I mentioned this last year in my post 3 Reminders About Year-End Mutual Fund Distributions. I see the conventional wisdom “don’t buy a distribution” is still going strong. Vanguard reiterated this conventional wisdom in its blog post The record date: Not a tune you can dance to in early December.
But the conventional wisdom is wrong. I patiently waited until I can have a real life example.
After Vanguard published the blog post, Ella posted on the Bogleheads investment forum and asked if she should invest in two ETFs right away or wait until the ex-dividend date.
The ex-dividend date is the date when the investor will not receive the dividend. Not receiving the dividend means not paying the tax on the dividend now but paying a higher capital gains tax in the future. In effect, the tax is deferred, but not avoided.
Ella got the conventional wisdom answer from the forum participants: don’t buy a distribution; wait until the ex-dividend date. One of the replies came from Taylor Larimore. Taylor is a respected forum leader and the lead author of two Bogleheads books. On December 10, Ella decided to wait.
The two ETFs Ella asked about were Vanguard Total Stock Market ETF (ticker VTI) and Vanguard Europe Pacific ETF (ticker VEA).
On December 10, VTI traded between a low of $55.61 and a high of $55.97 a share. Let’s take an average and call it $55.79. The ex-dividend date for VTI is December 22. On that day, VTI traded between $56.30 and $56.59. Let’s take an average and call it $56.45.
If Ella bought VTI on Dec. 10, for every $10,000 she could have bought $10,000 / $55.79 = 179 shares. Those 179 shares were worth $56.45 * 179 = $10,105 on Dec. 22. In addition, she would also receive a dividend of $0.358 per share. That’s $0.358 * 179 = $64 in dividends. Together with a leftover $13 from the share purchase, Ella would have $10,182 in shares and cash if she bought on Dec. 10, versus $10,000 if she bought on Dec. 22.
The conventional wisdom market timing advice cost Ella $182 for the sake of deferring tax on the $64 dividend, which comes out to $10 at 15% qualified dividend tax rate. Giving up $182 to defer $10 is penny wise pound foolish.
The story on VEA is a little better. VEA’s ex-dividend date was December 24. Doing the same math shows Ella was worse off by $98 for the sake of deferring $34 tax.
Although the story “don’t buy a distribution” sounds credible, its base assumption “ignoring market appreciation/depreciation” is false. The market appreciation/depreciation is many times the size of the tax effect on distributions. It can’t be ignored. Worrying about the tax effect while ignoring the market movement is missing the forest for the tree leaves.
Of course someone can argue the market could’ve gone the other way and Ella would be better off waiting. But that’s precisely my point. Whether some one is better off waiting is determined by the market movements, not by buying before or after the ex-dividend date. Trying to be clever about the distribution and the ex-dividend date is unproductive in the face of market movements.
If an investor is going to time the market on the purchases, he/she should time on market movements, not on distributions and ex-dividend dates, because the former’s effect is a magnitude larger. Of course we all know one shouldn’t time the market. Therefore, don’t worry about the distributions and ex-dividend dates when their effect is just a tiny blip overwhelmed by daily volatility.
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The last paragraph is self-contradictory, isn’t it? I agree we should not try to time the market. Since the day to day volatility could go either way, the effect of waiting could be positive or negative, and is not predictable.. However the effect of “buying the dividend” is always negative. Over the long term, the market volatility will cancel itself out but the tax drain on the dividend favors waiting till the x-dividend date.
Harry Sit says
Over the long term, the market volatility will not cancel itself out because the market tends to go up more often than not. Waiting is timing the market.
@TFB – Yes that is true, assuming a longer time frame. I agree, waiting 6 months to buy ex-dividend is not a good idea, because as you say, over the long haul the market tends to go up. On the other hand, waiting “a few days” to buy ex-dividend is not timing the market, it’s just good tax practice. Over a very short period (day-to-day) the market is quite “random” or unpredictable.
I’m inclined to agree with waiting until an ex-dividend date. It’s a prudent strategy to reduce known costs (taxes, in this case).
But I also agree that the impact is probably pretty small. It would take a person to invest huge chunks of cash right before the dividend every year for thirty years to have any significant impact (I don’t know for sure, I didn’t do the math).
Harry Sit says
At the very least there should be a big warning that goes with this conventional wisdom: the benefit is really small while there’s a substantial risk you may miss a gain several times the size of your expected tax savings. If Ella had understood she could’ve given up $182 in order to defer $10, at least she would be making an informed decision. The Vanguard article and the Bogleheads forum participants did not warn her about this risk.
This is a good point to be made aware of, illustrated well with an example, but more should be said on how long before ex-dividend or what threshold of dividend yield matters. More often than not, you are doing a disservice to yourself buying before distribution and paying tax on the payout because typically the payout leads to a lower cost basis. The higher the dividend and closer to ex-dividend, the more likely the conventional wisdom is to be correct.
Heck, all my Vanguard ETF dividends got wiped out in the last half-hour of trading today anyway. Win some, lose some, some get rained out.
Thank goodness for my CDs. Mr. Market can’t wipe out my cash as he can evaporate everything else. Before you pooh-pooh CDs (and I admit rates are pathetic these days), 5 year CDs are nudging up towards 4% again. They are lagging the marked increase in the ten-year Treasury over the past month (whoh, nelly, a 65 basis point increase), but they’ll catch up (I hope).
Ladder, ladder, ladder.
4% is sort of my personal Maginot line, at least in my ladder. I had to settle for a renewal of a State Farm CD at 3.17% a few months back and I almost barfed. Since then, it’s gone down. While the ten-year has gone ballistic. Go figure.
This truly was the decade of fixed-income. With that, I can agree with Bill Gross of Pimco. I made so much money on my CDs I could almost puke.
I am sorry but I seem tio be missing something here.
What is the negative about getting a dividend? You have to pay tax on it, but you still make money, right? I am sure I am missing something big in this discussion. Any enlightenment will be greatly appreciated! 🙂
Harry Sit says
Arvind – Read the Vanguard article linked in the first paragraph. Conventional wisdom says if the market does not move at all, you can buy shares at a lower price on or after the ex-dividend date.