What Is Dividend Drag?
Dividend drag is the negative effect of the dividend structure of a unit investment trust (UIT), or exchange-traded funds (ETF) without an automatic reinvestment program, whereby investors can't immediately reinvest their dividends. There is a time lag between when dividends are issued and when those dividends can be reinvested. If the share price is rising, this time lag can mean the dividends are reinvested at a higher price than if there was no lag. With mutual funds, there is no lag or drag.
- Dividend drag reduces performance when the share price is rising because dividends aren't reinvested immediately. The time lag means the dividends reinvest at a higher price than if there was no lag.
- Dividend drag affects unit trusts because of how they are structured. The dividends pass through an extra set of hands, which means it takes time for the dividends to get reinvested.
- Many brokers offer a dividend reinvestment plan (DRIP), but how quickly those dividends are reinvested depends on the structure of the ETF.
- Mutual funds don't have dividend drag.
Understanding Dividend Drag
Dividend drag affects shareholders if they choose to reinvest the dividend themselves, or if they instruct their broker to do it.
The structure of UITs delays dividend payments for days, and in a rising market the share price to reinvest at is constantly increasing. Without an automatic dividend reinvestment (DRIP) option for shareholders, it may take a week for the money to be reinvested. In the meantime, the price of the shares will have increased, and the same amount of money will buy fewer shares than if it had been immediately reinvested.
In a declining market, dividend drag is not an issue per se. Because the price is falling, the lag may result in being able to buy more shares with the dividend.
Dividend lag exists because UITs have more than one participant. With a mutual fund, the mutual fund company can take your dividend and immediately put it back into their fund. They control the process. With a UIT, the pooled assets are usually held with an investment bank, so the dividend is passing through an extra set of hands. This increases the time it takes to receive and/or reinvest the dividend.
Some brokers offer dividend reinvestment plans, while others do not. Whether the plan is offered or not, the structure of the ETF will determine if there is a lag in getting the dividend reinvested or not.
ETFs Without Dividend Drag
Dividend drag is a feature specific to UITs. Today, most ETFs are open-end management investment companies. Like UITs, management investment companies take several days to get dividends into the pockets of shareholders. Unlike UITs, management investment companies can elect to reinvest profits as opposed to issuing a cash dividend, thus eliminating dividend drag.
Management investment companies’ operating costs are higher than those of UITs, but their mutual fund-like structure allows for more flexibility. Investors should assess the quality of an investment in the context of their personal investment philosophy and unique life situation.
Does Dividend Drag Matter?
While dividend drag is enough for some investors to swear off UITs completely, they remain a popular investment product. In fact, some of the largest ETFs trading today are UITs. For many investors, dividend drag doesn’t count for much. Some find the net effect of dividend drag, while valid and measurable, still too small to matter, particularly considering all the other factors in evaluating a fund, such as index tracking, exposure, operating costs, and tax efficiency. Also, the drag is unfavorable in rapidly rising markets, but can be favorable in falling markets.
Real-World Example of Dividend Drag
The SPDR S&P 500 (SPY) ETF Trust is a unit trust. Imagine a dividend is paid of $1.56 per share. A unit holder owns 300 shares, and therefore will receive $468 in dividends on the dividend payment date. Assume that the share price on that day is $240.
The dividends would buy an additional 1.95 shares or units. Now assume that it takes several days to process the dividend and get it reinvested. The share price of SPY has moved up to $245. The $468 in dividends now only buys 1.91 units.
While this may seem like a small difference, if it happens multiple times, this will reduce performance. In this case, the investor paid 2% more for the shares than they would have without the time lag.
To offset this, the lag will sometimes result in a better price.