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.
The authors observed 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% and an annual turnover rate of more than 2,000%.
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.
Not unexpectedly, the authors 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 above 1.38 have turnover 11% higher (with a t-stat of 4.2). Funds with an excess dividend ratio above 2 have turnover 17% higher (with a t-stat of 4.0). In addition, juicers incur increased taxes, ranging from 0.6% to 1.5% 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.”
Juicing Drives Inflows
Despite the many issues with juicing, Harris, Hartzmark and Solomon found that funds with an excess dividend ratio greater than 1.38 received on average an additional 6.8% of inflows a year when compared with other funds with similar observable characteristics. An excess dividend ratio greater than 2 is associated with an additional 12.2% of inflows a year.
Furthermore, the authors sought to identify who bought funds that engaged in this bad behavior. The hypothesis would be that juicing must appeal to less-sophisticated, uninformed investors. Consistent with this expectation, juicing is significantly less likely for funds with institutional share classes (institutions are considered to be more informed).
In addition, dividends should be more valuable to investors with lower income tax rates, or to those who pay no income tax at all. Yet juicing is more likely to occur among retail funds, whose investors have a greater likelihood of paying income taxes on dividends when compared with institutional funds (which are more likely to have tax-free investors such as retirement accounts or charitable institutions).
Perhaps not surprisingly, given the less-sophisticated nature of their buyers, the authors also found that juicing is more common among funds with higher expenses (which further serve as a drag on returns).
Finally, the authors noted their results are consistent with investors who psychologically distinguish between consuming income produced by their assets and consuming the capital value of their assets. This is simply a labeling error (or a framing problem), and thus leads to irrational behavior. Unscrupulous mutual funds, however, cater (or pander) to unsophisticated investors, charging higher fees and delivering lower returns with less tax efficiency.
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.