It has long been known that many investors have a preference for cash dividends. From the perspective of classical financial theory, this behavior 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 should favor self-dividends (selling shares) if cash flow is required. 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 (known as the “ex-dividend day”), collecting the dividend and then selling the stock afterward.