Dividends and ETFs By IndexFunds.com Staff April 19, 2002

The structure of an exchange-traded fund can influence its returns, especially when it comes to dividends that companies pass on to shareholders. For example, SPDR 500, by far the largest ETF, is a unit investment trust (UIT). This type of structure distributes dividends to shareholders quarterly. The dividends must be held and cannot be reinvested in the underlying securities, which leads to negative index tracking error or "dividend drag." The underperformance may only be a few basis points, but that can have a dramatic effect over longer time periods.

The SPDR 500 is also the oldest ETF, and its UIT structure made it easier to manage when it first came to market. A UIT is considered an unmanaged fund, for example the fund doesn't require a board of directors. On the other hand, the iShares S&P 500 are structured like an open-ended mutual fund and can immediately reinvest dividends.

Since we haven't done it before on this site, perhaps a look at how dividends are paid by companies and handled by mutual funds would be helpful.

There are four dates to keep in mind:

1. Declaration date - The day company announces that it will pay a dividend.
2. Ex-dividend date - This day is 2 days before the record date. The day a stock begins to trade "ex" or without its dividend. This is the cutoff day for earning the dividend. Those who bought the stock by the end of the day the day prior to ex-date would be entitled to the dividend. Those who purchase on or after the ex-dividend date are not entitled to the dividend. When the stock begins to trade ex-dividend, the price of the stock generally drops by an amount approximating the dividend because the stock trades without it dividend. The stock trades without the dividend in the net asset value (NAV).
3. Record date - Two days after the ex-dividend date. This is the date you must officially own the stock to receive the dividend. The 2-day difference between ex-dividend date and record date is a function of the 3-day settlement cycle for stocks. Buying a stock on the day it goes ex means you will not have earned the dividend. In addition, since the settlement cycle is 3 days, your shares would not have settled until after the record date.
4. Payable date - The day the company actually pays dividends to shareholders.

An example:

A stock trading at $10 declares a $0.25 dividend on Friday. Monday morning the stock will trade without the dividend (ex-dividend). Absent any market movement, the stock can be expected to trade $0.25 lower because the dividend is no longer intrinsic in the price of the stock. Your intrinsic value of the stock is $9.75 and you have earned $0.25 in a cash dividend. Purchasing the security on Monday would result in a settlement date of Thursday. Since the record date would be Wednesday, you would not have earned the dividend.

Although there are trading strategies that seek to exploit dividend payments, David Rapozo, manager of ETF product and regulatory delivery at Barclays Global Investors, doubts they could work effectively.

"What I hear on the street is that people have dividend trading strategies," said Rapozo. "But unless you are looking for cash or an increased tax bill, there isn't any one strategy that I buy into. In my mind there is no trading strategy because the NAV already incorporates the dividend. The market immediately opens with that new information reflected in the price. I really don't think there is a game to jump into."

Dividends are distributed much like capital gains. Capital gains in mutual funds are generated for two reasons:

1. A mutual fund needs cash for shareholder redemptions. It sells some its winners - the fund must pass these gains onto shareholders.
2. REIT (Real Estate Investment Trust) securities generate capital gains. REITs themselves act much like funds and are required to pass through gains to shareholders. REITs pass on capital gains to the mutual fund that holds them, even if the fund doesn't sell the REITs.