Dividend Scalping - Beating The Yield Curve with Equities

Dividend Scalping - Beating The Yield Curve with Equities

I am surprised by how many of my friends have their savings in a "riskier" money market yielding a 1% return for a 1-year investment. To their defense, they are getting a much better deal than they would had they loaned to the US Treasury, which yields 0.25% for a 1-year investment. However, what most people do not realize is that the stock market (using the S&P 500 as the barometer) produces an annual  dividend yield of about 3% (See Futures Fair Value). That may not sound like striking gold, but it's 1200% better than lending money to the Federal Government via the US Treasury.

If the stock market is such a good deal, then why haven't investors returned to it?
I don't have a complete answer, but in short, the public has lost confidence in the old adage that equities yield greater returns than debt. In other words, the ordinary investor has been badly burned by the last recession. He is adverse to his portfolio losing its value, so he has flocked to the safety of Treasury securities and other debt instrument (ergo the present bond bubble).

To his credit, he realizes that equities have one major drawback... you can lose your principal. Our parents told us to buy stock because, from the 1940s to 1998, the stock market had one direction... up. The bursting of the tech bubble shook investor confidence for a little, but stocks resumed their meteoric rise again through 2000. The recession of 2001 through 2003 can be partly attributed to 9/11, which rattled our beliefs in American Hegemony and set into motion an era of vastly increased government spending. But once fears subsided, the stock market began to recover and reached new highs again in 2008. When the full extent of the effects of over-leveraging debt had been realized in 2007, the housing bubble was first to go bust. Equities then followed. Between December 2008 and March 2009, the S&P 500 had lost 60% of its value.

Enter the modern era of equity volatility...

While we have recovered from those lows, volatility has behaved differently since. It is not unusual to have days where the stock markets will suddenly drop by 3% --- that's about 300 Dow points. To put this in perspective, "Black Monday", which saw a 97 point drop in the Dow, is just a day at the office. The average joe, unwilling to risk losing the value of his principal investment, has been reluctant to re-enter the stock market. 

Fortunately, there are strategies by which investors can still invest in equities, potentially beat the risk-free yield (i.e., zero-rate), and still protect their principal investments. ETFs provide one route, but I would like to hone in on one strategy in particular that utilizes futures contracts that I like to call dividend scalping.

In short, dividend scalping is hedging a high-yielding portfolio of stocks with the reverse position in an appropriate futures contract. In other words, it is going long a portfolio of stocks that offer high dividend yields, which are linked to the performance of a stock index futures contract (see beta correlation), and then shorting that futures contract. The S&P 500 currently yields about 3% annually in dividends. Since interest payments and dividends are factored into futures fair value, your equity portfolio that is hedged against the reverse position in the futures has to beat this yield (plus any interest you owe for margining your position over the discount rate) in order to produce a net return. For example, if my equity portfolio (assume a perfect beta) yields 8% annually, the futures contract that I am short reflects an implied 3% yield, and I can pay for the equities in cash, my effective annual yield will be about 5%.

A 5% - 8% annualized dividend yield is realistic. Remember, however, you have to discount this yield using the appropriate fair value calculation, and also factor in any interest payments you owe to your broker or lender. I would be skeptical of any equities yielding higher than 8%, because you to ask why those stocks are paying dividends that high, and determine if this is realistic and sustainable for your time-horizon.

The most difficult part of this approach is actually building your portfolio. You actually have to do your homework, which scares a lot of people. Choosing stocks with high yields is easy enough but you also need to ensure that your portfolio maintains its beta-correlation as much as possible. You also need to diversify appropriately, wich will depend on the futures contract you choose to short. And the best part is you always have to pay attention to the fundamentals. A company with a healthy balance sheet, with a neatly carved niche, and under good management, is more likely to maintain or exceed its beta expectations. If your stocks lose their beta by outperforming the market, do not panic... making money will not hurt you.

Now, let's walk through an example where I will be building a portfolio historically linked to the performance of the S&P 500 Index.

Steps:

1. Choose your futures contract to short:
   This must be the first step, because you have to know what the base beta is before selecting your portfolio. For example, if you are shorting the S&P 500 Futures, you should diversify into all sectors. However, if you are shorting the Dow Futures, the bulk of your portfolio should be in manufacturing and industry. As a default, we will be selecting the S&P 500 Index. For information regarding the S&P 500's constituents, please visit www.standardandpoors.com.
2. Build your equity portfolio:
   There are many stock screeners available. I recommend using Google Finance's stock screener  because its free, easy to use, and is powered by Google's uber-cool search engine. The major limitation is that only the beta calculations of the S&P 500 are calculated for you.
•  Part 1 - Select your parameters:
  The first level of parameters that we are looking for are Dividend Yield (%) and Beta. See below for an example from Google Finance:
  

Based on the criteria of stocks with yields greater than or equal to 4% and beta of between .85 and 1.15, there are 98 stocks to choose from for our portfolio. Please note that all individuals stocks do not need to have a high beta, but that your portfolio beta is the most important factor. For example, if I pay $10 on 10 shares of A with a beta of .5, and pay $20 for 5 shares of B with a beta 1.5, my portfolio beta still equals 1.
• Part 2 - Refine the search by market sector:
  In order to build a portfolio that tracks the S&P 500, we should have an idea of how stocks in the index are allocated, and allocate our portfolio accordingly. About 11% of our portfolio should be in energy, 3.5% in materials, 10% in industrials, and etcetera.  The following table is available from Standard & Poor's Index Data Platform.

• Part 3 - Examine the fundamentals:
  Before selecting a stock, prudence dictates that we should have a good idea of company's fundamentals (e.g., the company overview, management, earnings, balance sheet, etc...). We have to do this because we need to make a qualitative judgment of a company's viability in the short, middle, and long runs. Is it feasible that ConocoPhillips can continue to pay a 4.02% dividend for an extended period? Probably. Is it feasible that Company X can continue to pay a 10% annualized dividend indefinitely? Perhaps not. 
• Part 4 - Continue to build your portfolio until its value is a multiple of one futures contract:
  Repeat step 1 through 3 until our portfolio equals the size of at least 1 futures contract. The contract value of 1 point in the E-Mini S&P 500 Futures contract is $50. The index is currently at about 1150. That means the value of one futures contract is $52,500
• Part 5 - Back-test (optional)
  Before buying stocks, you may want to re-create your portfolio using a simulator. This will help you determine what your real transactional costs will be. Also, you may want to test whether your portfolio has performed as expected.

At this point, if you're ready to pull the trigger, buy stocks and short the futures contract. Your principal investment is effectively hedged because a loss on the cash position (stock) will be offset by a gain on the futures. Because the basis between cash and futures narrows towards expiration, you should expect a loss of about 3% per year on your basis position, but which will be offset by your high yield. Again, if your portfolio's annual dividend yield is 7% of its total value, and the annual fair value premium is 3% of the index's value, you would expect your portfolio to earn about 4% on its principal per year.

Managing your portfolio is another matter. If you did well in choosing your portfolio, the need to  manage your portfolio should be minimal. However, you absolutely have to manage your futures position by rolling it near expiration (shorting a deferred futures contract minimizes this need, but the spreads between the bids and offers are typically much wider). If for some reason, your portfolio's correlation with the index deteriorates, you'll have to manage your position to re-establish a stable beta correlation. Furthermore, if your portfolio's yield diminishes, you will also have to manage your position to bring yields back up. Micro-management is time consuming and racks up incremental transaction costs. I implore you to due diligence when selecting your portfolio the first time around to minimize this need.

In summary, there may be ways to beat the risk-free yield of .25% on a 1-year investment. Riskier money markets currently yield 1% for a 1-year investment. Dividend scalping may be a way to beat even the risky yield. Realistically, you can produce net annual returns of 2%+ on your position, but also have to factor in fair value premium and transactional costs. Carefully selecting your portfolio to track performance of the index futures contract will minimize the need to manage the portfolio, thereby minimizing transactional costs.

• The upsides to this approach are:
• You can beat risk-free yield, probably by scales of magnitude. There are many equities that pay quarterly dividends of 1% or more.
• Your principal investment is protected from losing its value by the opposite position in the futures.
• Interest rates are low, which means that borrowing margin is cheap compared to dividend yields, and that discounting the future value of your returns will have a smaller negative impact on your effective yield.
• Many brokers will allow you to margin your futures poisiton(s) with equities. 
• Total flexibility -- your position in equities is 100% puttable. You can liquidate your position at any time. In the debt market, on the other hand, your capital is locked in at a fixed (or sometimes floating) rate for a definite period of time. If rates go up, opportunity to invest at a higher yield is lost because your money is tied up elsewhere.
•  The downsides are:
• Your portfolio could lose its beta correlation.
• The yields on the your equity positions could fall.
• Short term interest rates go up. This strategy works well right now because interest rates are so low compared to dividend yields. If interest rates go up significantly, there may be no point in trying to beat the yield curve in the first place.
• If your portfolio loses beta or yield falls, you'll have to manage your portfolio to maintain its correlation and yield.
• If you have to manage your position too much, transactional costs could be prohibitive.
• This approach requires access to cash. Most brokers require you to have at 25% percent of your portfolio's value in cash before allowing stocks to be bought on margin. For example, if I wanted to buy an equity portfolio with a value of $52,500 (one E-Mini S&P), I would need at least $13,125 on deposit. In this scenario, my broker would lending me $39,375 and me charging interest on the principal. However, if I bought the equities outright, I would not have to adjust my net returns to account for interest owed because the discounting of future cash flows is already factored into the fair value premium (i.e., the cash to futures basis).

I hope you found this helpful, enlightening, or least interesting. Please leave us with your feedback below!

- MTL