The Price Investors Pay For High-Dividend Mutual Funds by Larry Swedroe
It has long been known that many investors have an irrational preference for cash dividends. New research shows that some mutual funds prey upon this preference by artificially inflating – or “juicing” – their reported dividend yield.
From the perspective of classical financial theory, the preference for dividends is an anomaly. The reason is that, in their 1961 paper, Dividend Policy, Growth, and the Valuation of Shares, Merton Miller and Franco Modigliani famously established that dividend policy should be irrelevant to stock returns. This theorem has not been challenged since. Moreover, the historical evidence supports this theory, which is why there are no asset pricing models that include a dividend factor.
Given the combination of logic and historical evidence, the preference for dividends among individual investors is perplexing behavior. It’s perplexing because, before taking into account what are referred to as “frictions” (such as transaction costs and taxes), dividends and capital gains should be perfect substitutes for each other. Stated simply, a cash dividend results in a drop in the price of the firm’s stock by an amount equal to the dividend. This must be true, unless you believe that $1 isn’t worth $1. Thus, investors should be indifferent between a cash dividend and a “homemade” dividend created by selling the same amount of the company’s stock. One is a perfect substitute (excluding any frictions) for the other.
Without considering frictions, dividends are neither good nor bad. However, once the friction of taxes is considered, investors who need cash flow should favor self-dividends (selling shares). Unlike with dividends, where taxes are paid on the distribution amount, when shares are sold, taxes are due only on the portion of the sale representing a gain. And specific lots can be designated to minimize taxes.
Because the investor preference for cash dividends has been well-documented, it should not come as a surprise that mutual funds have been exploiting this knowledge and attract assets by “juicing” the dividend. We’ll take a look at two recent papers examining how mutual funds exploit investors’ anomalous behavior.
Mutual funds exploit investor preferences
Lawrence Harris, Samuel Hartzmark and David Solomon, authors of the paper Juicing the Dividend Yield: Mutual Funds and the Demand for Dividends, which was published in the June 2015 issue of the Journal of Financial Economics, found that some mutual funds purchase stocks before dividend payments as a way to artificially increase their dividends. In fact, greater than 7% of the authors’ fund-year observations had dividend payments more than twice as large as their holdings imply. The authors called this behavior “juicing.”
Mutual funds can meet investors’ desire for large dividend payments in two ways. Either they can buy high-dividend-yield securities, or they can artificially increase their dividend yields by “buying the dividends” (or “juicing” them). The process involves purchasing stocks before the day on which the dividend will accrue to investors (the “ex-dividend day”), collecting the dividend and then selling the stock afterward.
The authors observed that a few funds actually advertise their juicing behavior. In 2010, Morningstar identified seven funds that explicitly describe a juicing strategy in their prospectuses. The properties of these funds are astounding. The authors noted that in 2009, the First Trust Dividend and Income Fund (FAV) listed a ratio of income to assets of 19.3% and an annual turnover rate of more than 2,000%.
The authors found that juicing is a persistent, and thus predictive, behavior. Funds that juice in one year (i.e., have an excess dividend ratio outside what chance alone would predict) are much more likely to juice in other years. This is consistent with juicing being a deliberate behavior.
Read the full article here.