In this partnership interview, Rob Davies, UK Equity Income Index Specialist at Elston Consulting, explains the background to the firm’s UK dividend index.
Background
As the Elston Smart-Beta UK Dividend index approaches its 10-year anniversary, we ask Rob Davies – UK Equity Income Index Specialist at Elston Consulting – about the background to this dividend-contribution weighted index and why it has delivered superior returns to traditional market-cap weighted indices.
Rob developed the selection methodology used in the Elston Smart-Beta UK Dividend Index and managed the VT Munro Smart-Beta UK fund using the same systematic approach from 2007 to 2015. Since then, the fund has been benchmarked to the Elston index.
When did you first have the idea for a dividend-weighted index?
In 1999 after the dot com crash. It became clear to me that market-cap weighted indices were flawed. When tech became a bubble, the index reflected that bubble – it validated a self-fulfilling prophesy on the way up – and on the way down too. So I was interested in other ways of weighting an equity index and given the importance of dividends to long-run returns – particularly in the UK – that’s where my focus shifted to.
Why did you focus on forward-looking, not backward-looking dividends?
The rationale for using forward-looking dividends is because markets are forward-looking too. I wanted to ensure we capture the positive changes in future dividend growth, rather than relying on a backward-looking measure.
Markets can change fast and the results for last year may represent a very different world. As a former equity analyst, I know the data on forecast is out there, and while not always accurate, it is more reflective of future trends than looking at historical data.
What piece of academic research most inspired you to develop this methodology?
For equities, dividend income and capital growth are the core components of Total Return. Dividends can also be used to estimate the intrinsic value of a company. The Dividend Discount Model (DDM), and its variants, the multi-period DDM and Gordon Growth Model (GGM) represent a fundamental approach to estimating the intrinsic value of a company, based on the net present value of its future dividend payments (grown into perpetuity for the GGM) and a terminal value. So dividends – in classical investing – are a core measure of a company’s worth.
I also found the work of Dimson, Marsh & Staunton around long-run returns interesting and helpful.
You launched the fund back in 2007: what were the challenges in the early years?
The hardest part of a fund launch is the initial distribution strategy. Without sufficient AUM, the OCFs of a fund can be high. And with high OCFs, it’s hard to get the AUM – particularly for a systematic fund. That chicken-and-egg issue was a real challenge for the first ten years, and although there were a number of partnerships explored and even commenced, none of them yielded sufficient results. In that time, I stuck to the investment process, but the higher fee drag did weigh on returns in the earlier years and that carries through the whole track record, unfortunately.
Elston Indices took on the administration of the index in 2017: what changed?
Elston Indices took on the administration of the index in 2017: what changed?
The administration of benchmarks became a regulated activity from 1st January 2018, so what had been a quantitative process run internally needed to be a published, regulated benchmark using a codified and published, systematic, rules-based methodology. I chose Elston Indices to take on the running of the index because of their creativity and agility and readiness to work with more specialist fund providers. They took over and fine-tuned the process and it is now powered by Elston’s Minerva, a proprietary suite of quantitative tools, screens and methodologies to build targeted and systematic investment solutions.
Elston provides daily target weights to the investment management team at Valu-Trac Investment Management, which fully replicate this smart index by aligning the underlying holdings to the correct weights. They have also helped develop and publish research around this UK Equity Income strategy. The original and enhanced methodology focuses on dividend compounding as a source of persistent returns.
How often is the index rebalanced?
The index rebalances monthly to check any changes in forward-looking dividend expectations. This does result in a bit of churn but as it is all trading predominantly large cap UK equities, it’s not a big issue. What is frustrating is stamp duty. Where some fund providers exclude it, in our case, the policy is to include it, and this creates frictional costs. If stamp duty was abolished, the OCF could come down.
Are you personally invested in this fund?
Of course! It pays me a monthly income from the underlying 200 or so companies ranked by dividend contribution. Interestingly, the Income unit share price has just recovered to its initial level in 2007 of 100p or so. So my capital is preserved, having lived off the income the fund pays out each month. That’s perfect for my retirement as – unlike an annuity – dividends from real companies give me inflation protection too. The Accumulation unit share price is 209p, illustrating the power of reinvested dividends.
What are your ambitions for the future?
I have devoted a lot of my time to bringing this idea to life so it is great to see it finally gain traction. Investors have been wedded to vanilla passive strategies for so long, but in volatile times like 2022 and now with the correction in the US, the staying power of dividend compounding really shows its colours.
I would love to see a Global Equity Income version constructed along the same principles: that would require substantial development work from Elston on the index side and it would also depend on whether a fund provider would see it as having sufficient potential to merit a launch. Once the Munro UK fund gets to GBP100 million, then perhaps that’s something to start looking at more seriously.
