Dividend reinvestment remains one of the most important tools available to investors in the current market environment and can help to deliver significant returns over the longer term, according to Schroders’ Nick Kirrage.
The past decade has been characterised by extremely low rates and unprecedented quantitative easing (QE) measures following the global financial crisis, contributing to a steady rise in markets with valuations climbing to new highs, as the below chart shows.
Indeed, the low rate environment has meant that stocks paying an income have been particularly sought-after as they tend to have more stable, dependable balance sheets and offer decent income potential.
Performance of indices over 10yrs
Source: FE Analytics
This has become increasingly important as government bond yields across much of the developed world remain near historic lows thanks to central bank policies mentioned above, forcing savers and more cautious investors into risker asset classes.
For example, yields on 10-year benchmark government debt in the UK, Germany, and Japan are 1.54 per cent, 0.67 per cent and 0.03 per cent respectively, according to Schroders while the yield on US government debt is a little higher at 2.88 per cent.
This compares poorly to the yields on offer 25 years ago, when all four bonds were paying out 4.5 per cent, and makes it unlikely that investors will enjoy similar returns over the next 25 years.
If you had invested $1,000 in government bonds at the beginning of 1993, as measured by the BofAML Global Government Total Return index, the capital growth would have produced a notional return of $2,548 (by 7 March 2018). Annually, that represents a growth rate of 5.1 per cent.
As such, income-hungry investors have turned their attention to stock market dividends in recent years which have a much more attractive headline yield.
In comparison, the dividend yield on the FTSE 100 is now 4.1 per cent while in the US it is 3 per cent and in Japan it is 2 per cent.
As investors have the choice on how to receive future dividend payments – as cash (income) or to repurchase more company shares – those who chose to reinvest would have benefited significantly over the past 25 years.
If you had invested $1,000 on 01 January 1993 in the MSCI World, the capital growth would have produced a notional return of $3,231 (by 7 March 2018). Annually, that represents a growth rate of 5.9 per cent.
However, as the below chart shows, the MSCI World with dividends reinvested (as represented by the orange bars) are much higher and investors would have seen a return of $6,416 – or annualised growth of 8.3 per cent.
MSCI World vs MSCI World with dividends reinvested over 25yrs
Source: Schroders
In percentage terms, it’s the difference between your money growing by 323 per cent without dividends reinvested or 640 per cent with dividends reinvested.
The reason for this difference above is the effect that compounding can have on a portfolio – what Albert Einstein referred to as the “eighth wonder of the world”.
Put simply, by reinvesting dividends, you give your stock holding the potential to earn even more dividends in the future.
Nick Kirrage, manager of the Schroder Income fund alongside Kevin Murphy, said: “Dividend reinvestment is one of the most powerful investment tools available. As our research shows, the potential difference to the rate of return dividend reinvestment makes could be substantial.
“In an era where interest rates are so low investors need to be aware of relatively simple investment techniques that can help them build up their returns. Dividend reinvestment is a simple technique."
Kirrage added: “Over time, those seemingly small amounts reinvested can grow into much bigger sums if you use them to buy even more shares that pay dividends in turn.”
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
However, he said investors need to do their research to make sure the company they are investing in can afford to pay their dividends on a sustainable basis rather than paying it through increased levels of debt.
For those looking to take advantage of this phenomenon, investors could look to buy an investment trust that has a proven track record of increasing its dividends in every year.
Currently, four firms have upped their payouts each year for the last 50 years according to the Association of Investment Companies (AIC) – City of London Investment Trust, Bankers Investment Trust, Alliance Trust and Caledonia Investments.
Annabel Brodie-Smith, communications director at the AIC, said: “We now have four dividend hero investment companies with more than half a century of dividend increases, an enviable achievement.
“Investment companies have an important structural advantage, namely, they can squirrel away up to 15 per cent of the income they receive each year to boost their dividends in tougher times.
“Whilst markets have seen volatility since the start of the year, interest rates remain historically low and income is very much in demand, with many investors relying on regular dividends for everyday spending and bills.”