Avoid the Dividend Illusion
Dividend-capture funds aren't the place to look for yield, says closed-end fund strategist Mike Taggart.
Dividend-capture funds aren't the place to look for yield, says closed-end fund strategist Mike Taggart.
Christine Benz: Hi, I am Christine Benz for Morningstar.com. With yields as low as they are, investors are tantalized by anything that offers yield above the mid-single digits right now. But could one type of dividend paying fund actually be an illusion.
Here to discuss that is Mike Taggart. He is closed-end strategist for Morningstar.
Mike, thanks for being here.
Mike Taggart: Thanks for having me.
Benz: So Mike, you've recently written a couple of pieces about dividend capture funds, and I've gotten a couple of questions about them as well. Like to dig into, first of all, what these funds are purporting to do? What's the premise here?
Taggart: So, what these funds claim to do is they claim that they're going to invest the money in stocks, right before they pay a dividend, and then sell them shortly thereafter or sometimes up to 60 days, if it's trying to be tax advantaged, and by that they are capturing the dividend and passing it on to shareholders as a dividend.
Well, that doesn't work, to say the least, and this gets into finance, and I'm not the biggest efficient market hypothesis person. But if a stock is trading at $10, and it pays out a $1 in dividends, typically what happens is the next day the market adjusts for that, and the stock will open at $9 a share, because that $1 is gone. And that's kind of what is left unsaid in the annual reports of these seven funds that do this.
Benz: So, they've got very tantalizing dividend yields in some cases, but you are essentially saying they are giving with one hand and taking away with another because they are depressing investors' principal values along the way.
Taggart: Right. So what they are doing is, I mean I call it, they are laundering investors capital. They are taking investors' capital, they are laundering it through dividends, and then they are paying out the dividend, but the net asset value of the fund actually falls because, like I said, like just invested in a stock that was $10, today is $9; they pass on that dollar, and there is less capital left in the fund.
It doesn't work long-term. The total return is what investors should look for. And if you can find a fund that has good total return over the long term and a nice distribution rate, nice, what most people call, yield, that's a great thing. But these funds aren't the place to look for that in my opinion.
Benz: So, you highlighted another problem with them Mike, which is that, you've got high trading costs in some cases, so this dividend capture strategy involves a lot of moving around.
Taggart: They are turning over this portfolio. I mean one of the funds last year turned it over 2000%. So, that's like a two-week holding period on average. They're not long-term investments; basically, they're just flipping your money through dividend payments ... so you got these hidden costs from trades.
Benz: And those would not be reflected in any expense ratio. The other thing is you also noted that, it's a tax-inefficient strategy also?
Taggart: Right. So, with some close-end funds, 125 close-end funds out of the 620 have in the past year returned investors' capital to them. So, when you get your capital returned to you, tax wise you write-down the cost basis. So, if you invested in a fund at $20 and its returned a dollar's worth of capital, you don't pay tax on that dollar that you receive, you just write-down your cost basis. That's probably the only benefit of getting your capital returned to you.
With these funds, with these dividend capture funds, that dollar shows up as distribution, so it's just returning the capital laundered through a dividend mechanism, and the taxes on the dividends are taxed in this year. So, you get – typically, declining net asset value and you have to pay taxes on that distribution.
Benz: So, these funds aren't, I don't that any of them are called dividend capture funds, and they don't have red warning labels on them. So, if I am looking across the closed-end universe, how do I identify one of these funds? What are some red flag?
Taggart: So, one other things you want to look for is, just in general, a very high turnover rate. So, although that isn't true for all of the funds that do this. I think just in general, if your fund is demonstrating a very high turnover ratio than that, whether it's a dividend capture fund or not, you might want to have second thoughts about that fund.
Benz: Because of the trading cost.
Taggart: Because of the trading cost, right. Market-timing and that sort of thing, so long-term, how are they going to perform?
The other thing is like, these funds talk about – they are upfront that they do this in their annual report, it's not like they being shady. So, I would just always urge investors to read the annual reports, and if they have questions, or if something seems fishy, you call the fund company and if its too shady, then just pass on it and go look at something else.
But yes, I mean they all are very upfront that they do this strategy. I think the big problem in my mind for investors invested in these types of funds is that they don't understand what it is they're reading. You know it's a dividend capture strategy. That's fine. And then they just move on, they don't fully stop and say, well, what exactly is this fund doing to make me money?
Benz: And you also published a list of what you view is the main dividend capture funds along with your articles. So, that's available for users, too.
Taggart: They're not just the main users, they are the ones that – whose prospectus allows them to participate in dividend-capture strategy. Some of the funds that I looked of the seven, they seem to have that option, but they don't really use it at all, it doesn't seem.
But there is a First Trust Active Dividend fund, ticker symbol FAV, and that's only been around for a short time, but that's the one that had turnover issue of over 2000% last year. And then the Alpine funds, Alpine Global Dynamic Dividend and Alpine Total Dynamic Dividend, and then they have a real estate fund as well. They are the ones that are known in the industry as doing this sort of strategy.
Benz: Okay. Well, thanks so much, Mike. It sounds like you're saying focus on total return, don't get hung up on that current yields.
Taggart: Absolutely, investors need to focus on total return.
Benz: Okay, thank you for being here Mike.
Taggart: Thanks for having me.
Benz: Thanks for watching. I am Christine Benz for Morningstar.com.
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