(Un)Qualified: The Dirty Little Secret of (Some) ETF Dividends

August 25, 2005

The Three Sources on Unqualified Dividends

While ETF investors can't possibly know the purchase and sale date for every security within a fund, they can get a general feel for a fund's tendency to create unqualified dividends.

The largest source of unqualified dividend income for most mutual funds (and some ETFs) is turnover.  If a fund buys a stock on its dividend date, collects the dividend and then sells the stock less than 60 days later, the dividend income will not be "qualified" - it will be taxed at the higher, marginal tax rate.

Because ETFs track indexes, they have relatively low turnover compared to most active mutual funds.  But regular index changes and rebalancings can force funds to sell securities, possibly violating the 61-day holding rule and creating unqualified income. More substantial index changes - or even worse, switching the benchmark for a fund - can have a more significant impact. 

But turnover can't explain all the trouble - after all, funds tracking the same index suffered different levels of unqualified income in 2004.  For instance, the Standard and Poor's Depositary Trust (SPY), which tracks the S&P 500, paid 100 percent qualified dividends in 2004[3]; the iShares S&P 500 Index Fund (IVV), in contrast, had 17.4 percent of its dividends paid out as unqualified dividends.

How can that be?  The answer is two-fold.

First, changes in the asset base of a fund can create unqualified income.  Funds that see their assets shrink - even temporarily - can be forced to sell shares of stocks, thereby violating the 61-day holding period.  Although the assets of most ETFs continue to rise on a year-by-year basis, there are periods in which assets fall, and that can trigger sales.

Second, there is the issue of security lending. Fund companies often loan out stocks held by their funds to short-sellers. These short-sellers pay the fund company interest, which is often used to offset expenses.  Short-sellers must also compensate the fund company for any dividends they would have received on the shares in question. But this "synthetic dividend" is not really a dividend - it's a direct cash payment from the short-seller to the fund company - and therefore, it does not qualify for the lower 15 percent tax rate. 

iShares Unqualified Dividends

What's curious about the issue of unqualified dividends is that it is not spread out evenly among the different ETF families.  Of 52 relevant iShares[4], only nine paid out all of their dividends as "qualified" dividends; the remaining 41 paid at least some non-qualified dividends.  Meanwhile, only two of nineteen funds from SSgA paid out non-qualified dividends, and only four of sixteen VIPERs from Vanguard. 

PowerShares Capital Management paid out 100 percent qualified dividends for all of its funds in 2004, despite the semi-active nature of the PowerShares "enhanced indexing" strategy, which creates higher turnover in the PowerShares than in most traditional index funds.  PowerShares introduced its own dividend-focused fund in December 2004 - the PowerShares High Yield Equity Dividend Achievers Portfolio (PEY) - but it's too early to tell how the fund will fare on the qualified vs. unqualified dividend front. Most fund companies do not release data on whether fund distributions are qualified until year-end; Vanguard is the exception.

iShares spokesperson Lance Berg said that the rapid growth of the iShares family, combined with some degree of share lending, caused many of BGI's ETFs to pay out unqualified dividends.  Differences in the client mix between iShares and other fund companies may play a role too: SSgA, for instnace, has a strong background in institutional management, which may help it attract a more stable group of investors, while iShares captures the bulk of the retail and trader markets. 

Whatever the reason, the numbers are worth paying attention to, particularly for products where there is a highly competitive market.  While most funds paid out the majority of their income as "qualified dividends," a few turned in huge non-qualified payouts.  The iShares Morningstar Small Value Fund (JKL) paid out 48 percent non-qualified dividends, while the iShares Russell 2000 Fund (IWM) paid out 39 percent.  The StreetTracks Small Cap Value Fund (DSV) took the cake, though, paying out a whopping 79 percent of its dividends as non-qualified income! 

It's possible that the ratio of unqualified-to-qualified dividends will settle down as these funds mature, and as asset levels smooth out over time.  But it's also possible that the reverse will happen - especially if the market turns south.

Either way, in an era where investors scrap for the last ounce of return, and where one index fund manager recently told me he would "sell his mother for 10 basis points," paying attention to qualified dividends could pay off.

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