At ETF.com, we love to explain why ETFs are better than mutual funds—tax efficiency, transparency, lower average fees, insulation from forced buying and selling and intraday liquidity make ETFs a fantastic choice for all types of investors.
We missed a problem. It’s time to add dividend reinvestment to the ETF trouble list.
For fund holders who want to reinvest dividends, mutual funds offer a true advantage. ETF holders have to wait at least four business days to put their dividends back to work. Then they have to buy new shares on the open market, piling up costs and risks:market volatility, spreads and premiums/discounts.
The Dividend Dance
Mutual fund investors can reinvest their distributions at net asset value, on the ex-dividend date. ETF shareholders have to wait for all transactions to settle until the cash hits their brokerage account.
This happens because mutual funds keep their own records, while ETF issuers rely on brokerage firms to track fund ownership. Therefore, mutual fund trades generally settle in one day, while ETF trades commonly take three days.
Settlement times affect the dividend-payout schedule.
Three Key Dates
Security issuers must follow a strict routine for paying dividends. It’s old school—very formulaic, very meticulous—and it’s all set up to make sure the right people get the right payments.
First, the issuer declares a dividend. They specify the dates and dollar amounts of upcoming distributions. Actually, they specify three dates:
- Record Date – Shareholders have to own the shares as of a particular date to receive the distribution. Brokerage records prove ownership, so issuers must follow brokers’ settlement rules to determine the record date.
- Ex-Date – The first day that anyone buying the stock can no longer become a shareholder in time for the record date, because any shares bought won’t settle in time for the record date. This is the date on which the share price adjusts downward to account for the dividend payment.
- Payment Date – The date that the shareholders of record will receive the cash in their brokerage accounts. This must be at least one day after the record date, but sometimes stretches longer.
Settlement Rules Create Gaps
There’s always a gap between the ex-date and the payment date, because settlement, record checking and payment processing take time. It takes custodians and brokers a few days to verify the cash payments, resolve ownership and deliver certification.
ETF record dates are generally two days later than mutual-fund record dates. This means ETF payment dates come two days later than mutual fund payments.
When Four Days Turn Into Eight
It gets worse:Issuers can sometimes extend this waiting period by adding days between the record date and the payment date. Check out the September dividend payment schedules for three top-yielding funds.
The SPDR S&P International Telecommunications Sector ETF (IST | C-62) went ex-dividend on Sept. 19, 2014, with the record date two business days later on Sept. 23, and the payable date delayed until Oct. 1—a full six business days later. That’s an eight-business-day delay.
The iShares Mortgage Real Estate Capped ETF (REM | B) most recently went ex-dividend on Sept. 24, 2014. The record date was Sept. 26, with payment two business days later on Sept. 30. That’s a speedy four-day delay.
The ProShares Global Listed Private Equity ETF (PEX | F) had the same ex-dividend and record dates as REM, but didn’t pay the distribution until Oct. 2, four business days later. That’s a six-day delay.
Brokerages Add Convenience, But Some Extend The Wait
Getting the cash from your ETF distribution is a good start, but you won’t have reinvested anything until you use that cash to buy more ETF shares.
Some brokerages, including TD Ameritrade, Vanguard, Scottrade, Schwab and, to a lesser extent, Etrade, offer ETF DRIPs—no-cost dividend reinvestment programs. This is very helpful for busy clients. Other brokerages, such as Fidelity, leave ETF dividend reinvestment to their clients.
Some firms will “DRIP” all ETFs, but others are more selective. Vanguard and Schwab will DRIP almost all ETFs; TD Ameritrade will reinvest dividends in all but the most illiquid funds. Scottrade reinvests dividends on “most” ETFs, but doesn’t handle fractional shares. Etrade will DRIP a few ETFs, but doesn’t make its list public, though it did tell me “most are not eligible.”
There’s variety in how long each brokerage firm waits to buy new shares with the dividend money. Vanguard reinvests dividends on the payable date, on the opening.
Etrade waits until it has confirmation that the cash has been deposited, which happens generally around 10 a.m. ET on the payment date. Schwab and TD Ameritrade wait until the following day, adding more price uncertainty. Scottrade pools dividend income and reinvests monthly or quarterly, executing at 2 p.m.
In a rising market, delays push the reinvestment price higher, so reinvestors buy fewer shares compared with what they could have gotten on the ex-date. Over the five years to Oct. 15, 2014, global equities rose 8.30 percent per year. On average, an eight-business-day delay would have translated to a 0.25 percent price rise.
With average dividend yields at 2.5 percent, an eight-day delay would have cost investors an average of 0.006 percent annually. For high-yielding funds like IST, REM and PEX, the impact would have been far higher—and that’s before you factor in trading costs.
Trading Is Never Free
The only way to reinvest ETF dividends is to buy shares on the open market. ETF traders must contend with spreads, premiums and discounts. Brokerage firms’ trades are regulated, so brokerage DRIP clients face additional hurdles.
As of Oct. 15, 2014, the median spread for dividend-paying ETFs was 0.14 percent. This means that an ETF buyer could expect to pay 0.07 percent above the midpoint between the bid and the asking price, on average. If the midpoint turned out to be above intraday net asset value (iNAV)—meaning the fund traded at premium—investors could wind up with a much less efficient execution than what they would get in a comparable mutual fund, if such a thing existed.
But that’s not all. If you trust your DRIP order to a brokerage firm, you lose your ability to work your order, which is to say, to pay less than the posted asking price.
You see, brokerage firms are strictly bound to not manipulate securities prices, so they’re essentially price takers. Although Schwab, Etrade and TD Ameritrade “work” their DRIP orders, they have to demonstrate they’re not setting market prices. Vanguard and Scottrade simply use market orders—they pay the asking price.
Market Order + Opening Bell = Trouble
The market opening can be a bad time for market orders, because sometimes ETFs trade roughly at the opening. Market makers posted wide spreads in IST right after the opening bell, as you can see from this chart, which shows the spreads on IST—the SPDR S&P International Telecommunications ETF—during the first hour of trading on Oct. 1, 2014.
That day, IST’s spreads took about four minutes to drop from 2.47 percent to 0.08 percent, before normalizing around the day’s average of 0.20 percent.
In total, 229 shares traded during that four-minute window—a few odd lots, and a 202-share block. Could the 202 shares have been Vanguard’s DRIP buys? After all, Vanguard buys its DRIP shares at the market open, using a market order.
DRIP Cost Example
Let’s look at the costs of reinvesting IST’s latest distribution, versus what the costs would have been for a hypothetical mutual fund version of the S&P International Telecommunications index.
IST went ex-dividend on Sept. 19. Its closing NAV that day was 26.45. On the Oct. 1 payment date, IST opened 3.74 percent lower, at 25.57. In this case, time was on IST investors’ side, but that’s the exception, not the rule. Over the past three years, IST gained an average of 0.50 percent between its ex-date and its payable date.
Next issue is spreads. IST has traded at a median spread of 0.19 percent in the year through Oct. 13, 2014. Since we’re analyzing an ETF purchase, rather than a round trip, we should count only half this spread—0.095 percent—as a DRIP cost.
Overall, for the past few years, reinvesting IST’s dividends has cost 0.595 percent versus what you would pay for a mutual fund tracking the same index. IST’s distribution yield has been 13.69 percent over the past 12 months. On an annual basis, this translates to 0.08 percent of dead-weight loss from DRIPs in the ETF structure.
Premiums Can Get Costly
Premiums and discounts add risk. IST’s spreads are not always centered around iNAV. On Oct. 1, 2014, IST’s bid/ask midpoint ranged from 1.31 percent premium to a -0.04 percent discount to iNAV, all in the first half hour of trading. After 10 a.m., all of IST’s underlying securities stop trading for the day, and iNAV becomes stale and irrelevant.
If those 202 shares of IST traded on the open were actually Vanguard’s DRIP buy, then, despite Vanguard’s reliance on market orders, its trader executed well, paying a mere 0.04 percent premium—that’s only 1 penny over iNAV. Still, that’s 0.04 percent more than mutual fund shareholders would pay, if such a fund existed.
Maybe Vanguard got lucky. Over the first half hour of trading in IST, when premiums and discounts are measurable, trades printed anywhere from a 0.67 percent premium for some odd lots, to a -0.16 percent discount.
Clearly, premiums add risk for DRIP investors.
Raising Cash, Raising Tracking Error
Mutual fund portfolio managers don’t necessarily have to raise cash to meet dividend payments. If their in-house records indicate that most of their distributions are slated for reinvestment, they can treat the distributions as an accounting issue—distributions “buy” new shares on the ex-date, no cash changes hands.
ETF portfolio managers don’t have that luxury. Because ETF issuers do not have to keep shareholder records, ETF portfolio managers have no idea what share of distributions will come back to the fund. Therefore, ETF portfolio managers have to make sure they have sufficient cash to distribute. This means they might have to sell some securities, possibly incurring tracking error, and definitely paying trading costs.
And that’s just what we see. Take a look at the table below, which shows the mean daily standard deviation for all nongeared equity ETFS, sorted by trailing 12-month yields. As yields rise, tracking error rises too.
|Yield||Average Tracking Error|
|0.00% to 0.99%||0.06%|
|1.00% to 1.99%||0.05%|
|2.00% to 3.99%||0.07%|
|4.00% to 4.99%||0.09%|
|5.00% to 5.99%||0.08%|
|6.00% to 6.99%||0.10%|
|7.00% and above||0.14%|
Data:ETF.com as of 10/15/2014
A Better Mousetrap
Mutual funds are really, truly better than ETFs for dividend reinvestment. Mutual funds’ ability to pay distributions in stock, rather than cash, creates a seamless investor experience that ETFs can’t mimic. Delays, spreads, premiums/discounts and tracking error get in the way.
But let’s be clear:ETFs are still a better mousetrap. ETFs offer greater variety of exposures, lower expense ratios, better index tracking, cheaper tax bills, daily transparency and better portfolio management than their mutual fund counterparts. The DRIP drag costs don’t change the equation, even for extreme cases like IST.
DRIP drag really matters in two instances:It increases the efficiency of nondividend-paying ETNs over their ETF counterparts; and it makes Vanguard’s mutual funds a better access vehicle than its portfolio-sharing ETFs.
At the time this article was written, the author owned no positions in the securities mentioned. Contact Elisabeth Kashner, CFA, at firstname.lastname@example.org .