No Tax Or Income Justification
While fund manager behavior is consistent with an underlying investor demand for dividends, it cannot be explained by either taxes or the need for income. Funds can generate equivalent tax-free distributions by returning capital instead of acquiring and then distributing dividends.
Similarly, investors in individual stocks can generate self-dividends by selling shares. If investors sell shares, generating the same proceeds that a dividend would have paid, they will end up with an identical amount of dollars invested in the company’s stock as they would have had if they’d kept all of their shares and the company instead had paid a dividend. This occurs because the company’s share price would drop, reflecting the dividend that has reduced the company’s assets.
However, while distributing cash to fund shareholders is easy, such distributions can only be labeled as “dividends” if they correspond to dividends received by the fund on its underlying securities. As a result, mutual funds must hold dividend-paying securities in order to pay out dividends themselves.
There are two ways a mutual fund can meet investors’ desire for large dividend payments. Either it can buy high-dividend-yield securities, or it 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 (known as the “ex-dividend day”), collecting the dividend and then selling the stock afterward.
Uncovering The Juicing
The authors noted that a few funds actually advertise their juicing behavior. In 2010, Morningstar identified an illustrative list of seven funds that explicitly describe a juicing strategy in their prospectuses. The properties of these funds are sometimes quite 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 percent and an annual turnover rate of more than 2,000 percent.
Since mutual funds are not required to report every trade, the existence of a dividend-generating trading strategy must be deduced through indirect means.
The authors were able to infer the total dividends that a fund received based on the dividends distributed to shareholders, and then comparing this total to the dividends the fund would have received based on reported quarterly stock positions. If funds trade without regard to dividend ex-dates, the total implied dividends from quarterly reports should be an unbiased estimate of total actual dividends received.
Funds paying substantially higher dividends than indicated by their holdings are likely the juicers. Note that funds must hold stocks for at least 60 days for dividends to be considered qualified, and thus receive preferential tax treatment (qualified dividends are taxed at a lower rate than the ordinary income tax rate).
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. When funds have a high excess dividend ratio, the average time to the next dividend for reported holdings is lower than for similar funds, and their turnover is higher.
Not unexpectedly, the authors also found that juicing is costly to investors through higher trading costs (commissions, bid/offer spreads and market impact costs). They found that funds with an excess dividend ratio of above 1.38 have 11 percent higher turnover (with a t-stat of 4.2). Funds with an excess dividend ratio above 2 have 17 percent higher turnover (with a t-stat of 4.0).
In addition, juicers incur increased taxes, ranging from 0.6 to 1.5 percent of fund assets per year. And this assumes that all dividends are qualified.
The implication is striking: “Investors who seek an income stream are better off creating it by selling fund shares than by investing in a fund that juices.” Note that there may be no cost to selling mutual fund shares as they trade at their NAV. If capital gains result from divesting shares, only the gain is taxed, not the full proceeds (as is the case with dividends).