We now turn to a July 2016 study, “Strategic Use of Dividend Payments by Mutual Funds.” The authors used a unique sample of open-ended Chinese mutual funds, the rationale being that these funds have flexibility in their dividend policies. This isn’t the case in the United States and many other countries, where mutual funds are required by tax law to ‘‘pass-through’’ essentially all investment income to fund investors. Thus, in the latter case, the amount of dividend a fund could pay largely depends on the composition of the fund portfolio.
The authors, Jun Xiao, Mingsheng Li and Yugang Chen, tested whether the Chinese funds pay dividends in order to either cater to investors’ demand for cash or to exploit investors’ imperfect rationality to serve the fund managers’ own interests. They note: “Unlike U.S. mutual funds, the Chinese open-ended mutual funds are very flexible in dividend policy because there is no such ‘pass-through’ rule in China. The main restrictions related to dividend distribution in China are that the net asset value after dividend distribution is no less than its book value and that the maximum amount of dividend to be distributed cannot be greater than either the undistributed gains or the realized undistributed gains.”
Their study covered the period 2003 through 2012. Following is a summary of their findings:
- Dividend yield is positively related to a fund’s post-dividend net cash flow. The finding was robust after controlling for various possible factors that affect fund inflows.
- Unfortunately, dividend yield was negatively related to future risk-adjusted performance in terms of both the CAPM (which uses the single factor of beta) and the Fama-French three-factor model (which uses beta, size and value).
- High-dividend-yield funds attract disproportionally more individual investors, who are prone to the behavioral preference for cash dividends.
- Funds that experience low inflows and smaller-sized funds are not only more likely to pay dividends, but they also pay higher dividends. In sharp contrast, funds that experienced high net cash flows in the past pay small dividends, suggesting that funds reserve dividend-paying capacity for the future and that they pay high dividends strategically when the funds suffer poor cash flows.
The authors concluded: “These results suggest that fund managers take advantage of the individual investor’s irrational dividend chasing behavior, thereby using dividends strategically to benefit managers at the expense of fund investors.” In other words, they prey on investors in order to benefit themselves.
A logical question that arises from the authors’ findings is: If high-dividend-paying funds underperform other funds, why do investors put more money into them? They speculate that this puzzling anomaly may be explained by the irrational behavior of individual investors. Later this week, we’ll review some additional research from the field of behavioral finance that seeks to explain the irrational preference among investors for dividends.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.