The PACER PERSPECTIVE
December 2022

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Dividend Multiplier:
An Innovative Way to
Enhance Dividend Income
Part 2: Application - Dividend Strips and Multipliers

- Danke Wang, Portfolio Manager

With a fundamental knowledge of dividend futures, we can dig deeper into how to utilize dividend futures contracts to enhance an investor’s income-potential through the Dividend Multiplier Strategy.

Key takeaways:

• With long positions in the S&P 500’s dividend futures contracts, investors can isolate the index’s dividend into a separate “investment asset” — a Dividend Strip.
• By holding multiple dividend strips, investors can construct a portfolio producing a multiple of the initial, ordinary dividend yield of the S&P 500 Index.
• The Dividend Risk Premium exists because of the market’s mispricing of the S&P 500’s future dividend. Realization of the Dividend Risk Premium drives the return of the dividend strip, which further enhances the portfolio’s performance-potential.

Dividend Component Creation
Combining a long position in dividend futures and the corresponding full collateral creates a synthetic holding replicating the S&P 500’s dividend payment, though dividends are never guaranteed. As a result, the S&P 500’s dividend becomes an isolated “investment asset,” like a stock or bond, so the price must be paid in cash at the time of purchase.

The ending value of the dividend component will equal the actual dividends paid during that period.

For example, taking a long dividend futures contract position for $60 and holding $60 in cash collateral is the theoretical equivalent of investing in the S&P 500’s dividend for a price of $60.

Here are some potential scenarios:

• If over the period, the actual dividends paid are $65, the value of the dividend contract position will also be worth $65. Because $5 was received from the settlement of the futures position ($65-$60), and that plus $60 of cash collateral equals $65.
• On the other hand, if the actual dividends paid are $55, the value of the position will be worth $55 as well: $60 of cash collateral minus a $5 “loss” from the futures position
  ($55 - $60 = -$5).

Dividend Multiplier Construction
The next step is a simple one: asset allocation.

To create a portfolio mimicking the S&P 500’s return while utilizing the dividend and price component, an investor can allocate 1 unit of the annual dividend component along with 1 unit of the yearly price component (the dividend component and price component should have the same maturity to meet the 1:1 ratio requirement).

Assuming S&P 500 dividend futures for 2022 are trading at $60 and, the S&P 500 Index is at $4,200, the value of the 1-year dividend strip is worth $60 or 1.43% of the S&P 500 Index value.

Furthermore, to take advantage of the dividend risk premium (more on this later), an investor can also allocate to a longer-term dividend strip. A 3-year dividend strip, for instance, can be used to match the price component of the same time length.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU CANNOT INVEST IN AN INDEX

The chart above shows the realization of 1x dividends by allocating 1 unit of the dividend strip. By multiplying the dividend strip allocation, a dividend multiplier strategy emerges.

The dividend multiplier strategy involves overweighting the dividend component and subsequently under-weighting the price component to enhance the overall dividend level. Here's the trade-off: to get a multiple of the index’s dividend yield, an investor must give up some of the S&P 500’s price exposure, thereby reducing the portfolio’s beta. Which is why in the above example the beta is 0.86.

Dividend risk premium
Finally, let's talk about what's driving the excess returns of dividend futures contracts.

Historically, forward dividend expectations of the S&P 500 index (the dividend futures price) have been substantially lower than the realized dividend (the settlement value of the dividend futures contract).

Source: Bloomberg

For example, as of December 2015, based on the dividend futures price, the implied 1-year and 3-year dividend growth was 3.76% and 6.77%, respectively.

However, the actual 1-year dividend growth in 2016 was 4.92%, while the S&P 500 dividend grew 25.1% from 2015 to 2018.

The discount between implied and realized dividends translates to investment returns on dividend futures contracts.

Source: Bloomberg

The table below shows the cumulative and annualized return when investing in the N −period dividend futures at the end of 2015. The annualized return is referred to as the realized dividend risk premium.

Source: Bloomberg

The dividend risk premium is what investors demand to compensate them for the risk of actual dividends coming short of market expectations. Like a risk premium, the dividend risk premium indicates that investing in the dividend strip comes with certain risks, but it also has the potential for rewards.

On a forward-looking basis, the dividend risk premium can be measured using the difference between dividend futures prices and analyst dividend forecasts. As of 12/31/2022, equity analysts expect the S&P 500 index to grow its dividend by 4.3% annually for the next several years, while the current futures market implies a -0.5% dividend growth per year till 2030.

Source: Bloomberg

The disagreement between the futures price and consensus estimates indicates that investors can take advantage of a decent risk premium to enhance investment return-potential.

The Pacer Metaurus Dividend Multiplier Strategy (DMS) extends the dividend strip to a 3-year period (dividend futures contracts maturing in 1, 2 and 3 years), seeking compensation with higher premiums.

Pacer Metaurus US Large Cap Dividend Multiplier 400 ETF

Utilizes the dividend multiplier strategy to reallocate capital between an index’s dividend cash flow and potential price appreciation/depreciation. By holding 4 times the dividend component, including dividend futures and equity investment, the fund aims to provide cash distributions equal to 400% of the S&P 500’s ordinary yield in exchange for modestly lower exposure (approximately 88%) to the S&P 500 Index performance.

As of 12/31/2022, the fund's indicated yield is 7.45% vs. only 1.7% from S&P 500. At the same time, the 1-year beta is 0.9.

 

Dividends Risk: There can be no assurance that a dividend-paying company will continue to make regular dividend payments. The ability for a company to pay dividends is dependent on the economic climate and the companies’ current earnings and capital resources. Changes in economic conditions or a company’s earnings or financial resources could cause a company to reduce its dividend payments or suspend the payment of dividends altogether. The possibility that such companies could reduce or eliminate the payment of dividends in the future, especially if the companies are facing an economic downturn, could negatively affect the Fund’s performance.
The S&P 500® Index is a popular gauge of large-cap U.S. equities and includes 500 leading companies, capturing approximately 80% coverage of available market capitalization.
Beta is a concept that measures the expected move in a stock relative to movements in the overall market. A beta greater than 1.0 suggests that the stock is more volatile than the broader market, and a beta less than 1.0 indicates a stock with lower volatility.

This document does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. Please consult with your financial advisor and tax advisor before investing. This document is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. This document represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. The user of this information assumes the entire risk of any use made of the information provided herein. There is no guarantee this strategy will be successful.

The Metaurus US Large Cap Dividend Multiplier Index – Series 400 (the “Index”) is the property of Metaurus Advisors LLC which has contracted with S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC) to calculate and maintain the Index. The Index is not sponsored by S&P Dow Jones Indices or its affiliates or its third party licensors (collectively, “S&P Dow Jones Indices”). S&P Dow Jones Indices will not be liable for any errors or omissions in calculating the Index. “Calculated by S&P Dow Jones Indices” and the related stylized mark(s) are service marks of S&P Dow Jones Indices and have been licensed for use by Metaurus Advisors. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”), and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”).

Metaurus Advisors LLC serves as investment sub-advisor to the Fund.