Your ETF Has ‘DRIP Drag’!

October 21, 2014

When it comes to reinvesting dividends, mutual funds have ETFs beat.

At ETF.com, we love to explain why ETFs are better than mutual funds—tax efficiency, transparency, lower average fees, insulation from forced buying and selling and intraday liquidity make ETFs a fantastic choice for all types of investors.

Still, we never shy away from discussing ETFs’ shortcomings, like spreads, premiums and discounts and tracking error.

We missed a problem. It’s time to add dividend reinvestment to the ETF trouble list.

For fund holders who want to reinvest dividends, mutual funds offer a true advantage. ETF holders have to wait at least four business days to put their dividends back to work. Then they have to buy new shares on the open market, piling up costs and risks: market volatility, spreads and premiums/discounts.

The Dividend Dance

Mutual fund investors can reinvest their distributions at net asset value, on the ex-dividend date. ETF shareholders have to wait for all transactions to settle until the cash hits their brokerage account.

This happens because mutual funds keep their own records, while ETF issuers rely on brokerage firms to track fund ownership. Therefore, mutual fund trades generally settle in one day, while ETF trades commonly take three days.

Settlement times affect the dividend-payout schedule.

Three Key Dates

Security issuers must follow a strict routine for paying dividends. It’s old school—very formulaic, very meticulous—and it’s all set up to make sure the right people get the right payments.

First, the issuer declares a dividend. They specify the dates and dollar amounts of upcoming distributions. Actually, they specify three dates:

  • Record Date – Shareholders have to own the shares as of a particular date to receive the distribution. Brokerage records prove ownership, so issuers must follow brokers’ settlement rules to determine the record date.
  • Ex-Date – The first day that anyone buying the stock can no longer become a shareholder in time for the record date, because any shares bought won’t settle in time for the record date. This is the date on which the share price adjusts downward to account for the dividend payment.
  • Payment Date – The date that the shareholders of record will receive the cash in their brokerage accounts. This must be at least one day after the record date, but sometimes stretches longer.

 

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