Dividend arbitrage

Why would almost a third of a bank’s stock be out on loan on Friday, then drop back to under 5% on Monday? It’s an interesting point highlighted by a paper from Richard Davies Investor Relations.
Having undertaken detailed analysis of stock-lending levels in a range of PLC stocks, the firm notes that these big shifts take place around ex dividend dates. A reasonable conclusion, therefore, is that this is linked to dividend arbitrage – the practice of moving stock between jurisdictions in order to reduce the tax hit on dividends.
Whilst, in its basic form, the practice is legal under FCA rules, the huge amount of stock being shuffled around in some cases has not, to our knowledge, been revealed previously. And the companies involved are household names. RDIR found almost 30% of HSBC out on loan in one case, over 20% in the case of Centrica, and up to 18% in the case of BP. These stock movements are so large now that, in some cases, they result in regulatory announcements – TR1 notices – being triggered because of significant changes in voting rights. Having dug into these TR1 notices we think we can identify at least one major asset manager making changes in the nature of its holdings around ex dividend dates.
Looking at shareholding data we think we can spot others. In one case it looks like an asset manager’s position drops from over 4% to less than 1% before returning to around the original level, and this happens more than once. To be clear, it’s possible that these are pure investment decisions, or it could be that it’s underlying clients loaning stock. But again in some cases there look like big shifts taking place.
To reiterate, it’s a legal practice. However, in an era where some institutional shareholders are pressuring companies to behave more responsibly, including on tax issues, it feels hard to square with demands that issuers adopt a long-term stance. It’s not obvious there is a big difference in principle between profit shifting by companies and dividend arbitrage by investors.
In addition, there may be occasions where this has a knock-on impact on voting. If the ex dividend date is close to the AGM are investors able to recall the stock in time to vote at the meeting? If this occurs in a market where there is share blocking it may not be possible to both run the dividend arbitrage trade and vote,so a choice has to be made. Presumably if this is happening the manager’s clients will be made aware of it happening and why it’s happening.
It is also clear that there is renewed policy interest in this area. Just last week ESMA, the European securities regulator, issued a paper looking at the dividend arbitrage trade where multiple tax credits have been claimed. This is the (understandably) more controversial type of activity that we’ve covered previously in PIRC Alerts. But it would be a surprise if regulatory and political interest stopped here. With investors’ own behaviour under scrutiny as never before, this looks like the type of activity that will become increasingly hard to defend.

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