Canceling Investors Won’t Fix the London Market

(Bloomberg Opinion) -- A prominent hedge fund manager has a provocative idea to fix the U.K. stock market's addiction to dividends — abolish income funds. Paul Marshall, co-founder of Marshall Wace LLP, blames them for starving the biggest London-listed companies of the investment needed to fuel growth.

It's a novel solution to a longstanding problem. Shares in the FTSE 250 index of mid-sized companies have delivered strong total returns through capital growth and dividends this century. But once these stocks graduate to the FTSE 100 index, they start to die. The blue-chip benchmark has gone nowhere; almost its entire return is from dividends. Individual stock prices get punished or rewarded according to whether cash goes out to shareholders or stays in the firm for capital expenditure.

Comparisons with the S&P 500 are embarrassing too. True, none of Europe's markets house the growth stocks that have fueled the U.S. index's ascent. The question remains whether the attempted reinvention of BT Group Plc, GlaxoSmithKline Plc and Royal Dutch Shell Plc might have progressed further had these U.K. stalwarts cut dividends before the pandemic to accelerate investment in high-speed broadband, drug discovery and the energy transition.

One possibility is that the situation has nothing to do with shareholders. Rather, boards are setting the bar too high for the returns that new projects need to deliver. Given interest rates are so low, investments should be allowed to earn lower returns than might have been demanded before the financial crisis.

That said, investor influence must be a factor. U.K.-based fund managers may be a small portion of the typical London-listed company's shareholder register — and Marshall's despised income funds are just a subset of that group. But their voice carries disproportionate weight. And their main client is the domestic pension-fund sector, whose reliance on dividend income has increased as bond yields have fallen and closing defined-benefit plans to new members has cut cash inflows.

As for the overseas funds that own the majority of U.K. stocks, their holdings are probably a small part of geographically diversified portfolios, and their engagement with U.K. boards may be commensurately limited.

Marshall's solution is essentially to overhaul the investor base. But canceling one corner of the U.K. financial sector won't end the pro-dividend forces at work in the London market. The U.K. equity income strategy runs just 44 billion pounds ($58 billion) of assets, according to the Investment Association trade body. The FTSE 100 and FTSE 250 indices are worth 2.5 trillion pounds.

The change in stewardship would need to be on a grander scale, like the idea to consolidate the fragmented pensions sector into a handful of national mega-funds with the scale and patience to back adventurous corporate strategies, as proposed by advisory boutique Ondra Partners. But that can't happen overnight.

The other snag with just targeting investors is that it treats boards as mere puppets of asset managers. Company directors may be appointed by shareholders, but they should make day-to-day decisions by themselves when it comes to deploying capital.

If boards are slavishly doing what the noisiest shareholders want, the answer must involve bolder boards as well as more growth-focused investors. The consequences of overpaying dividends build up gradually until the cost becomes inescapable. A decent chief executive will argue for restraining or cutting shareholder payouts, accepting the risk of getting fired if the case isn't convincing. In other words, let the dividend addicts scream and shout — and carry on regardless.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

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