weak for the foreseeable future as the UK brings its public finances under control and interest rates remain low.

This is a particular problem for funds because, according to research by Evolution Securities, 45 per cent of all dividends paid out by companies on the FTSE All Share index are denominated in US dollars. Sectors including oil and gas producers, banking, mining and industrials metals, which together pay out 40 per cent of all dividends in the UK, declare virtually all dividends in dollars.

So how do dividend-hunters hedge against a potential currency loss? Brennan Leong from Evolution Securities points out that investors need to not only take a view on equities, but also on currencies: “For example, if you have a strong opinion that the dollar will continue to appreciate then you might want to scale back your exposure to companies that declare their dividends in dollars.”

Assuming that you do believe that the dollar will remain strong relative to the pound, one common way to neutralise the effect of the relatively strong dollar is to purchase currency futures of a value equivalent to the income the fund expects to earn, a tactic which will at least lock in a dollar-sterling exchange rate.

Another way to benefit from a strong dollar is to invest in sectors with above average sales exposure to the US but which declare their earnings in sterling. This includes food and beverage producers, pharmaceuticals and tobacco companies. When the dollar is strong this means that profits, on a sterling basis, will be higher. And good profits often mean a higher dividend. One example would be FTSE 250 mainstay Tate & Lyle, which derives close to 70 per cent of its revenue from North America.

No hedge is perfect, of course, but at least this one might sweeten your returns a little.