By Jason Zweig | 2:00 pm ET Dec. 5, 2014
Image Credit: Christophe Vorlet
If you can’t beat ’em, juice ’em.
Unable to pick stocks that outperform the market, dozens of mutual funds appear to be chasing higher dividend yields with a costly and potentially risky trading tactic that new research calls “juicing.”
A study co-written by Lawrence Harris, a finance professor at the University of Southern California and former chief economist at the Securities and Exchange Commission, finds that more than an eighth of all U.S. stock funds that pay annual dividends of at least 0.5% of their share price may have significantly inflated their income in at least one year. That would be about 300 funds.
Juicing is the nickname Prof. Harris and his co-authors give to a tactic called dividend capture, in which traders jump in and out of stocks to pocket the quarterly or annual income payouts. Instead of owning the stocks continuously, such traders own them only long enough to grab the dividend—sometimes a period as short as from one afternoon to the next morning.
Mutual funds engaged in juicing trade much more frequently but produce total returns—growth in share price plus income—that are no better than the average of all U.S. stock funds that pay a significant dividend, according to the study, soon to be published in the Journal of Financial Economics. Examining more than 2,200 funds between 1990 and 2011, the researchers found that the worst offenders—those with dividends more than one-third higher than their long-term holdings would imply—underperformed the average fund by 2.1 percentage points annually.
And the funds that juice the most end up sticking their investors with excess taxes that average 0.6 percentage point a year of total account value, and probably more once short-term capital gains are included. Trading costs are presumably higher, too, although they aren’t directly measurable since funds don’t have to report them.
How does dividend capture work? You must buy a stock before its “ex-date,” the day on which new buyers are no longer eligible to receive the coming payout. You need to hold it only until the “record date,” generally two business days after the ex-date.
Since it takes three business days to settle payment for trades, you can buy the day before the ex-date, sell on the ex-date and still be counted as a shareholder on the record date. One quick overnight squeeze, and you are out—but the dividend comes with you.
If you had tried this overnight technique on each of the 30 stocks in the Dow Jones Industrial Average, you would have earned a compounded average of 0.2% over their past four dividend payments, counting both price and income gains, according to analyst Jeffrey Yale Rubin of Birinyi Associates, a research firm in Westport, Conn. If you had instead owned the entire index during each of those trading windows, you would have earned 0.3%.
Either way, trading costs and taxes would have eaten most or all of those returns, Mr. Rubin says.
And pogo-sticking your way from one risky stock to another can be a dangerous game.
Consider the extreme case of the Alpine Dynamic Dividend Fund, managed by Alpine Woods Capital Investors in Purchase, N.Y., a fund that has long specialized in dividend capture.
In both 2006 and 2007, Dynamic Dividend’s portfolio-turnover ratio was around 200%, indicating that the fund held on to its typical stock for about six months. In 2008, the ratio was 323%; in 2009, it was 656%, equivalent to a typical holding period of just seven weeks. The average for all stock funds in 2009 was about 90%, according to investment research firm Morningstar, or about 13 months.
For a while, returns were great. In 2006, Dynamic Dividend delivered a 22.6% total return, outperforming the MSCI All-Country World Index of global stocks by 1.6 points.
And the fund’s annual yield, or its income divided by share price, exceeded 13% in both 2006 and 2007—a stupendous sum in a world of low interest rates.
In response, investors flung money at the fund; it nearly doubled in size in 2007, to $1.4 billion.
Then disaster struck. Some of Dynamic Dividend’s stocks, such as Anglo Irish Bank and FreeSeas, had high income—but even higher risk. The fund’s yield soared to 30.9%, according to Morningstar, but not even that level of income could cushion investors from a catastrophic drop in share prices. In 2008, Dynamic Dividend lost 48.9%, far more than the global MSCI benchmark.
Dynamic Dividend underperformed again in 2009 and each calendar year since, although it is up 8.9% over the past 12 months, while the global index has gained 8.1% in that span. Assets have shrunk to $215 million as of the end of last month.
Through an outside spokeswoman, Alpine declined to comment. Alpine has since scaled back its trading, reducing the turnover rate to 197% last year, the latest available annual data.
Only a few funds openly state that they practice dividend capture, including seven closed-end funds with combined assets of $4.5 billion, and two mutual funds, the $3 billion Henderson Global Equity Income and the $221 million Huntington Dividend Capture.
But the new research suggests that many more employ the tactic to some degree. Portfolio managers may be trading too much, racking up higher costs and raising tax bills, all in pursuit of dividend income that probably won’t even improve total return.
If you buy a stock fund with a dividend yield above 2% and a portfolio-turnover rate greater than 67%—the current average, according to Morningstar—you will have nobody but yourself to blame if the juice goes bad.
Source: The Wall Street Journal