Published: Oct 22, 2015
by Rob Davies, Fund Manager
There aren’t many ways to improve returns in the super-efficient world of modern investing. The application of modern portfolio theory (that the market already prices in all known published data), behavioural finance and more and more computing power leaves little scope for beating the competition without increasing risk.
But there is one avenue left to explore.
It is simple, does not cost much and carries absolutely no extra risk. That might sound facile but we can prove it with some simple arithmetic and recalling this famous aphorism.
Albert Einstein, the eminent scientist, once said “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
What, some will wonder, has that got to do with equity investing? The answer is that reinvesting dividends accounts for about half of all the returns made from investing in shares. So maximising dividends should be one way of improving returns. Indeed, there is a good evidence of income biased investment strategies, such as Warren Buffet’s, doing better than the market.
Putting those reinvested dividends to work as soon as possible is the logical next step. Just by increasing the frequency of dividend distribution, and allowing the magic of compound interest to do its work on reinvested cash sooner, will boost returns relative to funds that either distribute less frequently or ones that focus on capital growth. This financial logic applies to the accumulation units of a fund as well as the income units. Even though the fund earns interest on the dividends received it can only reinvest that cash after payment has been made by the fund. The ex-dividend date determines the cut-off point to which dividends are accrued but then there is an interval between that date and the date the cash is paid out to income unit holders or reinvested on behalf of the accumulation unit holders.
Once paid those funds are then available to be reinvested in the fund and can earn the higher returns from equity relative to the low returns on cash. This logic of course only applies to funds that have strong and steady stream of dividends that will provide the cash to be reinvested. Although the time scales are small the benefits accruing from compound interest are clear and well known.
To put this into perspective consider a fund yielding 4.6% that only distributes income at the end of the year and experienced no capital growth in the course of that year. Its return would be 4.6%, the same as its yield. Now imagine if the fund were to switch to making quarterly payments thus bringing forward the date the cash can be utilised in the fund by up to 9 months. Assuming that returns from the reinvested cash rise from the 1% deposits earn to the 4.6% yield on equities an excel spreadsheet tells us that the return would increase by 0.079%. Not a huge increase it is true, but an increase all the same.
None of these changes involve any alterations to the way a fund is run, the portfolio constructed or its risk profile. It does of course assume the fund has a lot of dividend paying shares and clearly this approach would not work on a higher risk fund that only invested in non-dividend paying shares.
In practice the additional returns would be less than those indicated by this theoretical exercise because some of the growth would come from capital which would not be affected by changing the distribution frequency. Even so, in the fiercely cutthroat world of managing money it is clear that giving money back to investors sooner rather than later helps everyone.