Unrealised Returns
March 28 2011, 10:19 am
7th March 2011
Since the late 1990s, equities investment has been through significant peaks and troughs. Hyped to unsustainable values in the dotcom boom, the post-millennial stock market crash then wiped billions off portfolio values. Growth throughout the Noughties was followed by a similar radical depression in capital values in 2008 financial markets crisis and its aftermath.
Since that time, equities have recovered strongly, although the total market capitalisation of stock exchanges around the world in early 2011 has yet to regain the peaks of $60+ trillion reached in late 2007. Growth is once again strong, but apparently more sustainable and logically based on solid results rather than unrealistic futures. Institutional investments, which fled into fixed income instruments during the financial markets crisis, are now rebalancing their portfolios back into equities, using the stellar growth of stocks and shares during 2010 to offset at least some of the losses they sustained in the previous couple of years.
Throughout the first decade of the new millennium, earnings from dividend payment have grown. Even taking into account the natural suppression of dividends paid after the financial markets crisis, in line with suppressed profits, the culture of the dividend is far stronger now, compared with the nineties, when returns were often predicated solely on capital growth.
The importance of dividends
Looking historically, a watershed moment arrived in 2003 when Microsoft announced its first ever dividend. Since then, dividend payouts have steadily increased in popularity until the financial markets crisis.
Then came a natural downturn. Dividend increase announcements were in decline even before the liquidity crisis as companies relied on the greater flexibility of share buybacks to return cash to investors. One commentator1 has noted that in reality, dividend increases are driven not by excess cash, but instead by a good economic and market environment.
Yet to award dividends solely when times are good creates the least favourable impression on investors. Analysis of dividend reduction during the recent liquidity crisis reveals that investors indiscriminately punished companies cutting dividend during the panic in the second half of 2008 but rewarded dividend reductions in the first half of 2009 as they became comfortable with companies shoring up liquidity buffers in the tough economic and funding environment. Learning from this experience, an increasing number of astute corporates are now starting to use their dividend payments as a proactive tool to manage investor opinion and enthusiasm – in other words, as an investor marketing tool.
Some years ago, research by Dresdner Kleinwort Wasserstein2 delivered some key figures that firmly punctured the popular notion that long-term equities gains come from capital growth. The bank’s study told us that: in Europe since 1970, 70% of total equity returns have been derived from dividend yield; and between 1950 – 2000, the average contribution by Europe (excluding UK) of dividend yield to total equity returns has been 62%. The research then goes on to state that the bank sees dividend yield once again becoming the greater proportion of equity returns in the future.
Indicators are now showing a major resurgence in dividend payments as the markets grow strongly. One major index provider in the U.S.3 has reported that across the 7,000+ publicly owned companies whose dividends it tracks, only 35 decreased their dividend payment during the third quarter of 2010 marking a continued, dramatic improvement from the 135 that lowered their dividend payment during the third quarter of 2009. Dividend increases rose 56% during the third quarter to 299 from the 191 recorded during the third quarter of 2009.
Year-to-date, 117 have decreased their dividend payment compared to 730 for the corresponding period last year. 1033 issues have increased their rate so far this year, a 46% gain over the 707 issues that did so last year. The same commentator also reported that, on a dollar-weighted basis, the first nine months of 2010 saw a net gain in annual dividend rates of $18.5 billion compared to a $45.7 billion decline in rates during the comparable period of 20094. This is substantial growth indeed.
Cross-border Investing
Not only are equities back in fashion, but interest in cross-border investing is also on the rise. According to the statistics from the International Monetary Fund and from global stock exchanges, the market capitalisation of global equities rose 79% between 2001 and 2009, whereas the value of cross border equities investments rose 163% over the same period.
So cross-border shareholdings have risen at something around double the market rate, showing that fund managers have increased the proportion of foreign shares in their portfolio from around 20% in 2001, to more like 28% in 2009. The market capitalisation of the global equities markets (excluding investment funds) is currently around the $55 trillion mark. By comparison, the average proportion of foreign shares in a fund manager’s equities portfolio is in the region of 20-30%.
Fixed-income
The subject of this GOAL study covers cross-border investment in all securities – equities and bonds. The fixed-income market has been very much the beneficiary of the equities market’s crisis of confidence in 2008, with the value of bonds listed on global markets rising from $14 trillion in 2001, to over $63 trillion at the end of 2009 (the latest IMF’s most recent globally reliable measurement point).
Whether growth in issuance will continue, and how strongly, is a moot point. As the equity markets crashed in 2008-9, funds poured into the debt markets. With the huge and sudden demand, prices on the secondary market soared, and yields on the primary market plummeted. The forward outlook for earnings on gilts is now being debated between various commentators, one of whom noted, “the global savings glut (or investment dearth) has depressed gilt yields. It’s possible that, as these factors weaken, bond yields could rise without jeopardizing equities simply because the bond-earnings yield ratio returns towards normal. Even if ten year gilt yields were to rise to five per cent, this ratio would still be well below its pre-crisis levels.5”
Withholding Tax and Reclamation Rates
More companies are now paying a dividend. Those who have historically done so are looking to increase the dividend payout year-on-year. And according to Standard and Poors, this trend is expected to continue strongly through 2011 and beyond.
Holding foreign shares is also becoming more popular with fund managers. The growth in foreign equity holdings between 2001 and 2009 was more than double the growth in global stock markets capitalisation over the same period. This shows that fund managers are increasing the proportion of their portfolio made up by foreign shares.
Bond market activity has increased markedly since the global stock market nadir of 2008. This increase in debt securities may or may not continue to grow at the same rate in future years, but has introduced a new balance into the fixed-income vs. equities portfolio balance.
At all events, dividends on foreign shares and yield from foreign bonds are subject to withholding tax6. This is a tax on earnings that the country’s tax office (the country in which the share or bond is issued) deducts at source, a proportion of which can be reclaimed by the owner of the shares/bonds.
However, GOAL’s research shows that around 25% of that reclaimable tax is left unreclaimed. This amounts to some $16-17 billion of shareholder returns that are being wasted – left unreclaimed in a foreign country’s tax system. This represents a 50% increase in the annual amount wasted compared with 2005 when GOAL last conducted an analysis of the situation.
Pressure on FMs and Custodians
With the increasing popularity of both dividend payments, and cross-border securities, the unreclaimed tax will continue to rise unless fund managers’ service providers – often custodian banks – improve reclamation levels. Increasingly savvy investors, in markets where high yield investments are harder to come by, are putting the fund management community under growing pressure to maximise their investment returns.
As a result of all these factors, dividend yields have become a far more highly scrutinised element of the investor’s portfolio, with consequent pressure on fund managers to devote greater attention to maximise this element of return in the portfolios they are managing.
The significance of unreclaimed withholding tax on cross-border securities holdings has therefore risen to a prominence it has not enjoyed since the ‘nineties and earlier ‘noughties. Back then, however, technology was not available to automatically perform the highly complex task of reclaiming withholding tax, a process which has to incorporate up to date information, formats and procedures from a multiplicity of different legislatures around the globe.
In contrast to the last such period of attention enjoyed by the faithful dividend, technology solutions are now widely available to automate the process of withholding tax reclamation, making it an economic – indeed profitable – process for custodians, and a ‘must have’ for fund managers under pressure from their investor clients.
1. CEB Views, Dividend Trends and Market Reactions, 25 November 2010
2. Dresdner Kleinwort Wasserstein, DrKW launches new Pan-European Income Service Research, Jan 2004
3. Standard and Poor’s, Dividend Record, 4 October 2010
4. ibid
5.Investors Chronicle, Shares shrug off rising gilt yields, 4 Jan 2011
6. See, for instance, definitions at www.goalgroup.com, or at http://www.ubs.com/1/e/ubs_ch/wealth_mgmt_ch/company/c_tax/backtax.html
Stephen Everard
Managing Director
